David Fairs reflects on the responses to our first DB funding code consultation and busts a few myths.
Impacts of the new DB funding code
We have seen several estimates on the additional costs our new defined benefit (DB) funding code could heap on schemes. We are really pleased with the debate that has been generated but it is fair to say that in (virtual) Brighton, some of what we have seen has taken us by surprise.
While some schemes and advisers seem confident that they already know the impact the new funding code will have on DB schemes, we have yet to firm up the proposals for our second consultation. These will be informed by responses to our first consultation, an impact assessment and the final legislative package (Bill and regulations).
Having read the 130 or so consultation responses – a record for The Pensions Regulator (TPR) by the way – we are reflecting on whether any of the principles that we set out in our first code need to be adjusted.
As we advised schemes to do in our last Annual Funding Statement, we are thinking through the different economic scenarios we may encounter in a post-Covid, post-Brexit world. Only once we have completed that, will we start thinking about the parameters we set for Fast Track. As we refine those parameters, we will look at the impact of different options.
We also need to work through the issues raised in our consultation. We are listening and we understand the pressure on employers in these unprecedented times. We are far from blind to what is around us and know that we need to strike the right balance between protecting members and ensuring flexibility, so employers are supported.
I am not saying “don’t worry, just trust us with it all”. It is right we are held to account and pushed for answers. But there is some way to go on this journey and we should not be making rash predictions. More is to come. Let’s get the basics right first.
De-risk or not de-risk
One thing that has come through in much of the commentary, and consultation responses, is support for the idea that maturing schemes should be on a pathway to limiting the risk they are taking when they become very mature.
As the White Paper and our consultation set out, as schemes mature, their ability to deal with volatile and poor investment outcomes is limited and the impacts this could have on the sponsor could be significant. There is consensus that it makes sense for trustees to plan to reach a position of higher resilience to risk and less reliance on the employer when their scheme is very mature.
Indeed, this is what many schemes are doing. This is not new: it is good risk management. But we need to be able to address the challenges posed by trustees not thinking about this properly.
Our key focus is on those schemes carrying more risk than their covenant can reasonably support and who are not considering that they don’t have time for their investments to repair any damage.
This is a problem for them, their members, their employer and for the Pension Protection Fund (PPF). We think it is right to address this problem as part of giving clear guidance to the market as whole. I doubt many would argue against this.
So, what about immature schemes and open schemes?
Immature schemes have more time on their hands. They can take more risk and with luck, bear the fruits of those risks. While time does not guarantee riskier investments will deliver, we think it is reasonable to give immature schemes room to invest in more volatile, but higher return-seeking, assets. However, immaturity alone is not sufficient to justify this approach. We expect a covenant to be strong enough to provide the support a scheme would need to get back on track over time should things not turn out as hoped.
Open schemes are likely to be at the immature end of the DB universe and have a much longer journey to low dependency (Long-Term Funding Objective or LTO), so they should be able to invest with greater freedom than their more mature comrades. This is all positive. But the crunch question is… should trustees be able to assume that the scheme will remain open forever and so adopt an investment strategy that reflects this and take credit for those returns in their funding?
It is not our place to give a view on the ongoing discussions around the Pension Schemes Bill, but it is right that we explain how we have approached this issue in our consultation.
It is sometimes said that TPR focuses too much on protecting accrued savings which pushes up the cost of future accrual, which in turn will lead to employers prematurely closing their scheme.
We thought very hard about this in preparing our first consultation. We made the point that open schemes and closed schemes should provide the same level of security for members’ accrued benefits. But open schemes will be less mature than closed schemes.
Truly open schemes with a strong flow of new entrants may always be immature. In those circumstances, as I have set out above, we recognised that schemes might invest in more illiquid and volatile assets in the expectation of a higher return. They might anticipate that higher return in their discount rate and consequently set lower technical provisions. The rationale being that there is sufficient time for the scheme to ride out that volatility.
As a consequence, their LTO may be some way off. And if they continue to remain open and in a ‘steady state’, they will continue to ‘stand still’ and not progress towards it. My policy colleagues love a picture, so below they have tried to illustrate all this.
TPR Fast Track proposal
- Closed schemes mature and move towards LTO
- Open schemes that have few or no new entrants move towards LTO more slowly
- Schemes open to new entrants remain immature and don’t move towards LTO
It seemed elegant to us that a truly open scheme could not mature, would not be expected to de-risk and would be able to continue to invest in a long-term way.
But a scheme that started to experience lower levels of new entrants and began to mature would start to recognise that the period to ride out volatility was reducing and therefore plan some de-risking (hence the benefit for all schemes of setting a low dependency LTO as a good long-term planning tool irrespective of their maturity).
Similarly, an open scheme that closed would not see an immediate change to its funding or investment strategy but, over time, would need to change both to reflect increasing maturity.
Our Fast Track proposal
So, this is about being able to plan for these changes and be in a position to manage them should they come about. Fast Track would enable a…well… fast track way for a scheme to sail through.
In Bespoke, we could see perfectly acceptable scenarios where open schemes propose to fund and invest based on their expectation that they will remain open. But trustees should be able to evidence to us how they could (among other things) manage the risk of their scheme closing or maturing faster than expected. All part of good integrated risk management.
Going Bespoke may mean more regulatory engagement, but in many cases, there is unlikely to be any (or only minimal) additional engagement if the thinking has been done, is clearly explained and well documented.
My friend Henry Tapper has blogged on this topic many times and in fact in one of his recent blogs an ‘anonymous’ contributor said almost exactly this:
“I would suggest that a reasonable alternative would be to allow open schemes to set their funding and investment strategy based on the trustees’ expectation of the future flow of new entrants, but require all schemes to carry out contingency planning regarding the actions they would take if their scheme were to close to new entrants (and even potentially future accrual). This would include consideration of how they would achieve their LTO (funding and investment strategy) and their expectation of how long they would have to get there (ie when they would be expected to become “significantly mature”, if they were to close to new entrants tomorrow).”
This is almost exactly what we said, but we would go further and say that just ‘planning’ is not enough, it needs to be something more concrete and evidenced. However, I’m comforted that we may not all be as far apart as we thought.
The importance of liquidity
As a final mention, I want to add that liquidity is important for all schemes and is especially acute for those that are maturing, be they open or closed. But that doesn’t mean that investment in illiquids is a bad thing. Far from it.
One of the benefits of being a long-term investor is that you can take advantage of the additional premium that being able to hold less liquid assets brings you. We are supportive of this and there is nothing in our funding consultation that means schemes will need to stop investing in illiquids as some have said.
Trustees just need to be cognisant of their liquidity needs, what this means for their scheme and be able to manage scenarios where things don’t go as planned. For some, this is about ensuring that they have enough liquidity available so that if markets move in ways they were not expecting they can manage the risk without being forced to sell assets. For example, for those that may be looking to buy out soon, some insurers may not be willing or able to take on those illiquid investments.
Debates are still ongoing in Parliament on all these issues and the DWP and legislators may decide that a different regime for open schemes is the better approach. We will, of course, regulate the legislation we are given. As always, it is important that decisions are taken with a full understanding and acceptance of the risks to members’ accrued benefits, sponsors and the PPF that each approach brings.
Unfortunately, in this area, as in most if not all areas of life, there is no free lunch.
By David Fairs, Executive Director of Regulatory Policy, Analysis and Advice