On 3 March the Pensions Regulator published a consultation on its defined benefit funding code of practice. The current consultation is the first of a two part consultation and considers the principles of the Regulator's approach. A second consultation is due to focus on the draft code itself.

Two compliance routes: Fast Track and Bespoke

On 3 March the Pensions Regulator published a consultation on its defined benefit funding code of practice. The current consultation is the first of a two part consultation and considers the principles of the Regulator's approach. A second consultation is due to focus on the draft code itself.

Two compliance routes: Fast Track and Bespoke

The consultation proposes that schemes will be able to follow one of two routes, referred to as "Fast Track" and "Bespoke". Schemes following the Fast Track route can expect minimal regulatory involvement.  

For Fast Track, the Regulator will set out standards in relation to all aspects of funding and investment arrangements. The idea behind Fast Track is that the Regulator regards the level of risk being run overall as tolerable. The Fast Track standards will cover:

• the funding level;
• timing of the scheme's long term funding objective;
• technical provisions;
• recovery plan length and structure;
• and (for open schemes) future service contribution rates.

The consultation says the Regulator has not yet decided how employer covenant strength will be factored into the Fast Track model.

To be considered Fast Track compliant, a scheme would have to satisfy all aspects individually. The Bespoke route allows schemes flexibility to diverge from one or more of the Fast Track standards, but trustees will have to explain how and why they have moved away from the Fast Track approach and how they believe the risks posed by diverging from a Fast Track standard have been managed. If the trustees are submitting that it is genuinely not possible to manage the risks, they will have to provide robust evidence. The level of Regulator engagement that trustees following the Bespoke route can expect will vary according to the Regulator's initial assessment.

Eight key principles

The Regulator sets out eight key principles which it believes should stand behind all scheme valuations:

• Demonstrating compliance and objective risk taking. Trustees and employers should understand their scheme specific funding and investment risks (compared to the Fast Track position) and objectively evidence how these can be supported or mitigated (or that support or mitigation is genuinely not possible).
• Long term objective (LTO). By the time schemes are "significantly mature" they should have a low dependency on the employer and be invested with a high resilience to risk. The Regulator is consulting on the technical definition of "significantly mature", but gives the example that a scheme will be significantly mature if most of its members are pensioners and it is cash flow negative, ie paying out more funds than are coming in. Volatile investments are a particularly high risk for such schemes, which may find themselves forced to sell in a falling market in order to pay benefits.
• Journey plan and technical provisions. Trustees should develop a "journey plan" to achieve their LTO and should plan for investment risk to decrease as their scheme matures. "Technical provisions" (ie the amount assessed as necessary to meet the statutory funding objective at each valuation) should be seen as stepping stones to meeting the LTO. Over time, technical provisions should converge to the LTO as evidenced by the journey plan.
• Scheme investments. The actual investment strategy and asset allocation over time should be broadly aligned with the scheme's funding strategy (technical provisions and recovery plan). Investment strategy should have sufficient security, quality and liquidity with a reasonable allowance for unexpected cash flows. Once the scheme is significantly mature, asset allocation should have high resilience to risk, a high level of liquidity and high average credit quality.
• Reliance on the employer covenant. Schemes with stronger employer covenants can take more risk and assume higher returns. However, trustees should assume a reducing level of reliance on the employer covenant over time, depending on its visibility. The consultation says that trustees should not assume that the employer covenant remains undiminished beyond the period over which they have reasonable visibility. It suggests that for most schemes, "visibility" will be limited to three to five years, and that it some cases it could be less than this.
• Reliance on additional support. Schemes can account for additional support when carrying out their valuations provided that it (i) provides appropriate support for the risks being run, (ii) is appropriately valued, and (iii) is legally enforceable and realisable at its necessary value when required.
• Appropriate recovery plan. Deficits on a "technical provisions" basis should be recovered as soon as affordability allows while minimising any adverse impact on the sustainability of the employer. This does not mean that the Regulator necessarily expects deficits to be recovered via a single lump sum payment when affordable, but the Regulator considers that where affordable, recovery plans should be broadly limited to the period for which there is good visibility over employer covenant strength. It proposes to set some limits on recovery plan length for Fast Track compliance accordingly.
• Open schemes. Members' accrued benefits in open schemes should have the same level of security as accrued benefits in closed schemes. The Regulator considers that trustees' focus should be on ensuring the security of members' accrued benefits rather than ensuring the provision of future benefit accrual.

Next Steps

The consultation was due to close on the 2 June 2020, but due to Covid-19 this has been delayed to 2 September 2020.  The consultation was published shortly before the impact of Covid-19 became apparent so we do not yet know how Covid-19 may influence the Regulator's thinking or future developments in relation to the Code.