Pensions update – Defined Benefit Funding Code Consultation

The Pensions Regulator issued its first consultation on the new Defined Benefit Funding Code on 3 March 2020. Our pensions advisers ISIO explain the detail behind it.

With difficult market conditions in terms of pension scheme finances, and challenges facing employers, pension scheme funding is increasingly relevant as a short to medium-term issue as well as a long-term strategic concern.

The consultation document sets out the technical content involved in detail, and contains a handy 16-page summary guide. But despite this, it poses many more questions to the Defined Benefit pensions industry than it answers.

The regulator sets out the key principles that should govern funding:

1. Long-term objective: This is the cornerstone of the new code. In short, when schemes are 'significantly mature' they should be fully funded and invested on a 'low dependency' basis.
2. Technical provisions: This is the measure of liabilities on a funding basis. These must explicitly converge to the long-term objective over time, so it is 'baked in' to all valuations, with risk reduction over time from current levels.
3. Investment strategy: Actual investment risk taken must be consistent with the technical provisions and have sufficient liquidity and quality.
4. Employer covenant: Strong covenants can be reflected in the technical provisions but only for a short period of time, and a maximum of 3-5 years in most cases.
5. Contingent assets: These can be relied upon but only if sufficient in size and quality, and the trustees have legally enforceable rights and can realise the cash.
6. Recovery plans: Back to 'as soon as affordability allows' terminology, six years is mentioned for strong covenants.
7. Open schemes: Future benefits must have the same security as closed schemes, hence the same rules apply.

As has been well trailed, the regulator will allow schemes to choose an off-the-shelf fast track set of valuation guidelines or justify their own bespoke route to the regulator.

Fast-track vs. bespoke options

A valuation that meets the fast-track requirements is expected to attract limited scrutiny and engagement from the regulator. 

Schemes will be able to diverge from the fast-track assumptions but will need to provide significant justification to the regulator. Examples of acceptable bespoke valuations are:

• Schemes that cannot meet fast-track due to affordability.
• Schemes that get to the same (or better) outcome but using different approaches.
• Those that have a different fact pattern or robust contingent assets that justify a different approach. 

The regulator believes that contingent assets have a role, but they will need to be legally enforceable, of sufficient quality and value, and realisable by the trustees when needed. It appears that guarantees will be of limited value in valuation discussions although they may still provide valuable other protections.

Perhaps the most interesting new information is what the consultation says about sponsor covenant and investment strategy. Investment risk is clearly getting a much higher profile and attention from the regulator, whereas covenants appear to be becoming less influential in valuations. 

What does this mean for housing associations?

The consultation runs until June and leaves lots of options open. 

The regulator’s next steps include a second consultation, planned for later in 2020, that will focus on the draft code itself. This is promised to be a short document – and to be fully in force by the end of 2021. Meanwhile, the regulator is already applying some of the same thinking to its ongoing Defined Benefit regulation and we’d expect this to accelerate once the code is issued.

There is reference (paragraph 219) in the consultation to schemes with ‘atypical’ employer covenants. This includes multi-employer schemes (including with non-associated employers such as SHPS) and schemes supported by not-for-profit organisations, including charities and public sector. 

The consultation explains that these will require further thinking and that views will be sought in the second consultation. But with a second consultation not due until later in 2020, paragraph 219 leaves a lot of uncertainty around how the Code will apply and so housing associations, especially those with strong covenants, might reasonably choose to engage with this consultation rather than wait for the next.

Organisations should take time to understand the implications for the sector as a whole as well as at an individual level, and to engage with the consultation. For example, a housing association with a 30-year plan and strong balance sheet will want to understand its options – take a fast-track route and potentially be treated the same as all other employers, or go down the bespoke route and invest management time into achieving a better outcome overall. The consultation closes on 2 June 2020.