DB funding code’s bespoke route could reduce schemes’ costs

A new report from Hymans Robertson, published on Thursday, estimates that 60 per cent of schemes will be able to take the fast-track route, dispelling fears reported a year ago that 70 per cent of schemes would fall short of the requirements.

Schemes that opt for a prescriptive fast-track funding arrangement would be subject to less regulatory scrutiny, while those opting for a bespoke arrangement would face stricter oversight.

The next consultation into the DB funding code is expected in 2022, although David Fairs, TPR’s executive director of regulatory policy, analysis and advice, told an SG Pensions Enterprise event on Monday that it is unlikely to be published before the summer, according to a blog from Henry Tapper, executive chair of AgeWage.

Those in a position to comply with fast-track can be relatively unfazed by the new funding regime, and should instead be prioritising their endgame strategy and the most efficient way to run off the scheme or get it off balance sheet

Alistair Russell-Smith, Hymans Robertson

Of the 40 per cent of schemes that do not meet the requirements for the fast-track route, Hymans Robertson’s analysis of FTSE 350 pension schemes suggests that there are significant cost benefits to be won by companies taking an active interest in the bespoke alternative.

“Without the corporate driving the strategy, these schemes might adopt a fast-track strategy, which would increase annual cash costs relative to current levels by 150 per cent on average,” it explained.

“However, by driving a bespoke strategy with provision of security to the scheme, these companies could reduce these cash costs by £15bn and actually reduce current annual cash costs by 35 per cent.

“To support this, trustees might require up to £25bn of additional non-cash security (the difference between the fast-track and bespoke liabilities),” it added.

This is not the first time the cost benefits of the bespoke route have been raised. In a report published in June, Hymans Robertson argued that charities could cut their DB cash contributions by between 35 per cent and 65 per cent if they opt for the bespoke option over the fast-track route in the new DB funding code.

It noted, however, that the new regime will also see pension deficits for the 40 largest charities in England and Wales increase by an estimated £1bn, bringing the overall deficit up to £3.5bn. The consultancy attributed the increase to changes in the way deficits are calculated under the new code.

Alistair Russell-Smith, head of corporate DB at Hymans Robertson, said: “The end of 2022 may seem a long time away but corporates really need to start considering now if they will adopt a fast-track or bespoke funding strategy, as it will have a fundamental impact on valuation approaches.

“Those in a position to comply with fast-track can be relatively unfazed by the new funding regime, and should instead be prioritising their endgame strategy and the most efficient way to run off the scheme or get it off balance sheet.

“However, existing strategies fall short of fast-track requirements for 40 per cent of FTSE 350 [DB schemes]. These companies should instead be considering a corporate-driven bespoke strategy,” he continued.  

“We estimate this route could collectively save as much as £15bn of deficit contributions for FTSE 350 DB schemes relative to fast-track costs, reducing current levels of annual cash costs by 15 per cent. If this can be achieved with provision of security or other covenant-enhancing measures to the pension schemes, then these lower levels of contributions can still improve member security.”

Climate risk in the spotlight

The report also found that many sponsors have already embraced Task Force on Climate-related Financial Disclosures rules to manage and report on climate risk, in addition to existing reporting on some “externality” risks associated with their operations.

However, with TCFD requirements now being extended to pension schemes, starting with the largest but quickly expanding to cover the smaller schemes, the importance of monitoring the impact of climate risk on DB funding will only grow.

“The implications of climate risk need to be integrated into DB funding strategies. Strategically, climate risk is most likely to impact on downside risk mitigation, and subsequent timescales for achieving full funding if things go wrong,” the report explained.

It encouraged schemes to ensure that their investment portfolio is sufficiently diversified and divested, to consider both scheme and sponsor outcomes, and to embrace downside risk mitigation such as accelerated cash, contingent security and parent company guarantees.

“There’s international consensus that we need to transition from fossil fuels, so we might expect significant transition risk within the UK. But with major polluters such as China and India refusing to give commitments on reduced use of coal, we might also expect some of the longer-term physical risks too,” the report stated. 

“Schemes and sponsors therefore need to continue to develop their approach to this issue.”

Funding levels improve

Hymans Robertson’s analysis showed that IAS19 funding levels have seen a steady improvement over the year, driven by strong performance in equity markets and rebounding share prices following the low-point of the pandemic.

“The result is that the aggregate FTSE 350 IAS19 funding position has moved from a £30bn deficit to an £80bn surplus over the year,” it said.

While the market cap of the 177 companies in the FTSE 350 that sponsor a DB pension scheme has increased from £1.77tn at August 31 2020 to £1.99tn at August 31 2021, the actual spending with reported contributions on DB pensions has remained unchanged at £13bn, “although reported earnings fell significantly over this period”.

The £13bn of pension contributions compares with £52bn of dividend payments to shareholders. 

“It is reassuring for pension scheme trustees to see that aggregate pension contributions did not reduce last year, despite a 30 per cent drop in corporate earnings,” Russell-Smith said. 

“This provides further evidence that most of the FTSE 350 [companies] are well placed to support their DB schemes, retaining contribution levels even when grappling with a major risk event like the Covid-19 pandemic.”