Scheme Funding - What the Regulator expects

United Kingdom

The revised DB funding Code of Practice has recently celebrated its first birthday and the last few months have seen the publication of several documents that develop the ideas set out in that Code. This edition of Horizon is intended to remind trustees about their key obligations under the Code and draw out issues raised in the more recent funding publications.

Code of Practice

Any trustees involved in a valuation process should have regard to the Regulator’s Code of Practice on Scheme Funding. The Code encourages trustees and employers to work collaboratively. It emphasises the need for trustees to act proportionately, taking into account a scheme’s size, complexity and level of risk, and try to strike a balance between the need to pay promised benefits and minimising adverse impact on the employer’s sustainable growth.

As investment performance affects the level of funding required from employers, dialogue between trustees and employers should deal with the impact of trustees’ proposed investment strategies.

Trustees do not need to eliminate all risk in their scheme. However, they need to understand the extent to which the employers can fund any downsides. Affordability for employers is an issue which trustees should consider, rather than just trying to eliminate any deficit as fast as possible.

Assessing the employer covenant

This guidance replaces earlier 2010 guidance on monitoring the employer covenant. Although the new guidance is much longer than its predecessor and contains more practical examples, the underlying principles are the same and it should all feel fairly familiar to trustees. The Regulator urges all trustees to make use of the guidance.

The Regulator says that a covenant assessment should provide sufficient information for the trustees to be able to answer a list of questions including the following:

  • Which employers can the scheme access value through?
  • What is the assessment of the employer’s current and future profitability and cash flows and how do these compare with the likely funding needs of the scheme now and in the future?
  • Over what period of time can the employer afford to repay the scheme’s funding deficit?
  • Is the scheme being treated equitably with other stakeholders?
  • Could the employer afford to increase deficit repair contributions?
  • Do employer plans to “invest for sustainable growth” restrict support for the scheme?
  • How much value could the scheme recover in an insolvency of the employer?
  • What are the risks to the covenant and how may it change over time?
  • What options are there to improve security for the scheme?

The covenant should be assessed and monitored with a level of detail and frequency proportionate to the circumstances of the scheme and employer. As a minimum, trustees should undertake a full covenant review at each valuation – the guidance sets out factors which indicate where a more frequent review might be required. Trustees should also regularly monitor the covenant and have contingency plans for prompt and effective action when required.

The guidance sets out factors for trustees to take into account when determining whether an external covenant review is required, including whether:

  • The trustees have the necessary expertise and experience to assess the covenant.
  • The trustees as a whole are able to take an objective view, for instance if an influential trustee holds an important role in the employer.
  • The scheme is highly reliant on the covenant, for example where the scheme is under-funded.
  • The covenant is complex, for example an asset-backed contribution structure is being used.
  • The covenant is undergoing significant changes, for example the employer is restructuring.
  • The employer and trustees do not have a good relationship.

As with the Code, the Guidance emphasises the need for a collaborative relationship between the trustees and the employer. Trustees should be concerned where information they have reasonably requested is not provided by the employer. The onus is on the employer to justify why the trustees can rely on it for support and if information relating to the covenant is not provided, trustees should consider reducing their reliance on the covenant.

Trustees need to identify which employers have legal obligations to the scheme (under the deed, as statutory employers and under section 75). They also need to be aware of guarantors. Where relevant, trustees should understand the employer’s position in any wider group, its interactions with other group companies and the impact this can have on the covenant.

In multi-employer schemes, trustees should take a proportionate response in deciding which employers to focus covenant reviews on. They should focus on stronger employers and those with the greatest liabilities. The greater the reliance placed on covenant strength, the greater the number of employers that should be assessed. Where the scheme has a partial wind-up rule, the trustees should understand how that works and each employer’s liability share.

The financial assessment of the employer should cover the financial support the employer can provide for the scheme in the short-term (within two years), medium term (two to five years), long-term (beyond five years) and in the event of employer insolvency.

On contingent assets, the guidance reflects the Regulator’s existing stance: “The valuation of an asset should reflect its anticipated value after a contingent event has occurred. Trustees should be mindful that assets whose value is closely related to that of the employer may significantly decline in value at the same time as the employer covenant deteriorates and when the contingent asset may be needed”.

