Making workplace pensions work is at the heart of what we do, but it’s also the job of those who fund and manage pension schemes.
It is right that our expectations of those accountable for delivering the retirement outcomes savers expect are clear, and properly enforced. It’s what is driving our clearer, quicker and tougher approach to all forms of pension arrangements, including defined benefit (DB).
In its White Paper published last year, appropriately named Protecting Defined Benefit Pension Schemes, the Government noted that the DB funding framework is working largely as intended but also acknowledged the need for improvements in some key areas, such as greater transparency and accountability around the risks being taken on behalf of employers and members.
It recognised the need for trustees to focus on the long-term strategic issues for their scheme as the landscape matures. And it highlighted unhelpful grey areas around how DB trustees should calculate their scheme’s ‘technical provisions’ or TPs (accrued liabilities) prudently and set an appropriate recovery plan.
This lack of clarity has led to a minority of schemes and employers abusing the flexibilities in the system and has made our job of proving non-compliance and taking enforcement action more difficult.
So, what are we, and the Government, doing to make the funding standard for DB schemes clearer, and therefore provide better protection and outcomes for savers?
The Government announced a range of measures in the White Paper. These included changes to the legislation and a revised code of practice on DB funding to set greater clarity on the funding standard, and the introduction of a DB statement where trustees will be required to articulate their approach and decisions on funding and investments.
The White Paper also introduced the concept of a long-term objective (LTO) and how trustees should achieve the scheme’s Statutory Funding Objective in that context. This will be at the heart of our revised code of practice.
This chimes with what we have been saying for several years now – trustees need to take a long-term view when managing their funding and investment strategies. This is needed now more than ever as many schemes are getting closer to their end game and becoming cash flow negative.
We plan to consult on options for a clearer framework, including what we see as a suitable LTO. For closed schemes, this will include ideas on how they should seek to progressively reduce their reliance on the employer covenant over time and reach a position of low dependency by the time they are significantly mature.
This is in line with the good practice we already see in place for many schemes and should improve their resilience when the risks associated with poor funding levels and shorter investment horizons are exacerbated. This will also provide trustees and employers with a good platform to pursue strategies which are suitable for their circumstances, whether that’s buying out, entering a consolidator or running off on a low risk basis.
It is also good practice for open schemes to plan for the long term, although clearly it is important to reflect the fact that they may be maturing more slowly (or indeed not at all) compared to closed schemes.
We are mindful to ensure the funding framework does not unduly increase the cost of future accruals and lead to unnecessary scheme closures. We will consult on a range of solutions for open schemes which take these factors into consideration while ensuring that members’ past service is protected to the same degree as in closed schemes.
Reaching the LTO is equally as important as setting a good LTO. We will consult on options for setting clearer parameters (for instance discount rates) around journey plans and associated technical provisions based on scheme specific factors (eg maturity or covenant strength) and in the context of the LTO.
As for recovery plans, our view is that affordability should remain a key driver and that deficits should be recovered as soon as reasonably affordable without impacting on the sustainable growth of the employer.
We will consult on our proposals for clearer guidelines on acceptable lengths of recovery plans for different covenant strengths and on how this could work in practice. In particular, we will seek views on whether, all other things being equal, stronger employers should be required to fund TP deficits in a shorter period (particularly where they have the benefit of proportionately lower deficits).
We will also set out our ideas for how contingent support could remain a central part of funding solutions, for instance to support long recovery plans (particularly where shorter ones are unaffordable) or risk-taking in the TPs and be made more accessible to all schemes.
The picture would not be complete without considering the investment strategy, a key factor in determining the likelihood of benefits being paid and the level of prudence overall. We are not seeking to direct how trustees should invest but want to ensure that investment risk is appropriate. We will outline proposals for how trustees could demonstrate whether the risk in their investment strategy is supported, for instance through a simple stress test.
We have heard concerns that we are scrapping the flexibilities in the regime. We don’t intend to pursue a ‘one size fits all’ funding framework – this is not MFR 2.0. The flexibilities in the funding regime will remain to help trustees and employers reach balanced outcomes. But we need to ensure they are not abused and that there is greater transparency on the risks DB schemes are running.
The new code will provide a more straightforward, fast track route to demonstrating compliance with requirements but there will be scope for schemes to choose a more bespoke approach subject to further evidence being provided and greater regulatory scrutiny.
Clearly these are complex issues and it is important we get them right. As well as informal conversations with trustees, employers, advisers and their representative organisations, we will undertake two formal consultations which will give everyone with an interest in DB pensions and how they should be funded an opportunity share their views and ideas.
The first consultation is expected this summer, depending on the legislative timetable, and will focus on options for a clearer framework for DB funding. Our second consultation on the draft code will take place next year once we have more clarity on the intended primary and secondary legislative package. We expect that discussion on these matters will be robust. But it’s crucial that we have those debates to ensure the DB funding regime is fit-for-purpose for the future.
By David Fairs
Executive Director of Regulatory Policy, Analysis and Advice