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A new funding
regime – How should sponsors of DB schemes respond?

Our viewpoint

On 3 March 2020, the Pensions Regulator published its first consultation on principles it will use in future to regulate how DB pension schemes are funded and invested (see our News Alert for our initial summary and analysis).

The consultation sets out that schemes will be able to fund using a “Fast Track” baseline set of funding principles, under which a scheme would expect a low level of Regulator supervision. The Regulator expects this route to be followed by the majority of smaller schemes. Alternatively, schemes can use a “Bespoke” route that is likely to appeal to schemes with more complex arrangements (e.g. those using contingent security to support funding agreements) and that will attract greater scrutiny from the Regulator.

Given its length and ambition, the consultation appears light on detail of the Regulator’s preferred Fast Track assumptions. This will concern companies looking for comfort that their schemes’ existing practices will not be significantly disrupted under Fast Track, e.g. by leading to unexpected cash calls. However, the Regulator does give a clear steer in some areas.

In particular, depending on how employer covenant is incorporated into the Fast Track framework, employers with weaker or less “visible” covenants could risk paying significantly higher contributions unless they are able to agree contingent funding or other security using the Bespoke route.  Also, stronger employers who currently have recovery plans longer than six years could be asked to pay more.

More reassuringly for these companies, the Bespoke part of the framework could look quite a lot like business as usual for some sponsors (and for example, the Regulator has noted that under the current regime “every valuation is bespoke”). Example case studies set out include schemes using experience investigations to support scheme specific assumptions, providing detailed financial analysis to support unusually “visible” covenant, and justifying higher than normal investment risk or longer recovery plans by using robust contingent security mechanisms. It is hoped that the new regime will promote best practice in these areas, without causing wide disruption for schemes already utilising such frameworks.

Interaction with the Pension Schemes Bill

The consultation complements the Government’s Pension Schemes Bill which contains several wider measures to increase the security of DB pensions (see our January 2020 News Alert for more details) and ensure fair treatment for pension schemes during transactions and other corporate events.

In particular, the consultation builds on this (and guidance in the Regulator’s 2018 and 2019 annual funding statements) by setting out how the new funding code interacts with its expectations around dividends and other covenant leakage, noting:

  • “For stronger employers, provided [Recovery Plans] are appropriately short…we would not expect to be concerned by a proportionately high level of covenant leakage as long as the employer remains strong after the covenant leakage and the leakage does not cause a need for the [Recovery Plan] to be subsequently extended…”;
  • For weaker employers, covenant leakage would attract scrutiny “other than where such leakage can be demonstrated to trustees and to us as absolutely necessary for the sustainable growth of the employer”; but that:
  • “a fast track compliant valuation…would not give an employer license to make large distributions without consideration of its pension scheme and appropriate consultation with Trustees”.  In particular: “exceptional distributions…are deemed to be “transactions” and we expect trustees to consider these in line with our guidance on corporate transactions”. 

Taken in aggregate, this positioning appears likely to place even greater emphasis on demonstration of covenant both for triennial valuation discussions and to justify “business as usual” activities such as dividend payments. Given this, many companies will wish to take advice pre-emptively to ensure they are comfortable with existing governance practices.

Immediate actions

Whilst the detail of the new regime won’t be formalised for some time, these dynamics suggest some immediate actions for companies (whether or not their scheme is currently undertaking an actuarial valuation or an investment strategy review): 

  1. Take early advice - to understand how your scheme’s current funding strategy and approach aligns with the Regulator’s new “Fast Track” funding regime. LCP have developed a Fast Track Forecast to analyse how your existing funding principles might fare based on the information set out in the consultation. You can find out more about this here. We can also use this to advise you on the potential implications for your scheme.
  2. Consider your priorities - for the scheme’s long-term funding and investment plan (sometimes called a “journey plan”) and in particular whether this might mean you have a preference for the “Bespoke” rather than “Fast Track” approach. There are several factors you’ll wish to consider in reaching this view, not least your views on the risk of future trapped surpluses, your preferred investment approach and the availability of contingent assets.
  3. Begin engaging with the trustees - all sponsors and trustees will need to agree a journey plan that meets the Regulator’s requirements.  Trustees are likely to begin their own planning processes soon (whether or not they are currently undertaking a valuation) and it will be important for sponsors to engage at an early stage to ensure their views are appropriately reflected.
  4. Consider the implications on dividends and other corporate activity – new criminal sanctions in the Pension Schemes Bill will support the Regulator’s drive to be tougher e.g. where it perceives dividends (or other so called “covenant leakage”) are inappropriately high compared to deficit contributions. You can read more about these measures here

For some sponsors this could potentially mean reducing, or even stopping, dividends under the new regime and will potentially constrain a range of other corporate activity such as transactions, financing, and reorganisations. Bearing in mind the need to manage expectations of boards and shareholders, the risk of these outcomes should be assessed at the earliest opportunity.

For now, wherever you are in your valuation cycle, we recommend you take early advice on the direction of travel of the new regime and start to think about its implications. This should help you develop a plan for how you will work with your trustees to build and implement a future funding and investment strategy.  

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Pension Schemes Bill

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