The Pensions Regulator has launched a consultation on its long-trailed, twin-track defined benefit funding approach, seeking industry views on how to get the average scheme to low dependency within 15-20 years.
Schemes and employers will be offered the choice of complying with a prescriptive funding regime in exchange for low levels of scrutiny by the watchdog, or submitting more detailed evidence of how risks to members’ benefits are being secured.
The preliminary consultation, which will be followed by a second questionnaire on more specific proposals, seeks to give meaning to a requirement in the pension schemes bill for plans to set “long-term objectives”.
In allowing stakeholders the option to vary from the low-risk approach prescribed by the new “fast-track” compliance regime, the regulator has sought to avoid the pitfalls of a compulsory regime. One such system, the minimum funding requirement, was scrapped in 2005 for driving adverse behaviours.
The main change will be that we’re likely to see pension schemes, for those companies that still want flexibility on cash, to have much better contingent assets and support in place
Wayne Segers, XPS
But regulatory executives were also quick to point out that they are seeking to clamp down on anyone stretching the limits of the current regime – those companies with strong covenants that have allowed themselves long recovery plans without credible proposals to reach low dependency by the time their liabilities mature, exposing members to undue risks.
TPR executive director for policy, analysis and advice David Fairs said: “For those employers that have bent the flexibilities beyond their expected use, then of course this may impact them.”
At this stage, the regulator is seeking input from the pensions industry on how it should define key new terms such as “low dependency” and “significant maturity”.
But its early-stage thinking suggests schemes opting for fast-track compliance should expect to demonstrate that they are on schedule to be fully funded on a discount rate in the range of 0.25 to 0.5 per cent by the time their cash flows turn significantly negative.
Investment strategies should run a similarly low risk by the end of this journey, while guidance is also likely to extend to technical provisions, length and profile of recovery plans, and future service contribution rates for open schemes.
“We think that the average scheme has got 15 to 20 years before they get to this low-dependency position,” Mouna Turnbull, policy lead at TPR, said.
“The key point to take from this is that trustees are only [currently] required to be fully funded on the technical provisions, not the long-term objective… they have got time to get there through their journey plan, and their technical provisions will progressively track towards the long-term objective.”
For those schemes that are unable to meet this prescribed funding level and pace of recovery, or where employers wish to deviate for reasons such as investing in the growth of their business, they will have to supply evidence of how they mitigate any additional risk.
Fast-track or bespoke?
The regulator said it was ambivalent about which option schemes choose, but it envisages several situations in which a bespoke arrangement might successfully be sought in its consultation.
Scheme strategies may fail one or more criteria of the fast-track regime, but be viewed to be more secure than this standard in totality. Alternatively, schemes may proactively take more risk than the fast-track standard while providing adequate mitigation, and others may be forced to take more risks due to affordability.
Industry experts broadly welcomed the consultation’s depth and attention to detail, saying it builds on the journey planning that is now ingrained in best practice for many trustee boards.
What of open schemes?
The tone of the regulator’s funding consultation is one that looks to encourage derisking over time, or “to progressively reduce [schemes’] reliance on the employer covenant over time”.
Given the regulator’s assertion that open DB schemes’ accrued benefits should be no less secure than closed plans, this may prove challenging to the future sustainability of open schemes.
Mr Fairs also expressed concerns about the policy, being explored by the Universities Superannuation Scheme, of using split discount rates for accrued benefits and future accrual, as “down the road that future service will become past service”.
Instead, for genuinely open schemes with strong levels of member contributions, the regulator looks likely to rely on its definition of maturity to let employers off the hook.
“The further you are away from maturity, the greater risk the proposed framework will permit,” Mr Fairs said.
Nonetheless, the proposals prompted Bob Scott, senior partner at LCP, to comment: “There is no doubt that these proposals, coupled with the laws currently going through parliament, mean that the regulator is going to be taking a tougher line on the funding of company pensions and represent a huge shake-up.
“There are still nearly 3,000 open DB pension schemes and these proposals could easily lead to a wave of closures.
“The regulator has been talking about long-term strategy for probably a couple of years, and I think that’s become increasingly embedded,” said Jane Beverley, a trustee director at Law Debenture.
She said the choice between fast-track and bespoke valuations may not be as binary as it might appear: “I suspect there will be schemes that are happy to jump through all the hoops when it comes to technical provisions, but when it comes to the recovery plan they will just say ‘six years is too short’.”
Experts envisaged a strong role for contingent assets in allowing employers to diverge from the regulator’s preferred profile of cash injections, with a higher level of due diligence done on asset valuations than has sometimes been the case.
“The main change will be that we’re likely to see pension schemes, for those companies that still want flexibility on cash, to have much better contingent assets and support in place,” said Wayne Segers, head of transactions at XPS Pensions.
“In situations where years down the line companies fail, the schemes that have those types of assets in place actually do better, because it gives them a seat at the table,” he added.
The consultation proposes that a contingent asset or a guarantee’s minimum enforceable value should be greater than the scheme’s projected deficit, relative to the fast-track guidelines, at the point of significant maturity.
Fix the roof while the sun shines
Introducing the consultation, Mr Fairs said the document could be condensed down to the search for a “simple balance” between member security and employers’ affordability.
However, some experts feel that employer contributions are only going one way.
“It’s hard to see this resulting in anything other than increased demands on employers to contribute into the scheme,” said John Sheppard, partner at Linklaters.
LCP analysis prior to the consultation’s release had suggested that a tougher line on tackling deficits could cost an additional £5bn a year in employer contributions.
Whereas previously employers with strong covenants have had the freedom to take long recovery periods and investment risk, “now it’s if you’ve got a strong covenant you should pay off the deficit quicker”, Ms Beverley said.
However, others said the consultation gives much-needed clarity over the extent of these increased contributions.
Raj Mody, partner and global head of pensions at PwC, said overly “vigorous” stances from some trustees and their advisers is seeing employers pushed to fund over their technical provisions, despite the fact that these are usually set at a level from which investment returns and longevity experience should see the scheme progress to low dependency without further cash.
“Your assumptions underpinning technical provisions are prudent, so you expect in real life to do better than those assumptions,” he explained.
“Even when the deficit’s repaired, psychologically it comes as a bit of shock, I think, that the tap is going to be turned off. The thing is, the bath is now full… if you carry on, the bath will overflow. The motivation might be reasonable but the outcome is not.”
Bespoke carries compliance burden
TPR has said that in setting the parameters for its fast-track regime, it will aim to avoid the route being chosen by most schemes as a result of not being demanding enough, or conversely being so strict that it is barely used.
Nonetheless, Andrew Coles, chief executive of newly formed consultancy Isio, doubted whether many schemes would use the more prescriptive option.
“We aren’t convinced that the one-size-fits-all will actually be as attractive as the regulator thinks,” he said.
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However, for smaller employers, the additional cost of evidencing a bespoke arrangement’s compliance could outweigh the cost of meeting fast-track demands, Mr Segers countered.
He welcomed the shared focus across the twin tracks on time to maturity, arguing that for schemes with the average time frame of 15 to 20 years, this journey should be comfortable.
“Time is one of the greatest assets that a pension scheme has, and for most schemes they will naturally move towards that [low-dependency] position over time,” he said.
