New DB funding code should focus on transparency

In its 2020 consultation, the regulator assumed that covenant strength and excess investment return should continue to be reflected in discount rates but invited other views. 

TPR floated an alternative approach, in which the technical provisions of all schemes would be set assuming low dependency on the employer, with asset outperformance allowed for in the recovery plan. 

Under either approach, we consider it key that there is a transparent relationship between covenant, funding and investment strategy. 

We consider it key that there is a transparent relationship between covenant, funding and investment strategy

Currently, technical provisions vary depending on covenant strength. With a further consultation on the way, there are benefits to considering alternative frameworks and how their advantages could be captured. 

In view of this, we set out how theoretically schemes could allow for covenant in the recovery plan rather than in technical provisions.

What would an alternative approach look like?

The alternative approach would allow for a measure common to all schemes, meaning greater transparency and comparability. 

With liabilities measured on a consistent basis, the regulator, trustees and members could look at any scheme and see where it is on its journey to low dependency. 

As a consequence, fewer schemes would present as fully funded. Most would need a recovery plan, but there would be greater understanding that the deficit could be removed by investment outperformance rather than just additional contributions. The stronger the covenant, the more risk that could be taken in the scheme’s investment strategy. 

Risk management would be more easily integrated. Investment risk could be monitored against the strategic plan, and this would give trustees increased freedom to invest in a more aggressive manner for tactical reasons if they had suitable downside mitigation and/or covenant support in place. 

Many trustees already invest in this way, aiming to accelerate their journey to their long-term funding target. The alternative approach would support this.

The regulator proposes to require schemes to demonstrate at each valuation how technical provisions link to the long-term objective of low-dependency funding. 

Under this approach the need for this additional step would go away, thus simplifying regulatory compliance.

The downside of the alternative approach is that the scheme’s disclosed liability figure will tell us nothing about the sponsor covenant. 

Two schemes may have identical disclosed funding positions despite being in very different predicaments due to the position of their respective sponsors. Therefore, one compromise could be for schemes to disclose this consistent measure alongside technical provisions set allowing for covenant.  

A fresh perspective on covenant

A new code of practice could be an important step in revitalising the way that sponsor covenants are understood. 

Covenant risk can be difficult to explain to scheme members, who are not always actively engaged. A more transparent approach would make it clearer to members how their benefits depend on the employer.

Covenants should be incorporated in scheme funding in a way that reflects the variety of sponsor business models while incentivising resilience to business risk. 

Many long-standing companies have fallen victim to changes in their markets, a trend that has only accelerated due to the impact of the coronavirus pandemic. 

The regulator’s first consultation talked about limiting “covenant visibility”. This is difficult to define and very employer-specific — it cannot be driven simply by management processes.

Covenant visibility is greater for a stable business with long-term contracts doing a 12-month forecast, than it is for an aspirational business with a five-year plan.

There may be questions of definition if scheme covenants were to be reflected in recovery plan outperformance, rather than technical provisions. This could lead to statutory recovery plans extending beyond the contribution period.

Any time limit on covenant reliance should therefore apply to the contribution period under the alternative approach, not the period over which outperformance is assumed.

Transparency builds resilience

By making the allowance for covenant more transparent, the regulator could simplify the scheme funding process. Greater transparency would also allow for a fresh perspective on scheme covenants and encourage the industry to look at funding through a different lens.

Recent events have shown the unpredictable nature of economic risk. The industry needs to work together to make DB schemes more resilient to future crises.

A more transparent approach to scheme funding could be an important step on this journey.

Sarah Brown and Andrew Horner are senior consulting actuary and covenant consultant, respectively, at Buck