The Pensions Regulator’s (TPR) new funding code aims to help defined benefit (DB) schemes in setting long-term objectives, journey plans and reduce their reliance on the sponsoring employer.
The core aim of the new funding code is to establish more generalised risk management processes across all schemes, using the strength of the sponsor covenant as a key to establish how much risk schemes can take.
Twin track
The consultation process is split into two separate proposals, the draft funding code and a proposal for a twin-track approach to assessing DB valuations. This is because the twin-track approach is not mentioned in the 2021 Pensions Scheme Act and, therefore, not included in the draft code.
But the bottom line of the proposed twin track is that the regulator hopes to establish a clearer distinction between schemes that are able to follow a more standardised “fast track” valuation and those who might need to follow a more bespoke valuation model.
Tiffany Tsang, head of DB, LGPS and investment at the PLSA, welcomed the proposals. “We are pleased that the draft allows for the flexibility the PLSA called for in determining technical provisions for schemes open to new entrants. Overall, we support TPR’s move away from using fast track as a benchmark and that TPR has signalled clearly that many bespoke valuation submissions will not result in detailed scrutiny or engagement. We note that recovery plans based on affordability will be a core focus for the regulator if schemes fall within fast track in all other ways,” she said.
Tricky timing
But much has changed since the consultation was launched, For many in the industry, a key question in this second consultation will be what lessons the regulator has drawn from the recent LDI crisis.
In releasing the consultation before the end of the year, the regulator has come under criticism from MPs that it might be too early to take on board the lessons of September’s LDI crisis.
Speaking at a Work and Pensions Select Committee hearing on the LDI crisis in December, Tory MP Nigel Mills challenged the regulator on releasing the code just months after the crash, suggesting that not enough time had been factored in to learn the lessons of the recent LDI crisis.
David Fairs (pictured), executive director of regulatory policy, analysis and advice at TPR, was keen to stress that lessons had been taken on board already but that the regulator had to prioritise speed to ensure that the new rules would be applied as soon as possible.
“The challenge we have is that if we defer our consultation beyond Christmas, there would be an entire year’s delay before the code is operational in terms of actual evaluations going forward,” he explained, speaking as a witnesses at the Select Committee hearing.
LDI lessons
What then, are the lessons TPR drew from the bond market meltdown in September? TPR’s earlier version of the code, published in July 2022, came under fire from some critics of LDI because of the requirement of low dependency funding basis, which was seen by some, including Charles Cowling, chief actuary at Mercer, as an incentive to divest from return-seeking assets, a process which could have the unintended consequence of adding to liabilities to sponsor’s balance sheets. And Con Keating, head of research at Brighton Rock, warns that this would force schemes into LDI strategies.
While the regulator is keen to stress that lessons have been learnt from the LDI crisis, it is not fundamentally ditching the concept of low dependency and shifting the investment allocation into lower risk assets.
The code defines low dependence as a strategy whereby cashflows from investments broadly match payments from the scheme the value of the assets relative to the value of the scheme’s liabilities is highly resilient to short-term adverse changes in market conditions.
In practice, this would mean an allocation in cash and high-grade government and corporate bonds, though the regulator acknowledges the use of derivatives to hedge interest and inflation risks.
The PLSA’s Tsang approaches the focus on low dependency and the strength of the sponsor covenant with caution. “The proposals may give disproportionate weight to employers’ preferences, which may not be aligned with trustees’ objectives, particularly in the current economic climate. We agree that the use of LDI should be wrapped into considerations of supportable risks that would naturally be laid out in journey plans; the drafted expectations around when and how to use LDI are reasonable,” she said.
Low risk assets and leverage
Many schemes that have pursued an LDI strategy aimed at managing interest and inflation risks have used leverage to offset the lack of returns from being invested in fixed income assets. This use of leverage came under fire during the LDI crisis when schemes were turned into forced sellers to meet collateral calls on their derivative investments.
But despite these criticisms, the regulator did not restrict the use of leverage as such, in line with its stated aim of not prescribing a specific investment strategy to schemes.
It did, however, see the crisis as an opportunity to double down on risks management procedures. “We have strengthened some of the guidance around governance and operational management. We have included buffer requirements and changed the stress tests for schemes going down the fast track route,” David Fairs told the Select Committee Hearing.
For example, the new funding code has raised the expectations on liquidity reserves schemes should hold and the stress test scenarios they might face. At the Work and Pensions Select Committee hearing, Counsell said that prior stress tests included potential bond market movements of up to 100 basis points. This measure was criticised by Nigel Mills, who told the regulator that they were “way off” in predicting the possible scale of bond market movements.
TPR seems to have taken that on board. The code now says that trustees should hold enough liquidity to cope with a rise of long-term interest rates between 300 and 400 basis points.
Smaller schemes
One criticism of the draft funding code that has been raised is that the increased focus on risk management puts a disproportionate burden on smaller schemes. David Hamilton, chief actuary at Broadstone, said: “Whilst TPR does make reference to proportionality, except for a few specific items for very small schemes, it seems that this flexibility will only begin at a point when a significant amount of additional analysis and work has been undertaken. The cost burden [which also needs to be built into valuations going forward] will be significant and as plans [and economic circumstances] evolve, it will be interesting to see how much of this additional planning delivers long term value,” he added.
The draft funding code is now subject to a consultation, which will last until the 24th of March. It is then due to be ratified at the end of October 2023. While it remains unclear what markets will look like in 10 months’ time, the new funding code has been described by consultancy LCP as “the biggest shakeup of DB pension scheme funding and investment for nearly 20 years”.
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