Smaller schemes face ‘significant’ costs with TPR DB funding code

TPR published its draft code on December 16, alongside two consultation documents – one for the code itself and one for scheme valuations’ “fast-track” option, which will form part of its twin-track DB funding approach. TPR received 127 responses to its first consultation on the code in 2020.

The fast-track option is not part of the DB funding legislation, which is intended to come into force in October 2023, and is therefore not included in the draft code.

The 14-week consultation, which runs until March 24 2023, invites responses to a regime that explains how DB schemes will be expected to set out long-term funding objectives and journey plans to explain the path to meeting these goals. TPR will expect schemes to reduce their reliance on sponsoring employers as they reach maturity.

This appears as close as TPR has got to mandating professional employer covenant advice

Tom Partridge, Teneo

The documents have been published in the aftermath of the autumn liquidity crisis, which prompted schemes to sell down assets in a bid to meet liability-driven investment managers’ collateral calls. 

In the days leading up to the draft code’s publication, the regulator said that it had lowered the amount of leverage it deems appropriate for schemes to have in order to meet the threshold for its fast-track.

The regulator denied a request from MPs to delay the launch of the code until after the Work and Pensions Committee had concluded its inquiry into DB schemes’ use of LDI.

Pausing the consultation would delay the implementation of the new rules to October 2024, TPR chief executive Charles Counsell told the MPs.

The devilish detail emerges

The Department for Work and Pensions published its own consultation on DB funding rules in July, which set out the expectations it shares with TPR for “low dependency” on sponsors. The government said that it would leave the finer details of the regime to TPR, observing that ”it is here that the devilish detail may yet emerge”.

In response to the DWP’s consultation, LCP warned that the new funding rules may lead to “potentially severe outcomes”, while Mercer predicted that the regulations would “accelerate pension liability buyouts and the demise of DB schemes”.

Schemes will need to target a low-dependency investment allocation, under which their investments’ cash flows are “broadly matched” with the payments of their benefits. The value of their assets relative to their liabilities must also be “highly resilient to short-term adverse changes in market conditions”.

Schemes should aim for a minimum level of interest rate and inflation of hedging of at least 90 per cent. An investment allocation drawn up to meet the low-dependency definitions could see 85 per cent of assets allocated towards corporate and government bonds, with the remaining 15 per cent in growth assets, TPR suggested.

Trustees should also quantify their supply of liquidity under normal and adverse market conditions, the regulator said. It expects schemes to be able to maintain hedging after a rise in long-term interest rates of 300-400 basis points.

Prior to the September “mini” budget, schemes typically held 200bp-249bp as a capital buffer, according to the Pensions and Lifetime Savings Association.

Covenant analysis costs have been ‘prohibitive’

Employer covenant is central to the code. When a scheme is in deficit on a technical provisions basis, it should assess its sponsor’s available cash and the reliability of that cash, as well as determine whether any of it could be reasonably used by the sponsor other than to make contributions to the scheme.

Trustees should assess the available cash by aggregating the sponsor’s free cash flow and its liquid assets. “The lower the funding ratio, the less reasonable it will be to use available cash for discretionary payments or to effect covenant leakage,” TPR said.

A scheme should assess its employer’s prospects, including analysis of its market outlook, its employer’s position with this market, and the risk of the sponsor becoming insolvent.

While some larger schemes already carry out this kind of analysis, some smaller schemes may struggle to afford this level of service from covenant advisers. “If I were a small scheme I would be very worried about this,” one consultant, who did not wish to be named, told Pensions Expert.

“While TPR does make reference to proportionality, except for a few specific items for very small schemes, it seems that this flexibility will only begin at a point when a significant amount of additional analysis and work has been undertaken,” said Broadstone chief actuary David Hamilton.

“The cost burden (which also needs to be built into valuations going forward) will be significant, and as plans (and economic circumstances) evolve it will be interesting to see how much of this additional planning delivers long-term value.” 

Dalriada professional trustee Vassos Vassou noted “the emphasis placed on the primacy of covenant for all schemes including small schemes, where historically the costs of completing a thorough covenant analysis has been prohibitive”.  

“However, recent market movements have improved scheme funding levels for many schemes, meaning that those schemes” reliance on long-term employer support has diminished,” he continued.

TPR, in fact, expects compliance costs for schemes to come down after the funding code has been bedded in.

“This is in some areas – not in all areas – a significant shift in approach, and so my expectation is that while people get to grips with what we’re saying, that there may be some implementation cost,” TPR executive director of policy, advice and analysis David Fairs told a media briefing.

“In the long run, you would expect the cost to go down,” he said, taking the view that the watchdog’s “clear guidelines” would help to lower compliance costs for schemes.

Teneo senior managing director Tom Partridge said: “This appears as close as TPR has got to mandating professional employer covenant advice. 

“The proposed requirements on trustees to assess the employer’s prospects entail a high degree of judgment and considerable financial acumen/experience. 

“Business as usual for large, well-advised schemes, perhaps, but a more significant development for some others.”

A risk of mixed messaging?

Schemes that choose 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 fast-track parameters cover low dependency and investment strategy, technical provisions, investment risk and recovery plans.

There will be one set of fast-track parameters for technical provisions and investments set by reference to the maturity of the scheme. There will also be a set recovery plan length depending on whether a scheme has reached significant maturity.

“Fast-track does not mirror the minimum level of compliance,” TPR said. 

“In some instances, the fast-track parameters are set above the minimum level of compliance. Some trustees may find fast-track a useful tool when negotiating with their sponsoring employers.”

According to the regulator, 51 per cent of schemes meet the threshold for the fast-track. As of September 30 2022, it estimated that around 50 per cent of schemes meet the fast-track technical provisions parameters – down from around 70 per cent in March 2021.

“However, our estimates of schemes meeting the other parameters have increased slightly over the same period due to the overall improvements in funding levels,” it said.

The regulator opted against adopting a fast-track route for those with “very weak” employer covenant out of concern for risk this might pose to members and the Pension Protection Fund. TPR believes that those with “very strong” covenant, meanwhile, are afforded the flexibility they need by the bespoke pathway.

TPR is borrowing the PPF’s stress-testing methodology for the fast-track process, which trustees will be expected to carry out in order to understand their schemes’ levels of investment risk.

“There is a risk of mixed messaging,” Cardano managing director Emily Goodridge warned. 

“On the one hand, covenant is seen as key to supporting scheme risks over a journey plan, and on the other hand the parameters to satisfy the fast-track regulatory channel do not include any covenant metrics.”

Cardano head of corporate solutions Alex Beecraft added: “The new funding code may be a double-edged sword for sponsoring companies.

“Fast-track risks increased funding demands to meet with TPR’s new yardstick, but sponsors with schemes funded beyond it could find that corporate activity actually becomes easier.”