Out-Law News 3 min. read

UK pensions regulator proposes new approach to DB scheme funding

Golden Egg Closeup - pensions

The Pensions Regulator (TPR) is consulting on proposed principles for the funding of UK defined benefit (DB) pension schemes as part of plans to revise the statutory code of practice.

The consultation proposes a 'twin track' approach to scheme valuations, depending on whether they opt for compliance with prescriptive regulatory guidelines or additional flexibility. Trustees would have to set a long-term objective (LTO) for the scheme, based on reducing dependency on funding from the sponsoring employer as the scheme matures and the majority of its members retire, as well as a 'journey plan' setting out how they will reach the LTO.

The consultation closes on 2 June. It will be followed by a second consultation later this year, which will focus on the draft code of practice itself. TPR expects the revised code to come into force towards the end of 2021.

Pensions expert Stephen Scholefield of Pinsent Masons, the law firm behind Out-Law, said: "The consultation has been well trailed, and is largely as expected".

Scholefield Stephen

Stephen Scholefield

Partner, Head of Pensions & Long-Term Savings

Underlying the new approach is a requirement for greater transparency, especially around how risk is managed as a scheme matures.

"The two track approach for 'fast track' or 'bespoke' valuations should allow the regulator to better focus its efforts, which should be welcomed by all concerned," he said.

"Underlying the new approach is a requirement for greater transparency, especially around how risk is managed as a scheme matures. For many schemes, this will simply require them to articulate what they already do – but for others, it could result in a more structured approach to risk, which could lead to increased deficit contributions and shorter recovery periods," he said.

TPR is revising its DB code to reflect measures being introduced by the Pension Schemes Bill, which is currently before the UK parliament. DB schemes, which include 'final salary' schemes, are those that promise a set level of pension once an employee reaches retirement age, no matter what happens to the stock market or the value of the pension investment. Many of these schemes are now closed to new members, or closed to future accrual.

The proposed requirement for schemes to set an LTO reflects a new legal requirement for trustees to set a funding and investment strategy, to be introduced by the Pension Schemes Bill. TPR has proposed that trustees be required to identify a scheme-specific LTO based on full funding, low employer dependence and investments highly resilient to risk by the time the scheme is "significantly mature" - around 15 to 20 years from now for the average scheme.

Trustees would be required to develop a 'journey plan' to achieve their LTO. The technical provisions (TPs) needed to pay pension benefits as they fall due should be calculated in a way that is consistent with that LTO, and should ultimately converge to the LTO over time. Trustees would be expected to plan for investment risk to decrease as their scheme matures and reaches low dependency on the sponsoring employer.

TPR is consulting on the extent to which the employer covenant – the employer's legal obligation and financial ability to support a DB scheme now and in the future – should remain an aspect of the funding regime, including how it should be assessed and how much reliance should be placed on it. It is also seeking views on what reliance should be placed on contingent assets, employer guarantees and alternative forms of support, as well as what characteristics this support should have in order to be recognised for funding purposes.

Investment risk borne by the scheme should be supportable. TPR is seeking views on how trustees would be able to demonstrate whether the risks in their investment strategy are supported, for example by stress testing. Where a funding shortfall arises, recovery plans should be appropriate in both length and structure based on employer affordability. TPR may expect the employer to reduce payments elsewhere, such as shareholder dividends, in order to fund an appropriate recovery plan.

A more straightforward, but prescriptive, 'fast track' regulatory approach would be available to trustees who can demonstrate that their scheme valuation meets "objective and quantitative" funding and investment compliance guidelines. Trustees which use this route can expect to have to provide less evidence, and for their valuation submission to receive less regulatory scrutiny. TPR is expecting the fast track route to benefit well-funded, well-managed and smaller schemes.

Schemes which cannot, or which choose not to, comply with the fast track would be able to submit their valuation, along with supporting evidence and explanation about where and why they have differed from the guidelines and how any additional risk is being managed. TPR stressed in its consultation that this 'bespoke' route is not intended as a "second best" option, and that both approaches would be equally compliant with the legislation if done correctly.

TPR is also seeking views on how its funding principles should be applied to open schemes, based on a general principle that accrued benefits for members of open schemes should be as secure as they would be in a closed scheme.

TPR's executive director for regulatory policy, David Fairs, said: "We want to make sure pensions have the necessary long-term approach to ensure savers get the benefits they expect".

"With most DB schemes closed to new members or future accruals, we can expect them to be significantly mature in 15 to 20 years' time, with the majority of their members retired. These schemes will be more vulnerable to risks associated with poor funding levels and shorter investment horizons. Therefore, trustees should aim to reduce their scheme's reliance on the sponsoring employer as they mature," he said.

"We want to be confident our expectations are effective and appropriate for trustees and in turn the savers in these schemes," he said.

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