The DB white paper sets out plans to review the funding regime, with 'prudent' and 'appropriate' possibly redefined. But James Phillips asks if this could this signal a return to an MFR-like approach
The words 'prudent' and 'appropriate' are vital in deciding the assumptions used for measuring the liabilities of a defined benefit (DB) scheme. Yet, legally, these terms are undefined and it is incumbent on individual schemes and their advisers to interpret these.
This creates a disparate set of valuations with discount rates accused of being set too high or too low, but proving this can be costly, time-consuming and resource intensive.
But this might not be the case for much longer - the government has said The Pensions Regulator (TPR) will consult on the two terms, and various other elements of the funding regime.
Within the Department for Work and Pensions' (DWP's) DB white paper - Protecting DB Pension Schemes - the government committed to improving DB funding standards by enabling TPR to step back from the current flexible framework and set out absolute definitions for both 'prudent' and 'appropriate'.
The new definitions will be inserted into the watchdog's DB funding code of practice - last updated in July 2014 and informed by The Occupational Pension Schemes (Scheme Funding) Regulations 2005.
Both documents are vague on 'prudent' and 'appropriate'; they include rules such as "the economic and actuarial assumptions must be chosen prudently, taking account, if applicable, of an appropriate margin for adverse deviation" but never set out what the two terms mean.
Willis Towers Watson head of scheme funding Graham McLean says well-run schemes could be disadvantaged by an altered meaning of these words, especially if legally enforced.
"There's a real risk that by being more prescriptive in the regime, you are doing well-run schemes a disservice rather than a favour," he says. "The current regime has a lot of flexibility; that is its strength and its weakness. It enables schemes to reflect their investment strategy, sponsor covenant, membership profile, and other factors that vary quite significantly."
In everyday parlance there is no consensus either. While Merriam Webster defines prudent as "having or showing good judgment and restraint especially in conduct or speech", the Cambridge Dictionary states it means "careful and avoiding risks". Therefore, will the DWP and TPR find it difficult to define these terms in a legal context?
McLean believes so. "It's going to be extremely difficult for TPR to not set the hurdle too high or produce something that's actually meaningless and could undercut the current agreements reached between sponsors and trustees," he says.
Assuming it does prove too challenging to apply fixed definitions, it is still possible to make them clearer. Pensions and Lifetime Savings Association (PLSA) head of governance and investment Joe Dabrowski says if rigid definitions are avoided, "the expectations around 'prudent' and 'appropriate' will need to be set out so trustees, employers and their advisers can have a clear idea of their responsibilities.
"There is a fine balance to be struck between creating a black and white approach, which could then be avoided by some, and giving schemes confidence to act without seeking constant approval, which would not be a proportionate use of time for either the scheme or TPR."
Return to MFR?
Yet there is a feeling that the sector could end up repeating the failures of the minimum funding requirement (MFR) regime, which took effect from April 1997 and was dropped in the early noughties following concerns over its inflexibility. As McLean comments, "the more you prescribe the regime, the more you risk ending up in an MFR-type situation with a very prescriptive hurdle where everyone gets shoehorned regardless of their circumstances".
While there is some need for the definitions to be hardened, it must retain flexibilities, he argues.
Lincoln Pensions chief executive Darren Redmayne agrees, warning there cannot be a return to the doomed MFR regime often blamed for the demise of DB schemes.
"This is a laudable ambition but it will be very interesting to see how it translates into practice," he says. "We have to remind ourselves that we had a one-size-fits-all; we had set targets under the MFR regime. We need to be wary that we don't go full circle."
Squire Patton Boggs partner Catherine McKenna says MFR shows fixing a definition could be unhelpful for both schemes and members.
"It's potentially a race to the bottom," she says. "When MFR first came in, a lot of companies had a starting point of 'we just need to fund to MFR', which was a fairly low standard and patently not a good thing for most schemes.
"The vast majority of schemes have a very good stance on what is suitable for them and trustees do a very good job. The regime ain't broke, so why fix it? We might put in a few extra boundaries, but there has to be some flexibility."
