Code of Practice 3 – Funding plans made to measure

Angela Burns

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Spence & Partners latest blog for Pensions Funds Online –

The Pensions Regulator implemented a revised version of Code of Practice 3 for funding defined benefit pension schemes.

The Code has been updated to take account of the Regulators new statutory objective to minimise impact on the sustainable growth of the employer, and recognises that a strong, ongoing employer alongside an appropriate funding plan is the best support for a scheme.

The revised Code is less prescriptive and more principles based and as such leaves room for interpretation. There is no longer scope for a ‘one size fits all’ approach where schemes will avoid the scrutiny of the Regulator provided they do not hit certain ‘triggers’.

In this new landscape, funding a scheme can be thought of in a similar way to buying a suit:

Off the rack

You may get a nice looking suit at a good price but it may not fit that well and it may not last the test of time, you may find that in a few years you need a new one and the market may have changed considerably.

Made to measure

You will pay a bit more for this but you will get a suit that fits in all the right places. Some aspects of your suit may be inflexible but this may be acceptable given your circumstances.

Bespoke

The crème de la crème of suits designed and made specifically for you. An expensive option, but one that is likely to stand the test of time.

The Code focusses on the need for Trustees to fully understand the level of risk inherent in scheme funding plans from the level of prudence contained in the technical provisions basis, to the level of risk inherent in the scheme investment strategy and the strength of the employer covenant. Risk should be assessed as a whole across all strands of a funding plan and if Trustees believe that they are exposed to a significant level of risk then they should mitigate this risk accordingly.

The Code suggests the use of stochastic modelling techniques and scenario analysis to help Trustees quantify and understand the level of risk they face. Contingency plans should also be used to help monitor and manage these risks over time.

Are we all therefore buying bespoke suits? Not exactly. The Regulator understands the need to be proportionate and would not expect significant analysis to be carried out when the level of risk across all three strands (funding, covenant, investments) is low.

For Schemes that face a significant level of risk, the level of analysis carried out to help Trustees understand the risks faced is likely to depend on the following:

  • The size of the Scheme and whether the Regulator is likely to be concerned if further analysis has not been undertaken and Trustees do not fully understand the risks faced;
  • The level of cash available to fund any additional analysis and the likely positive impact any additional analysis will have.

When approaching valuations under the new regime, Trustees should be aware of the risks faced by the Scheme and should make a decision as to whether or not better understanding these risks would result in a more robust funding plan that stands the test of time.

Trustees should ask themselves the following:

  • Is there a risk that members’ benefits cannot be paid as they fall due?
  • Can we mitigate this risk easily?
  • If a simple solution is not available, will further analysis and a better understanding of the risks faced help to identify a robust plan that suits all parties?
  • How far should this further analysis go?

Trustees should ensure a robust audit trail of all decisions is maintained to ensure information is readily available should the Regulator call for evidence.

In this new landscape, it is unlikely that the Regulator will accept an ‘off the rack ‘solution for any scheme that is exposed to a significant level of risk.

The future is all about ‘made to measure’ funding plans that suit the needs of the scheme and the sponsoring employer. How far trustees decide to go with analysing and understanding the risks faced will depend on a number of factors but any costs incurred should be proportionate to the size of the scheme and the level of risk faced, and how stylish you are of course.

Click to see The revised Code of Practice

Pension Funds Online

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