Consultation on the defined benefit funding code of practice – Sackers’ response to consultation

Background

The Pensions Regulator (“TPR”) is consulting on a revised defined benefit (“DB”) funding code of practice in two parts. This response relates to the first part of the consultation, which considers:

• TPR’s proposed approach to the new code
• the key principles TPR proposes should underpin the new code, and
• options for how these principles could be applied in practice through more detailed guidelines.

In this response

• General comments
• Responses to specific consultation questions / Chapters of the consultation

General comments

We welcome the opportunity to comment on TPR’s proposals in relation to the DB funding code of practice.

Given that much of the consultation is focused on actuarial and investment matters, we have not sought to answer every question in the consultation. Instead, we have limited our responses to those areas which are pertinent to our practice area, or which we believe could give rise to difficulties in practice for our clients.

Chapter 3 – Proposed regulatory approach

Do you think twin-track compliance is a good way of introducing objectivity into a scheme-specific regime? What are your views on the proposals set out above? If you disagree, what do you propose instead?

1. The scheme funding legislative framework

As noted at paragraph 44 of the consultation document, the scheme funding legislation prescribes a “scheme-specific” regime, it “does not prescribe a single funding standard that must be adopted by all schemes”. It is acknowledged in paragraph 44 that the revised code “will need to strike a balance between clarity and maintaining the scheme-specific regime”.

We agree that there needs to be very careful thought as to how the objective standards being proposed in the consultation can achieve the necessary balance with the scheme-specific regime. Whilst it is open to schemes to use the Bespoke route to ensure a scheme-specific approach, the proposals for the Fast Track route, and the encouragement of schemes to use that route, could be seen as a move away from the regime intended by Parliament.

2. Fast Track or Bespoke

The March 2018 White Paper (on protecting DB pension schemes) recognised that most schemes are well-run and already apply good practice in relation to managing their funding, investment and covenant risks. However, TPR also sees “a range of bad practice from poor risk management to inappropriate use of the flexible scheme-specific regime” (paragraph 34).

Schemes using the Bespoke route will be required to provide additional evidence and will be subject to further scrutiny from TPR (paragraph 56). In our view, well-governed schemes with more sophisticated funding and investment arrangements may well be drawn to the Bespoke route, raising the possibility of TPR’s valuable resource sometimes being spent on the “wrong” schemes. We assume that TPR is alive to this possibility and, where appropriate, that the Bespoke route will allow sufficient flexibility for TPR to be proportionate in its regulatory approach.

One of the main aims of the proposals is also to focus on the smaller number of non-compliant schemes. There may be instances where such schemes could be drawn to the Fast Track route because of its clarity and simplicity, or (albeit less likely) in order to avoid closer regulatory scrutiny. The parameters TPR ultimately sets (and how much wriggle room they allow) will therefore be key in helping to raise compliance standards.

Clearly, and no doubt TPR are fully aware of this, there is a careful balancing act required here between two possible extremes. Put in place a tough and highly prescriptive set of Fast Track requirements, and that is likely to drive schemes to Bespoke. Alternatively, introduce a Fast Track regime with lower standards which will enable TPR to concentrate on “outliers”, but which might not achieve the enhanced member security ultimately sought.

3. The trustees’ negotiating position

As TPR will be aware, some funding discussions between employers and trustees can be hard-fought. The standards set under the Fast Track could influence trustees’ negotiating position where they are pursuing the Bespoke route.

For example, if the Fast Track is set at too weak a level, this could undermine the trustees’ negotiating position when pursuing a more robust valuation under the Bespoke route. Even where the Fast Track standards are set quite high, it could tie the trustees’ hands. For example, where an employer proposes an approach that falls within the Fast Track, it could make it more difficult for trustees to then negotiate a Bespoke arrangement, even where they believe it is in members’ interests to do so.

4. Responding to changing circumstances

The impact of COVID-19 has highlighted the need, in certain circumstances, for schemes and employers to be able to react quickly and flexibly on funding arrangements. The degree of flexibility which the Fast Track will allow needs to be weighed up against that backdrop, as well as the future economic uncertainty.