Annual funding statement

In May, the Regulator published its annual funding statement which is primarily aimed at trustees undertaking valuations with “as at” dates between 22 September 2014 and 21 September 2015. It sets out the Regulator’s views on how trustees and employers can agree appropriate funding plans in the context of current market conditions.

In relation to its overall strategy, the Regulator says: “Paying the promised benefits as they fall due is the key objective for scheme trustees. The DB code recognises that, in doing so, it is not necessary to eliminate or manage all risk but the level of risk taken must be appropriate to the circumstances of each scheme and employer, in particular the ability of the employer to support the scheme when needed. We expect trustees to understand the scheme’s sensitivity to different risks, form a view on the likelihood and impact of a range of scenarios and then set investment and funding strategies that carry an appropriate level of risk, which is then clearly managed.”

Given market uncertainty, trustees need to consider the potential impact of both higher and lower investment returns than expected. They should be comfortable with the level of risk where expected returns are not met and understand what action, if any, could be taken should this happen. The Regulator anticipates that funding strategies will be based on lower expected investment returns than in the last valuation. Trustees also need to keep an eye on whether there are increased requests to transfer to a DC scheme and any funding implications this might have.

If the employer chooses to prioritise business investment over reducing a deficit, the scheme "should be treated fairly and the other stakeholders of the employer should likewise adequately support its growth plans, eg through dividend blocks or restrictions."

Where a scheme is in deficit, any recovery period should be appropriate and trustees comfortable with the overall level of risk within the recovery plan. They should consider factors such as the liability profile, the extent to which the employer covenant can support downside scenarios, any additional security, and what the employer can afford. Where the employer is unable to pay the level of contributions the trustees think the scheme needs, they should seek to manage this risk by, for example, obtaining additional security or structuring the recovery plan differently.

Recovery plan analysis for 2012/13 and predictions for 2014/15

The Regulator has published its analysis of valuations in the 12 months to September 2013. 72% of schemes in the period had an increased deficit. The majority extended their recovery plan period, most by between 6-9 years. The average length of recovery plans was 8.5 years. Half of schemes also increased deficit recovery contributions.

The Regulator has also looked forward to schemes with valuations between September 2014 and 2015. Its analysis suggests that, notwithstanding improved investment performance, the deficits in many schemes may have increased due to the impact of falling interest rates and schemes not being fully hedged against this risk.

Other things to be aware of...

HMRC Newsletter 71 looks at overseas transfers and explains the difference between a Recognised Overseas Scheme (ROPS) and a Qualifying Recognised Overseas Scheme (QROPS). A ROPS must satisfy a factual test, a QROPS is a ROPS that has undertaken to provide specified information to HMRC.

For an overseas transfer to be authorised, it must be paid to a QROPS and it is the responsibility of the individual and scheme administrator making the transfer to check that the receiving scheme meets the QROPS requirements. HMRC’s ROPS notification list shows “that the scheme manager has notified HMRC, wishes to appear on the list and has undertaken to provide information… but this is all it shows. It does not show that the scheme meets the ROPS requirements”.

The Regulator issued a press release to remind trustees of their duties under the new DC charging & governance requirements. It has also produced a page of FAQs on these duties which confirm, amongst other things, that:

  • The Regulator will consult on a revised DC Code this autumn;
  • If in doubt, trustees should prioritise completing their new Chair’s Statement under the Regulations over any voluntary DC governance statement;
  • There is no exception to the independent financial advice requirement on DB to DC transfers for non-UK residents or foreign nationals.

DWP has issued a Factsheet which explains the impact on the new state pension of having previously been contracted-out. On the introduction of new State Pension on 6 April 2016 two calculations will be undertaken:

  • current state pension calculation – calculated on the current basis as if someone has reached State Pension age in 2016;
  • new State Pension calculation – the entitlement someone would have if the new State Pension had been in place throughout their working life.

Both calculations take full account of a member’s contracted-out record. The higher amount will be the individual’s “starting amount” under the new rules. This represents the pension that would be payable from the state if the individual had no more years’ service.

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