ResearchMarch 13, 2020

UK Defined Benefit Code Revision ‘Biggest Revolution’ in 15 Years

The Pensions Regulator publishes consultation on British defined benefit investing regulations.

Reported by Michael Katz

The Pensions Regulator (TPR), the UK’s pension watchdog, has published its first consultation on principles it will use to regulate how defined benefit pension plans are funded and invested. This is expected to be “the biggest revolution to the requirements for pension funding and investment in 15 years,” according to actuarial consultancy firm Lane Clark & Peacock.

In 2018, the British government published a white paper that said some aspects of the defined benefit funding framework needed to be improved, such as greater transparency and accountability concerning risks being taken on behalf of members and employers, and that trustees should focus on the long-term strategic issues for their plans. It also highlighted some gray areas in the existing framework relating to how trustees should set technical provisions and an appropriate recovery plan.

“This lack of clarity has enabled a minority of schemes and employers to misuse the flexibility in the system and made it more difficult for us to regulate DB schemes,” TPR said in its consultation.

The consultation asks the pension industry for its views on proposed principles for the funding of defined benefit plans and how they could be applied through more detailed guidelines. TPR said this will enable it to set a clear benchmark for good standards of compliance. The revised defined benefit code will implement measures set out in the Pension Schemes Bill that was introduced in Parliament in January. TPR said it expects the revised code will come into force at the end of 2021.

The regulator is proposing a “twin-track compliance” approach to valuations, which is intended to allow trustees to demonstrate that their valuations are compliant with legal requirements. Under the proposals, trustees would be able to choose either a “Fast Track” or a “Bespoke” approach to completing and submitting a valuation of their scheme.

According to the consultation, the Fast Track approach will be relevant for trustees who can submit a plan valuation and recovery plan that is compliant with TPR’s guidelines. Their valuation submission will receive minimal regulatory scrutiny, and it is expected to ease the process for many well-managed and well-funded plans, as well as help the trustees of small plans understand what they need to do.

And the Bespoke approach would be for plans that choose not to or can’t comply with the Fast Track guidelines, such as plans that want to take on more investment risk or have affordability constraints. Those plans would have to submit their valuation together with a statement of strategy and supporting evidence that explain how they meet TPR’s principles, the legislative requirements, and, if relevant, how any additional risk is supported. TPR said it would apply more scrutiny to plans taking the Bespoke approach but added that they would be considered equally compliant with the legislation “if done properly.”

Regarding investing strategies by pension plans, the TPR said it expects all plans to take only a level of investment risk that is supportable, and it sets out proposals for how trustees could demonstrate whether the risk in their investment strategy is supported, such as through a stress test.

The stress test TPR is proposing is intended to incentivize plans, particularly mature ones, to invest more in bonds. But it also said there are alternative actions that plans may use that could reduce the impact, such as increasing their level of interest hedging without changing their total bond allocation by using longer dated bonds or by taking advantage of liability-driven investing and other leverage or derivative strategies.

“This would provide a better protection … against a fall in interest rates and a lower level of downside investment risk relative to the liabilities,” TPR said in the consultation. It also said that although government bonds are an important part of any long-term asset allocation, plans could choose to use corporate bonds or other bond-like investments to a greater extent.

TPR also proposes setting a limit on the percentage of investing in growth assets. It said that it considers “having a high resilience would be consistent with having a relatively low percentage of growth assets.”

Dan Mikulskis, a partner at Lane Clark & Peacock wrote in a blog post that plan sponsors and trustees should review their investment strategies to consider whether changes are needed. He suggested they ask the following questions:

Would my investment strategy meet the Fast Track test today?
What about in five years’ time? What if the covenant got downgraded?
How are we planning to be invested when we reach a significantly mature state?
How is the investment strategy going to evolve to get there?
Does this align with the evolution of the Technical Provisions discount rate?

“One possible consequence of the new regulatory funding regime could be increased sponsor engagement on investment strategy,” Mikulskis wrote. “So trustees ought to be ready to respond thoughtfully to sponsor proposals, or to plan to get on the front foot with their own proposals and negotiate a mutually agreeable position and journey forward where possible.”