New DB funding code could imperil sponsors and members

TPR is undertaking the first of two consultations on the DB funding code, with the first stage — closing in September — concerned with codifying the principles underlying the new code, while the second consultation (expected next year) will treat with specific details and parameters.

LCP's report acknowledged that much of what is proposed in the first consultation is unarguable insofar as it establishes best practice. But the consultancy highlighted a number of potential negative consequences arising from the regulator’s proposed two-track system, as well as concerns around its impact on investment strategies and recovery plans.

Master trusts are well-positioned. We’re well-resourced, we’re already doing a lot of things that look like what the regulator says is best practice anyway

Tom Neale, TPT Retirement Solutions

Though the option of a 'bespoke' arrangement allows diversity in theory, the requirement that schemes opting for this route would have to prove an outcome at least as good as the more restrictive 'fast-track' solution risks forcing a “one-size-fits-all” mould on schemes, according to LCP partner Jon Forsyth.  

“While it is understandable that TPR wants to press trustees to reduce risk and employers to fill pension deficits as quickly as possible, our modelling suggests that if this is overdone then in some cases it could actually reduce member security,” he said.  

“The idea of a bespoke funding regime is a good one in principle, but if it is too rigidly benchmarked against a standardised fast-track approach, then it will not be flexible enough to reflect the diversity of DB schemes.”

Integrated risk management is essential

The report also argued that the consultation takes too strict an approach in response to weak employer covenants.

In the case where the covenant is weak, TPR’s standard response has been to require earlier derisking of investments in order to reduce funding risks and militate against the effects of a future market downturn.

“However, this is likely to reduce the expected return on the scheme’s assets, and result in a higher funding target and higher contribution calls on the sponsor,” the LCP report stated. 

“The overall effect can be to shift the onus on meeting pension promises from a diversified pool of investments to a single (weaker) sponsor, ie increasing the future reliance on the sponsor and at the same time asking for higher contributions, potentially creating a weaker covenant.”

This apparent counterproductive stance could be remedied if the regulator assessed bespoke proposals independently of the fast-track benchmark. "For bespoke approaches, the particular circumstances should be analysed in greater detail to provide a more integrated optimal solution, involving an appropriate balance of risks for all stakeholders,” the report stated. "Our view is that there needs to be detailed thinking about whether a different solution is better from an integrated risk perspective including covenant — and not just assume that more prudence and less investment risk is better.”

Although the report acknowledged that riskier investment strategies could lead to worse cutbacks in member benefits in worst-case scenarios, it nonetheless argued “that using fast-track as a crude benchmark for assessing risk could create worse outcomes in some cases”.

Flexibility ‘strikes the right overall balance’

Laura McLaren, partner at Hymans Robertson, told Pensions Expert that the impact on individual schemes “will depend on the parameterisation of the framework and flexibility to accommodate the specific circumstances of schemes and sponsors”, and that details are unlikely to emerge until the second consultation next year.

“There are a few competing forces that will determine where TPR sets the fast-track parameters,” she said.

“Pressure to make fast-track a stiffer test comes from the risk trustees level down from stronger current funding plans. Set against this are Covid-19 market falls, post-Brexit recession risks, and balancing sponsor cash demands. That sweet spot is not easy to pin down.”

McLaren explained that the purpose of the fast-track approach is to force trustees and sponsors to agree to a purposeful plan to get their scheme to run-off, and many well-run schemes have been doing this for some time already.

“Trustees should be apprehensive about companies putting off contributions that they could still afford and exposing members’ benefits to unnecessary risk,” she said.

“Ultimately, if funding goes sideways for a decade, the costs to catch-up could put companies out of business. In many cases, bringing down investment risk helps to reduce the chance of that perfect storm — sponsor default at a time when market volatility has increased the shortfall.”

Ms McLaren added that the flexibility offered by the bespoke route is essential in “striking the right overall balance”, but concurred with the authors of the LCP report in warning that “TPR’s enforcement must not evolve in such a way that bespoke valuations are benchmarked too tightly against fast-track”.

Responding to the concerns, a TPR spokesperson said: “We want to hear views from stakeholders on how we can set clearer expectations with regards to DB funding. Our proposed principles build on the importance of trustees setting a long-term objective and putting a realistic plan in place to get there."

“There is good evidence that schemes which have managed their risks well, and have built in sufficient resilience in their long-term funding strategy, are likely to have fared better as market conditions have worsened. Integrated risk management is needed now more than ever,” they said.

“After the consultation closes on 2 September, we will consider the responses, prevailing market conditions, where schemes currently are and undertake an impact assessment to inform the setting of  the proposed Fast Track parameters. We will subsequently consult on the funding code itself.”

Regulatory burden a boon for master trusts?

One potential consequence of the new code and its requirements is that, should they be viewed as adding yet another burden on already stressed employers with small schemes, it may accelerate the move towards outsourced models like master trusts.

Tom Neale, head of IRM at TPT Retirement Solutions, told Pensions Expert that the added governance burden, coupled with the need for sponsors to focus on sustaining their business in light of the coronavirus crisis, could lead to more outsourcing.

“Master trusts are well-positioned. We’re well-resourced, we’re already doing a lot of things that look like what the regulator says is best practice anyway,” he said.

“If you want to do what you’ve been doing and it doesn’t look like fast-track, you’re going to need to get advice and engage with the regulator, and for a lot of trustees that might be a daunting prospect,” Mr Neale added.