Redmayne agrees the revision needs to retain scheme-specific elements, especially for covenants.
"We must ensure we have a level of prudence on an actuarial basis that covenants can support, because they will stand behind those risks," he continues. "The level of prudence will need to relate to covenant in a very explicit way, whereas up until now that linkage has been opaque and holistic."
This is not a universal concern, however. Dalriada Trustees trustee representative Greig McGuinness says that various parts of the white paper, referring to the desire to "build on the scheme-specific nature of the existing regime", show the system will not become overly-rigid.
"The regulator is going to have in its corporate head an idea about what prudent looks like and red lines that will set off the traffic light system to ask further questions," he says. "I can see them having an idea of numerics that are very prescriptive.
"But, I don't think we're going to dial the clock back to everyone using the same assumptions. The regulator is just going to clarify what it means and what it thinks prudent should look like."
Nor does the PLSA's Dabrowski believe this is the inevitable outcome: "I wouldn't expect a return to an MFR-style regime, rather a sharpening of the existing approach, and a real push for all schemes to be working towards a long-term strategy."
But, as always, the devil is in the detail.
Statutory funding objectives
The way DB schemes set statutory funding objectives is also under scrutiny. The DWP is concerned by evidence that nearly a third of schemes closed to future accrual did not have a journey plan or long-term target, leading to a short-term focus, with ineffectively-set investment strategies and management of long-term obligations. Altogether, this causes inadequate anticipation or management of scheme funding risks.
The regulator's code will further be revised to explain how statutory funding objectives should be set in relation to a long-term objective, and require reports on how this objective has informed triennial valuations and recovery plans.
This approach is welcomed by Dabrowski, who says it is vital that trustees and employers clearly recognise where their scheme is heading.
"A clear understanding of a scheme's funding position is vital and we welcome the requirement for scheme funding objectives to include a clear view of long-term aims - be they run-on with the employer, reach self-sufficiency, or buyout," he says.
The DWP believes these long-term objectives will clarify the actions and timeframes needed to agree statutory funding objectives, making trustees "better prepared to pay members' benefits".
Indeed, Dalriada's McGuiness believes this move will highlight best practice and ensure schemes are thinking about more than what is happening between valuations.
But McLean reckons the scrutiny here is really one aimed at pressing trustees to think about the long-term prospects for the scheme and ensuring good practice exercised by some schemes is rolled out to all.
"If schemes haven't thought about this then this is a bit of a wake-up call and they need to consider it before the regulator changes the code; now is the time to do it, not later," he argues. "But even if you have been through the process, it's a reminder that you need to refresh that as the journey plan evolves.
"This is really just drawing a harder line under what trustees and employers need to do."
There will be further consultation by TPR - including research and testing - but the government believes compliance must be enforced through the threat of regulatory intervention. This could include sanctions, fines, or improved section 231 powers.
It stated: "We intend to supplement and strengthen [the code] by legislating… to require trustees and sponsoring employers to comply with some or all of the clearer funding standards."
McLean believes setting more prescriptive terms will make it easier for TPR to demonstrate a lack of prudence or appropriateness but it may not use this power very often.
"Its primary means of regulating is still going to be through the annoyance factor of its other powers," he argues. "It still won't want to have to set technical provisions or contributions unless it's really pushed."
Even so, McKenna says TPR's "all-consuming" remit means it needs to be properly resourced to enforce these standards: "Otherwise, we're giving the regulator an impossible task, and one bound to fail. One would expect that better clarity and transparency would assist the regulator in its enforcement role, but only if it is supported by its own funding and resourcing regime."
Moving the funding regime to more fixed definitions will certainly improve understanding of the regulator's expectations but there is a danger schemes will fail to meet these due to scheme-specific circumstances.
It is therefore important the new definitions are not so rigid that they are akin to the scrapped MFR regime, and allow flexibility on a scheme-by-scheme basis.
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