How the DB code's employer growth objective affects scheme funding

By putting the employer covenant at the centre of any scheme’s decision-making, the regulator’s new code is essentially crystallising current best practice and encouraging trustees to adopt an integrated approach to risk management.

This decision-making and planning structure makes complete sense, as the covenant is the main driver of risk in the pension scheme.

Investments can underperform, life expectancy can increase, the funding position can worsen – but the only circumstance in which members do not get their full benefits is if the company can’t weather these negative experiences.

The code has been updated to take account of the regulator’s new statutory objective to minimise the impact on the sustainable growth of the employer. 

An imperfect world

We do not, however, live in a perfect world and, according to a recent statement from the regulator, only 20 per cent of sponsoring employers in the UK have a covenant considered to be ‘strong’.

For trustees of schemes with weaker sponsors there will be a need to justify any investment risk taken or contingency measures put in place, which may result in more prudent investment strategies and higher deficit figures – leading to increased reliance on sponsor contributions for already weak employers. 

This will be a really difficult, but important, balance for trustees to strike.

Trustees should partner with employers to allow them to invest in sustainable growth, recognising that allowing this investment may be in the best interests of the scheme over the long term.

However, this is not an investment that trustees should make without ensuring they have considered all available options for mitigating the downside risk, such as a charge over assets, nor should they agree to invest in the future of the company without a mechanism in place enabling them to share in any upside.

The revised code is less prescriptive and more principles-based, and as such leaves scope for interpretation. 

The regulator will ask for evidence of the analysis trustees have carried out in setting funding plans to ensure the level of risk exposure is acceptable – trustees should consider the following:

• The expected returns from any investment in the business, as well as how these returns are to be split between the competing demands of the employer in future, including the pension scheme;
• Contingency plans should any investment not provide the returns expected. This may involve contingent assets or increases in employer contributions based on certain funding level-related triggers;
• The risk they are exposed to if the investment return allowed for within any funding plan does not materialise. A decision should be made as to whether or not the employer is strong enough to absorb this risk.

For trustees of smaller schemes, where budget and governance resources are constrained, the requirement to obtain detailed covenant advice, or to carry out asset-liability modelling or stress test their strategies, may mean they are spending more in this area.

This is a good thing, though, as the spend on advice to implement and monitor a sensible, coordinated approach to risk is far more valuable than spending too much on number-crunching ‘compliance’ work.

The new code means advisers will have to go further in their efforts to advise trustees, presenting big-picture advice and refining their processes and use of technology to deliver cost-effective monitoring solutions.

The code encourages trustees and companies to think carefully about risk management and should result in better outcomes for members, as well as a better understanding from trustees and sponsors of the issues they need to overcome in order to get their scheme to a fully funded position. 

This framework will almost certainly help to make their decision-making and monitoring process clearer.

Marian Elliott is head of trustee advisory services at Spence & Partners