5. Enforcement

We await the second part of the consultation to see details of proposals on enforcement of the new framework. As a general point, TPR may want to consider whether there are certain cases where it would be helpful for TPR to be involved in funding discussions earlier in the process, rather than after funding arrangements have been agreed, and how that could be best achieved.

Chapter 12 – Open schemes

This Chapter looks at the application of the Fast Track route to open schemes.

From discussions with clients who operate open schemes (ie open to both accrual and new joiners), we believe there is industry concern that the proposals could contribute to the closure of such schemes. This is because TPR would potentially have limited scope to adopt a different approach for them when implementing its proposals. This will not be beneficial for members, in particular, where there is a strong employer supporting the scheme and good governance in place.

The specific considerations and concerns for open schemes were identified in an amendment to the Pension Schemes Bill proposed by the House of Lords (Clause 123 of the draft Bill as at 16 July 2020). If enacted, this amendment will require the Secretary of State, in exercising scheme funding powers, to ensure that:

• “schemes that are expected to remain open to new members, either indefinitely or for a significant period of time, are treated differently from schemes that are not”, and
• “the closure of schemes that are expected to remain open to new members, either indefinitely or for a significant period of time, is not accelerated”.

No doubt, TPR will be considering how its proposals align with these considerations. Again, this will require careful balancing. Therefore, when it comes to implementing the new code in practice, presumably TPR will recognise the very different status of genuinely open schemes. We assume that TPR will take a suitably risk-based and proportionate approach, reflecting that open schemes are not just different in investment risk but in profile of membership and maturity (often being used as auto-enrolment vehicles), covenant strength and employer / employee expectations. This flexibility, and the various differentiation factors being specifically recognised in the code, would fit with the White Paper of 2018 which stated that the scheme funding regime should balance “the needs of sponsoring employers with essential protections for members”.

Now, more than ever, TPR needs to be attuned to the reality of the world open schemes sit in and that they do differ from closed schemes. As it asked for help with open schemes, we suggest this sort of explanatory outline in the code would help.

Responses to specific consultation questions / Chapters of the consultation

6. Question 4a – Covenant assessment

Whilst this is not a legal question, we wonder about the practicality of introducing a prescribed, formulaic approach to assessing employer covenant, as opposed to retaining a holistic approach. Our concern about the formulaic approach centres around how the increased focus on cash flow will work.

The strength of any employer’s cash flow is constantly fluctuating, making it extremely difficult for trustees to monitor and pinpoint on a day-to-day basis. We assume that any requirement built around the need for trustees to assess “the employer’s forecast reasonably affordable cash flows” would take account of this.

7. Question 5 – Reliance on indirect covenant

We agree with the suggestion at paragraph 132 of the consultation document that reliance on other entities should be underpinned by some form of legal recourse that is directly enforceable by the trustees.

8. Question 13 – Broad consistency between investment and funding strategy

It would be sensible for schemes’ investment strategies to be broadly consistent with the level of current and future investment risk assumed in the funding strategy.

9. Question 16 – Use of additional support

We support the use of additional support, such as contingent assets and guarantees, as part of the scheme’s funding arrangements. If this is not allowed as part of the scheme’s funding arrangements, the risk is that employers could be tempted to withdraw support which is already in place (unless it counts for Pension Protection Fund (“PPF”) purposes).

The checks and balances referred to in the consultation (ie that the support is sufficient for the risk being supported, appropriately valued, legally enforceable and realisable at its necessary value when required) are all sensible. They are also in keeping with the conditions for recognising contingent assets set by the PPF.

10. Question 25 – Other assumptions for Fast Track low dependency basis – prudence

In deciding whether assumptions should be set on a “best estimate” or “prudent” basis, broader trustee duties (for example, to invest as a prudent person) would need to be kept in mind. Trustees must be comfortable that they are satisfying both their regulatory and trust law duties.