Oversimplification must be avoided in The Pensions Regulator’s (TPR) proposed revision of the defined benefit (DB) scheme funding code, and a third way might be necessary, the industry has said.
As the consultation on the principles underlying the code closes to responses today (2 September), several respondents questioned whether the twin-track approach would provide enough flexibility.
The proposal will allow schemes to choose between a prescriptive ‘fast-track' approach to DB funding, or a more flexible ‘bespoke' arrangement with greater regulatory scrutiny.
Some industry commentators have already expressed concern that the bespoke route would not be truly bespoke, due to its reliance on fast-track parameters, including a majority of participants in a Society of Pension Professionals (SPP) survey.
Mercer expressed a similar view, with chief actuary Charles Cowling having noted: "A fast-track option based on a much-simplified regulatory approach is suitable for pension schemes targeting buyout over the next 20 years, or for smaller schemes looking to minimise the cost and burden of regulatory oversight.
"However, we believe the fast-track proposals should not drive regulator thinking and behaviour for pension schemes adopting a bespoke approach."
Similarly, Isio warned that neither approach would necessarily suit some schemes, particularly those with struggling sponsoring employers, and called for a third option.
Partner Mike Smedley said: "With cash bleeding from corporate profit and loss accounts, life has moved on since TPR first aired its two options for raising standards on DB scheme funding. We need to raise standards, but we also need a ‘cut the crap' option for weak and weakening small- and medium-sized companies.
"If they are paying all they can afford in deficit contributions, there is no senses in the scheme spending tens or hundreds of thousands of pounds on the complex work needed to comply with the regulator's bespoke route.
"We are urging a pragmatic third option of ‘fast-track lite' for trustees and sponsors in this difficult approach. The third approach would have the same fast-track principles but with a more realistic approach to confirming the maximum level of affordable contributions."
TPR has consistently rejected deferring any changes to the DB funding code as a result of Covid-19, with executive director for regulatory policy, analysis, and advice David Fairs stating the "issues being looked at are even more important and relevant".
In a separate blog, he also rejected assertions that "bespoke is just fast track in a different guise", and added: "We are simply trying to ensure that trustees understand the risks in their approach, they have measured them, and, if appropriate, put in mitigation."
The fast-track approach, he added, should be possible for a "broad range of schemes" and would set out what "good looks like" for those seeking a more directed route.
Setting the bar
However, Lincoln Pensions raised concerns that the strength of the fast-track route could result in either too many or too few schemes meeting the requirements. In its response, managing director Alex Hutton-Mills wrote: "The twin-track approach offers the flexibility to address the disparity between schemes but much of the success of the approach will depend on how fast track is calibrated, and TPR's objectives underpinning that calibration.
"If the intention is to set the bar such that all but the riskiest schemes achieve fast track, many schemes with headroom over the fast-track requirements could slip backwards; conversely, if the bar is set too high, most schemes will end up as bespoke, and there will be limited efficiency gains."
The covenant adviser said it might be appropriate for the regulator to vary the fast-track parameters, while a staged calibration process - allowing more schemes to start as bespoke but gradually move to the fast-track option - could be "the most practical option". It also suggested using the latter approach with a "relatively low" bar but with the last valuation's technical provisions and recovery plan used as a recovery plan to avoid schemes "going backwards".
Last week, Aon made a similar observation that the proposal could result in a "levelling down for schemes that have made good progress on strong long-term objectives" with a majority of schemes with valuations between September 2018 and September 2019 having set long-term funding targets stronger than those suggested for the fast-track route.
The regulator has said fast-track principles could be changed if future market conditions render this necessary with substantial changes likely to be made following consultation.
Evolution, not revolution
One major aspect of TPR's proposed revisions is an aim to reduce scheme reliance on the sponsor, with the most mature schemes expected to have a low level of dependency on the employer, with a high resilience to risk in their investments.
But industry commentators have warned against this potentially weakening of the importance placed on the sponsor covenant.
EY UK head of covenant pensions advisory Karina Brookes noted: "While there are benefits to moving to a twin-track regulatory regime, it must be approached with caution and guarded from oversimplification. Oversimplifying proper covenant assessment could create additional risks to the security of members' benefits.
"While the push in this consultation paper for greater clarity, increased accountability, and defined parameters for flexible arrangements is to be commended, some of the more radical options - such as reducing covenant assessment to a formula - could be confusing at best and, at worst, undo much of the effort spent to date by trustee boards to build a more sophisticated understanding of their schemes' sponsors."
She added that heightened awareness and understand of sponsor covenants has enabled trustees to take "decisive action in the best interests of members" and that current practice, backed up by a strengthened regulatory response, could be sufficient.
Similarly, Lincoln Pensions questioned whether reducing reliance on the sponsor would be appropriate in all circumstances. Hutton-Mills said: "In our view, unless the long-term objective involves a full-risk transfer… or it is generally acceptable to run on a scheme without a substantive sponsor, there is long-term reliance on covenant and it is not appropriate that the long-term objective is covenant agnostic.
"The extent to which there are concerns over the long-term prospects of the sponsor, it may be appropriate to target a more prudent basis."
He added: "While we believe the investment de-risking profile should be primarily based on covenant strength, the ‘proverbial can' should not be kicked down the road indefinitely as covenant visibility and reliability are rolled forward, with ‘time to significant maturity' providing that backstop.
"In practice, there must be allowance for both positive and negative experience as schemes move forward in time: while affordability and visibility now may imply one investment de-risking strategy, it may be possible to extend this in future, or it may be necessary to accelerate."
The firm said there was no reason to change "this basic premise" - that covenant underpinning investment risk, and baked into valuation assumptions, is fundamental to the existing integrated risk management framework - for the fast track route, urging TPR "towards evolution rather than revolution… rather than risking breaking the link between covenant, funding and investment".
In Aon's response, partner Lynda Whitney equally warned of "mixed messages" on covenant in TPR's proposals. She said that while it is stressed as important overall, this could be minimised if the schemes are mature, or reduced by a focus on the length of covenant visibility.
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