Funding defined benefits – response to consultation

Background

TPR issued a consultation on DB scheme funding on 2 December 2013. The suite of draft documents on scheme funding are:

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

General comments

In general, the draft code of practice is a well considered and practical explanation of the statutory principles in Part 3 of the Pensions Act 2004. We appreciate that a lot of hard work has gone into setting up a framework that is both transparent and has the potential to be adaptable to changes in the DB universe.

We note that, based on our experience of clients’ discussions on scheme funding with TPR in the last few years, the draft code appears to us to represent the expression of existing policy rather than a major change to policy in this area. This is of course in keeping with the legislative framework which remains the same – subject of course, to the new objective for TPR.

We consider the biggest departures for schemes in the code are the new concepts of balance and collaborative working and of reasonable affordability. For TPR, the new elements for risk management for TPR in the code such as the Balanced Funding Outcome (BFO) Indicator are, in general, well thought out and practical.

We note, at the outset, that as well as meeting the requirements set out in Part 3 of the Pensions Act 2004, trustees must operate in accordance with general trust law principles.

At present the consultation document (p. 5) makes it clear how the documents fit together to regulate DB funding. It would be useful for this information to be repeated in the code or on your website after the code is finalised.

Unusual cases

By its nature, the code and policy only deal with the more unusual cases on DB scheme funding.

Schemes which are well funded and those multi-employer schemes with non-associated employers are key groups which are not well catered for in the code. We understand that the code cannot deal with every circumstance but it would be helpful to have further information on these key groups in the DB universe, based on experience gleaned from proactive or early engagement over the last few years.

For other more unusual outliers, a simple statement that TPR will deal with these cases based on the principles set out in the code in a fair and proportionate manner would be helpful.

Covenant assessment

One of the main areas where we consider the focus has shifted from current practice, is TPR’s expectations of what is appropriate in relation to covenant assessment.

There is a much greater focus on formal covenant assessments in the draft code rather than previous guidance. For example, the draft code (paragraph 71), states that “trustees should seek professional independent analysis and advice across the employer covenant, investment and funding strands”.

Earlier guidance from TPR suggests that covenant assessment may be done by the trustees themselves. In particular, we note that TPR’s guidance on monitoring employer support, published in 2010, appears to allow a much more flexible approach to covenant monitoring than that indicated by the draft code (in paragraphs 77-88). Some clients are keen to retain this flexibility, as they consider they have the appropriate skills on the board to assess covenant and are best placed to do so given their knowledge of their sector.

Covenant assessment is one part of the actuarial valuation process (though not a statutory requirement) but has added significance for TPR as we note that TPR will use covenant as part of its risk management process. This will be accomplished by segmenting the DB universe into 4 covenant grades – strong, tending to strong, tending to weak and weak. We wonder whether the focus on covenant assessment may have been given undue prominence in the code as a result of this segmentation.

We further understand that TPR will not disclose to individual schemes where they fall on this broad spectrum which may cause concern for some schemes and does not assist transparency.

Reasonable affordability

Forming part of the covenant assessment considerations, the new concept of reasonable affordability is dealt with extensively in the draft code. This is driven by the introduction of a new objective for TPR (in the Pensions Bill 2014, but not yet finalised). But we consider that the level of responsibility to investigate reasonable affordability placed on the trustees by the code is hard to justify legally.

It seems to us that some of the requirements, such as the requirement for trustees to understand fully the nature of any investments made by the company (specified in paragraph 95), may go beyond trustees’ legal duties under trust law or under Part 3 of the Pensions Act 2004.

Further, trustees may feel that TPR will not take their views into account in relation to reasonable affordability. For instance, the code specifically refers to the need for trustees to consider of whether dividend payments are “in line with industry norms”, but this could lead to a divergence of views between the employer and trustees and/or the trustees and TPR. This illustrates neatly the key issue which is that the objective, as drafted, applies specifically to TPR, not to scheme trustees. Therefore, a natural tension can arise between the trustees’ considerations when making decisions and those of TPR’s when assessing those decisions. It may be helpful to make specific reference to this, in either code or policy document.

In addition, it may be difficult to accurately assess affordability because of the confidential nature of the information required to undertake this assessment. Of course, the confidential nature of information has always been an issue in relation to all covenant assessment but this type of enquiry will necessitate a further and more in depth consideration of a company’s future plans which is more likely to include protected price sensitive information. We have a number of clients who are concerned that confidentially agreements are insufficient to protect a company against a leak of this type of information.

