On 3 March 2020, the Pensions Regulator published its long-awaited consultation on the principles it proposes to adopt in regulating DB pension scheme funding and investment strategies (see our News Alert for our initial summary and analysis).
This consultation is important because, when married up with regulations to come, the Regulator will be in a much stronger position to enforce its will where it sees proposals that fall outside what it considers to be an acceptable approach to scheme funding and investment. For funding, this includes it being able to set the technical provisions, the schedule of contributions and the shape and length of the recovery plan. For investment, this includes being able to impose its own investment strategy.
Whilst the new regime is not expected to be fully in place until the end of 2021, we expect the evolving consultations in the meantime to influence the Regulator’s view of “good practice” and so be relevant to current valuations and those coming up in 2020 and 2021.
In this blog I answer the simple question: how can you assess the financial implications of the new regime? I focus on the way in which the new “Fast Track” regime will impact on your pension scheme. This is important for all schemes, because even those that choose the new “Bespoke” route, are expected to need to justify to the Regulator why their approach is satisfactory when compared to Fast Track. And if they can’t justify it to the Regulator’s satisfaction, the Regulator could impose a Fast Track approach on the scheme.
Other colleagues have written blogs on the implications for corporate sponsors, trustees, and on investment strategies and covenant assessments.
Of course, we won’t know the detail of the new regime for sure until much later in 2020, when the Regulator publishes a draft of its new funding code ahead of which we expect necessary amendments to the Scheme Funding Regulations to also be consulted on. But reading between the lines of the current consultation, we’ve taken a view on the direction of travel and some of the possible landing places of the new regime. And based on this we’ve developed the “LCP Fast Track Forecast” basis to help sponsors and trustees get a feel for how their current funding and investment approaches might stack up.
The key features of LCP Fast Track Forecast:
- Most funding assumptions, other than the discount rate, are set to be the same as a scheme’s normal funding approach
- A discount rate is selected that depends on the maturity of the scheme and strength of the sponsor covenant, that trends down to Gilts+0.5% pa, and reaches this point when the maturity of the scheme is in the range 12 to 14 years
- An allowance for capitalised expenses may be needed, which is particularly significant for smaller schemes (eg those schemes with less than £100m of liabilities)
- A recovery plan length of 6 to 12 years is adopted, depending on the covenant of the sponsor – 6 years for a stronger covenant, and 12 years for a weak one
- There is no allowance for investment outperformance in the recovery plan (this can mean a significant increase in deficit contributions in some cases), and no back-end loading
- There are prescribed maximum levels of investment risk, depending on the maturity of the scheme and covenant of the sponsor – this can lead to an expectation of the need to significantly reduce the investment risk being taken in some cases, particularly where the scheme is mature or has a weaker covenant
The impact of the above is likely to mean greater reported deficits and higher required deficit contributions for some schemes.
From the consultation, we can also pick up hints at the direction of travel on the Regulator’s view of:
- acceptable levels of dividends (and other covenant leakage) compared to pension contributions (we seem to be heading for a tougher regime on this, meaning reduced dividends in some cases)
- parental guarantees and contingent assets like “Asset-Backed Funding” and escrow arrangements (likely to become more common, and the Regulator is looking for strong contractual terms to ensure schemes can make use of them when needed)
- the impact on funding assumptions where covenant visibility isn’t clear in the longer term (for some schemes, this will mean an even more prudent approach will be necessary); and
- the continuing provision of ongoing accrual of benefits, particularly for weaker covenants (we think the new regime may mean that some schemes are effectively required to stop future accrual of benefits for members).
It will be important for all schemes to consider how they fare against the new Fast Track regime, as the implications for some could be very significant, as set out in my colleagues’ blogs mentioned above. If you’d like LCP to provide results for your scheme using the LCP Fast Track Forecast, and to comment on the likely implications for the above points, please don’t hesitate to get in touch with me.