The Pensions Regulator has lowered the amount of leverage that it deems acceptable for schemes to have to meet the requirements for a ‘fast-track’ valuation, as part of its new defined benefit funding code.
The watchdog said on December 13 that it intends to publish its new consultation for the code before Christmas. Its previous consultation, published in 2020, set out plans for a twin-track DB funding approach, with the aim of reducing average scheme dependency on sponsoring employers.
The draft code will be based on the Department for Work and Pensions’ draft regulations.
“It is not usual for us to consult on a draft code before government regulations have been finalised, but we hope this will be helpful for industry to see how we have interpreted the draft regulations and to see holistically how the different elements of the package (legislation and code) will work together in reality,” TPR executive director for policy, analysis and advice David Fairs admitted in a blog post.
We have dialled down the level of leverage that we think is appropriate in fast-track and still be able to pass the stress test
David Fairs, TPR
‘LDI is a useful tool’
The new consultation on the draft code will last for 14 weeks. TPR will also publish a separate consultation on fast-track and its twin-track regulatory approach.
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 watchdog has considered schemes’ use of leverage, in the aftermath of the autumn liquidity crisis that gripped DB schemes. It has supported Irish and Luxembourgish regulators’ calls for larger collateral buffers across liability-driven investment mandates.
TPR is borrowing the Pensions Protection Fund’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, Fairs told a Barnett Waddingham webinar.
“We do think that LDI is a useful tool. We do think that it’s helpful to hedge against some of the downside risk, so in terms of the code that we’re consulting on, LDI is there,” he said.
“We have dialled down the level of leverage that we think is appropriate in fast-track and still be able to pass the stress test.” One consultant, who did not wish to be named, told Pensions Expert that “managers are doing this anyway”.
“There’ll also be mention of the level of buffers that we set out in our statement, and also the need for trustees to focus on their operational processes in order to be able to deal with any turbulence in the market,” Fairs continued.
Before the September “mini” Budget, which was followed by a spike in gilt yields and ensuing collateral calls for schemes, 48 per cent of schemes had capital buffers below 200 basis points to 249bp, according to the Pensions and Lifetime Savings Association.
Just one in five schemes had buffers of more than 300bp. In early October, more than half said they planned to increase their collateral buffer to more than 300bp by October 14, while a 10th intended to make their buffer 250bp.
“We’re asking [trustees] to maintain a buffer of around 300bp movement in gilts,” Fairs said.
Fairs will appear alongside TPR chief executive Charles Counsell in front of the Work and Pensions Committee on December 14 as part of its inquiry into DB schemes’ use of LDI.
A filtering mechanism
It is hoped that the code will come into force for actuarial valuations from October 2023, with the code needing to be laid in parliament by June in order to meet this target.
There have previously been concerns that the majority of DB schemes would not meet the watchdog’s fast-track requirements.
In 2020, Hymans Robertson claimed that 70 per cent of schemes would not be eligible, with just 30 per cent appearing suitable to pass all four of the proposed fast-track tests: long-term objective, technical provisions, recovery plan, and investment risk.
However, Fairs said that just over half of schemes would pass the regulator’s fast-track parameters. The fast-track would be used as “a filtering mechanism”, he added.
Schemes will have to set out how they expect to reach “significant maturity”, but rules around the definition of this yardstick – by reference to duration – could be changed in recognition of the recent average jump in funding levels following autumn’s market movements, Fairs noted.
Bigger LDI collateral buffers will increase sponsor reliance, MPs told
The Work and Pensions Committee has been reminded of the trade-off between bigger collateral buffers and investment returns, with one chief executive warning that buffers of 400 basis points would force some schemes to “pare back their growth ambitions” and increase their reliance on sponsor contributions.
He acknowledged that schemes probably thought they were eight to 10 years from significant maturity, with this time window having now narrowed for many schemes.
“We’re exploring a couple of alternatives. It would be possible to tweak the regulations a little bit, maybe to average over a period of time, or to use a definition of duration that uses a fixed rate of interest, so that there’s a degree of predictability and certainty of when significant maturity arises,” he said.
“Either it could be that there is a tweak to the regulations in the way that deals with the fact that duration has changed a lot over the past few months, or it could be that DWP looks at something very different.”
