A radical re-think of DB funding?

By Rosalind Connor, Partner, Arc Pensions Law LLP

September 16 2020 - The Pensions Regulator (TPR) is looking to shake up how it regulates the funding of defined benefit pension schemes. TPR announced a first stage consultation earlier this year, which is due to inform a new code of practice on funding direct benefit (DB) schemes. However, many in the industry are asking why the approach needs to be overhauled at all, since the existing arrangements are widely understood and work well.

Indeed, many regard the existing DB scheme funding regime under Part 3 of the Pensions Act 2004 as one of the pension industry's regulatory success stories. This regime has enabled schemes which had invested in inappropriate ways because of the constraints of the previous regime to find a funding basis that worked for them, and which was specific to their benefit structures, membership, investments and employers. Despite some initial uncertainty about how the legal obligation to negotiate and agree valuations might work in practice, this regulatory regime has started to work rather well for a the vast majority of schemes. The industry now has its head around the existing requirements and schemes are comfortably and efficiently agreeing valuations with their employers. So why does TPR want to change everything?

The impetus for change appears to have emerged from the 2018 white paper "Protecting Defined Benefit Pension Schemes". Interestingly, the paper noted that "the government believes the system is working well for the majority of Defined Benefit schemes, trustees and sponsoring employers," although it went on to say that "we need a tougher approach for those few whose irresponsible decisions impact on their pension scheme. " The paper also spoke of the need for more robust regulation, greater transparency and of "clarifying the rules and expectations, for example through a clearer, enforceable Defined Benefit Funding Code, but otherwise not making fundamental changes to the existing system."

It appears, however, that the proposed new code will indeed make fundamental changes to the current system as regards the regulation of DB scheme funding. The regulator clearly has concerns that the less advised schemes may still not have a robust employer-trustee negotiation and they want to be able to police these more closely. However, there is also a practical problem for the Regulator. As a levy-funded body, it is supposed to use its resources efficiently. TPR has significant powers under section 231, which allow it to impose its own valuation or schedule of contributions in certain circumstances. However, it appears that making regular use of this power would consume a disproportionate level of TPR's resources. Indeed, merely assessing whether those powers could be used would use a large proportion of the actuarial personnel available.

The system proposed by the consultation would provide a way around this problem with a twin track approach. The proposal is that schemes may choose either a "fast track" or "bespoke" valuation. A fast track valuation must follow certain constraints set out by TPR as to the assumptions and process. A bespoke valuation would mean that the scheme has a scheme specific valuation, as is currently required. The idea for the proposed fast-track valuation is that, if your valuation falls within the fast track criteria, the regulator will not look at it in any more detail, but will instead focus on bespoke schemes, only checking whether those give rise to the use of its powers.

This may well be a practical resourcing solution for TPR, but it doesn't amend the legislation, and so cannot adequately address the legal duties of trustees or TPR's powers. The law still expects each scheme to look at its specific position and negotiation of its own valuation with the employer. Nor does the law does allow TPR to only consider its powers as regards those that don't follow its chosen processes. Just as importantly, the law does not allow trustees to ignore their fiduciary duties in funding a scheme, simply on the grounds that they have followed a process that TPR has set out.

Introducing such wide ranging changes is a particular challenge at a time of significant economic flux. Indeed, introducing such a novel twin-track approach at all seems to go beyond the 2018 white paper's ambition for greater regulatory clarity - but without any "fundamental change" to the regulatory regime.

In its introduction to this year's consultation document, TPR says it is "seeking to create a sustainable framework, which provides the right balance between the security of member benefits and the costs to employers of running their DB schemes." It may be argued that the twin track approach would reduce the costs of running such schemes. However, any such savings must be offset against the costs to schemes of adjusting to a new system of regulation.

In terms of ensuring the effectiveness and cost efficiency of the regulatory regime, following a well-trodden path must surely be the best course of action. Continuing to use an effective and widely understood system allows trustees to focus time and money on new challenges, such as GMP equalisation, or on long neglected areas, such as data and benefit audits. It also gives trustees more time to focus on taking prudent steps to protect schemes from the ravages of the economic fallout from the ongoing coronavirus pandemic.

We are now expecting a new draft code to be published, which is due to come into force in late 2021. That draft code will be subject to a further round of consultation. Obviously, there is a long way to go yet before the new code is finalised. However, in the absence of a significant rethink of the current proposals, the clash between the law, the guidance and the practicalities of the present structure look set to remain.

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