Funding Defined Benefits

Introduction

TPR published its promised consultation on DB scheme funding on 2 December 2013, setting out the principles for DB funding and how TPR plans to regulate it.

A new code of practice and other documents look forward to the new affordability objective for TPR included in the Pensions Bill 2013, which we expect to receive Royal Assent in late spring 2014. As currently drafted, TPR’s new objective is to minimise any adverse impact, when exercising its scheme funding functions, on the sustainable growth of an employer.

Key points

There are 9 key funding principles set out in the draft code, universally applicable to all schemes
The draft code places a new emphasis on balance – recognising that a strong ongoing employer alongside an appropriate funding plan is the best support for a well-governed scheme
TPR aims to lay the code before Parliament in May 2014, with it coming into force in July 2014. We anticipate that the new affordability objective in the Pensions Bill will come into force at the same time
TPR says it would “urge” trustees and employers completing valuations between now and July 2014 to bear in mind the messages in the code

What documents have been published?

The suite of draft documents on scheme funding which have been published are:

the consultation document, Regulating defined benefit pension schemes
a draft code of practice on funding defined benefits
a defined benefit funding policy
a defined benefit regulatory strategy.

TPR will continue to publish an annual funding statement.

Key funding principles

There are 9 key funding principles in the draft code. These are:

working collaboratively – trustees and employers should work together in an open and transparent manner to reach funding solutions that recognise the needs of the scheme and the employer’s plans for sustainable growth
managing risk – trustees should implement an integrated risk management approach in relation to employer covenant, investment and risks (including setting clear triggers for action)
taking risk – where trustees take risk they need to be “confident” that the employer can mitigate any adverse outcomes
taking a long-term view
proportionality – trustees need to act proportionately bearing in mind the scheme’s size, complexity and circumstances
balance – as this is a key new principle we consider it in more detail in the next section below
well-governed – trustees should adopt good governance standards
fair treatment – trustees should seek to ensure that the scheme is treated “fairly” amongst the competing demands on the employer
reaching funding targets – having agreed targets, trustees should aim for any shortfall to be eliminated as quickly as the employer can reasonably afford.

Balance

The draft code explicitly recognises that a “strong, ongoing employer alongside an appropriate funding plan is the best support for a well-governed scheme”. The concept of balance focuses on achieving a balance between the needs of all parties. TPR’s view is that this is best accomplished by the trustees and employer working collaboratively in an open and transparent manner.

In order to achieve balance, trustees will need to assess and have a good understanding of the employer’s position and plans. Trustees should also be prepared to use flexibilities within the system to reflect the employer’s circumstances and to minimise the adverse effect on the employer’s sustainable growth, where this does not compromise the needs of the scheme. On the other hand, employers should recognise their role in underwriting the risks the scheme is running.

Monitoring schemes

TPR has developed a risk assessment tool, called a Balanced Funding Outcome (BFO) indicator. The BFO indicator does not set a minimum level of funding or contributions but provides a model for the characteristics of what a BFO for an individual scheme might look like.

The BFO indicator takes into account the strength of the employer covenant and the scheme’s needs to enable TPR to assess the level of risk associated with the scheme. But it will not take affordability into account.

To enable it to develop an initial high level and consistent view of the appropriate outcome for schemes with certain characteristics, TPR has decided to segment the DB universe by reference to covenant strength. In the future, TPR will use 4 broad categories – covenant grades 1-4, where 1 is strong and 4 is weak.

Intervention by TPR

Distance from the BFO will be TPR’s “primary indicator of risk”.

But not all schemes identified through the risk indicators will be the subject of regulatory intervention. Scheme selection will be informed by the “risk bar” for intervention. TPR says that the factors it will take into consideration in setting the risk bar are:

the shortfall compared to the BFO indicator
the size of the scheme’s liabilities
the potential impact of any intervention and
TPR’s overall resources.

Transitional issues

TPR aims to lay the code before Parliament in May 2014, anticipating that it will be in force in July 2014.
Trustees and employers completing a valuation between now and the date the code comes into force should “bear in mind” the messages in the code.
The 2014 annual funding statement which applies to schemes with effective dates from September 2013 to September 2014 is due to be published in spring 2014. This statement will set out a BFO indicator and will set the risk bar for TPR interventions.
The new funding policy will apply to recovery plans submitted after the 2014 annual funding statement.