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Pensions Regulator draft funding code highlights Government regulations need to catch up with Regulator thinking

Pensions & benefits Policy & regulation DB pensions

Today’s publication of a long-awaited second consultation on a funding code for DB pension schemes sets out a more pragmatic approach from the Pensions Regulator (TPR) in key areas, compared to DWP’s regulatory proposals earlier in the year, according to leading pension consultants LCP. However, concerns remain in key areas.

Earlier in the year, DWP published draft regulations on the funding of DB pension schemes which adopted a very rigid approach to DB funding, with little allowance made for individual scheme circumstances. The draft regulations said that all schemes (without exception) would have to reduce investment risk so that by the time they were ‘significantly mature’, they had ‘low dependency’ on the sponsoring employer. The consultation document said:

“A scheme has low dependency on its employer when it has sufficient assets invested in a low dependency investment strategy to provide for accrued pension rights and is not expected to need further employer contributions” p11, DWP consultation)

However, DWP declined to publish a full impact assessment as to what these rigid rules would mean for schemes, saying:

“We will not be able to determine the full impacts and costs that are introduced by these legislative changes until the detail of all components of the regime are known. This includes the Pensions Regulator’s revised Defined Benefit Funding Code of Practice..” (p29, DWP consultation)

Analysis by LCP suggested that if these rules were to be enforced up to 200 sponsoring employers could find themselves under severe financial pressure and even be driven out of business.

The new TPR funding code appears to take a different approach, saying about such schemes:

“However, we recognise that there are a likely to be a limited number of schemes where the situation is fundamentally incompatible with the funding regime – ie the level of risk which could be supported by the employer covenant is such that the scheme would severely limit the chances that the scheme could pay full benefits to members. Unsupported investment risk may be appropriate in these circumstances since it has a potential reward for the members.” (draft Code for consultation paragraphs 331 and 332)

More generally, the Code and Consultation document also suggest that all schemes may be able to invest up to 30% of their assets in return-seeking investments even at significant maturity. Whilst both approaches are welcome pragmatism from the Regulator, they are at odds with the DWP’s published plans.

Although there is some initial analysis of the potential behavioural impact of the new regime, TPR has not published a full up-to-date Impact Assessment of its plans, leaving schemes and employers in the dark as to the likely consequences of these new rules. We are told this won’t now be published until the new regime is finalised – when it will be too late for changes.

Other key points which emerge from the draft funding code include:

  • Schemes will, as expected, be able to choose between a ‘Fast Track’ (standardised) approach to meeting regulations or a ‘Bespoke’ (tailored) approach based on the individual circumstances of the scheme and its sponsoring employer; however, in a change from the first consultation, schemes will no longer be able to take account of the strength (or otherwise) of the sponsoring employer in seeking to qualify to be treated under the Fast Track funding route;
  • The standardised investment strategy embodied in the Fast Track approach includes an assumption that schemes will adopt a ‘leveraged LDI’ strategy, albeit at lower levels of leverage than would have been normal in the market prior to September 2022 – it is helpful to see TPR’s continued support for well managed leveraged LDI;
  • There is some welcome clarification on the pace at which sponsoring employers will need to pay down deficits in DB plans, but significant uncertainty remains around the interaction with DWP’s regulations, and potential new requirements for Trustees to challenge business dividend and investment plans.
  • There is also welcome clarification for open schemes, who will be allowed to make some allowance for future accrual and new members when projecting when they will reach significant maturity, subject to there being reasonable certainty around the sponsor covenant. However we expect that this will necessitate a change in approach for some open schemes, and potentially lead to higher costs and even further closures.

LCP point out that the Government’s approach to DB funding was a reaction to the controversies around schemes such as Carillion and BHS where it was felt that employers who could afford better funding of their DB scheme were choosing other priorities (such as paying dividends to shareholders). However, the world of DB funding has moved on considerably in the last 7-8 years, with many schemes now much better funded, and different solutions are needed in cases where scheme funding is poor and/or employer covenant is weak.

Jon Forsyth, Partner at LCP said:

“This long-awaited bumper set of documents is now helpfully putting some more workable detail on the future of DB funding and investment regulation, but it also highlights that the DWP's regulations now need to catch up with TPR’s thinking. Just a few months ago, DWP published proposed rigid new rules which would have forced all schemes into a straitjacket, required many sponsoring employers to put more money into their pension schemes, and could have resulted in dozens of sponsoring employers being forced out of business.

By welcome contrast, TPR has come up with a more pragmatic package, allowing some schemes to continue to take investment risk for much longer where appropriate, and indicating that recovery plans of up to 6 years might be acceptable even if employers can afford to pay off deficits quicker than that. But this doesn’t fit with the draft regulations, and we’d urge TPR and DWP to work closely together over the coming months to ensure TPR’s more pragmatic approach is reflected in the final regulations.

Although there is some initial analysis of the potential behavioural impact of the new regime, neither TPR nor DWP has yet published a full assessment of what they think these new rules will mean for schemes, making it very hard to evaluate what has been proposed. For the DB pensions world to know where it really stands, TPR and DWP need to set out a coherent and co-ordinated set of proposals which fit together – we’re yet to see this.”

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