Placing the responsibility on the trustees to act as a policeman on this issue may impact on the good working relationship, or collaborative working, between trustees and company which has been placed at the heart of the code.

BFO indicator

The Balanced Funding Outcome (BFO) indicator is a new concept for schemes but, we understand, has been in development at TPR for some time and will be used to assess schemes in tranche 8 onwards. It has obviously been thought through carefully in order to deliver to TPR a measurement on which to base scheme interventions, as TPR has moved away from setting triggers.

However, as the BFO indicator is set by TPR, it is not necessarily an objective measure of performance and may change over time. Setting the BFO indicator is, of course, constrained by TPR’s requirement to act in a fair and proportionate manner.

We suspect that schemes will wish to try to establish where they will appear in relation to the BFO. We understand that certain information about the BFO will appear in the annual funding statement but details of a specific scheme’s BFO will not be given to schemes unless the scheme is one of the 200 schemes per year selected for further investigation.

However, we do think it would be helpful if TPR could publish information on the BFO indicator in an easily accessible format – either by production of scattergrams (in the form given on page 45 of the policy document) for each of the 4 covenant segmentation grades and/or by scheme maturity, or by readily understandable formulas.

Proper understanding of the BFO and TPR’s expectations will be crucial for trustees when making decisions. Although we note that the BFO indicator will not take account of affordability, and so this will remain a key variable from the BFO.

Integrated risk management

We appreciate that TPR has taken a lot of effort to try to reassure trustees that a new approach or product is not necessary to meet the requirements to integrate the management of risks to the scheme.

However, we do think it would be helpful if, based on experience of proactive or early engagement, TPR could set out examples of the ways in which trustees of each of the four segmented covenant groups could meet this requirement. The most helpful way of addressing this would be to expand paragraphs 59-60 and 101-105 to include this information by way of case studies, including examples of contingency plans. These case studies should reflect trustees’ legal duties and as such would help trustees understand what is required of them in relation to contingency planning.

Cost of compliance

The costs of compliance with the code for many schemes could be considerable. Unfortunately, the costs of compliance are likely to be highest for those schemes which can least afford it.

Costs of covenant assessment and risk management are both areas which are likely to rise after the implementation of the code. In addition, we have seen that the costs of responding to TPR queries on both the early engagement programme and on the delivery of the valuation documentation can be considerable due to the number of questions raised and/or the quantity of documents sought.

There is no impact assessment provided but we assume that it is necessary for TPR to apply the considerations of proportionality to the further investigations it undertakes. It would be helpful to have a statement in the code to this effect.

Double counting

We note that TPR has made further reference to double counting in the code, following its October 2013 Statement on double counting. We consider that there may be circumstances in which double counting could be appropriate and would be grateful if you could consider revising paragraph 167 accordingly. We can provide examples on request.

Transitional provisions

We understand that the draft code is likely to be in force in July 2014, with TPR aiming to lay the code before Parliament in May 2014, and “will apply to schemes undertaking valuations from that time”. We understand that the new affordability objective in the Pensions Bill will come into force at the same time. The first main tranche of valuations the new rules will apply to in full are those at the 2014 year end.

But the transitional provisions (set out on page 15 of the consultation document) state TPR would “urge” trustees and employers “completing their valuations” between now and July 2014 to bear in mind the messages in the draft code. These statements lack clarity. Does this mean that TPR will expect trustees to implement some of the key messages, such as developing an integrated risk management plan, ahead of the coming into force date? Many trustees will be in the final stages and it will not be cost effective to go back and revisit decisions already taken and documents finalised.

The new funding policy will apply even earlier for recovery plans. The transitional provisions say that it will apply to recovery plans submitted after the 2014 annual funding statement (no date is specified for this statement, but the last annual statement was in May 2013). Given that schemes have 15 months from the effective date to submit documents, including the recovery plan, to TPR this means that schemes with effective dates dating back to March 2013 (and possibly even December 2012 in certain cases) will have to abide by the new policy.

We assume that TPR will be applying its overriding principles of proportionality and fairness to schemes which fall within the transitional provisions. It would not be reasonable in our view for TPR to penalise trustees for meeting previous requirements but failing to meet the standards required under these transitional provisions.