Revised Code of Practice 3 – Funding Defined Benefits

Susan McFarlane

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The Pensions Regulator (“the regulator”) has laid before Parliament a revised Code of Practice 3 (“the Code”) for defined benefit (DB) scheme funding.

This new code takes into account their new statutory objective and reflects their developing approach and changing circumstances since they published the current Code in 2006. The Code emphasises the need for Trustees and employers to work collaboratively in order to achieve an integrated risk management approach which doesn’t compromise the needs of the Scheme or the employer’s plans for sustainable growth.

We have reviewed the revised Code and prepared the following summary for you.

Spence’s View

Marian Elliott, Head of Trustee Advisory Services at Spence, commented:

“It (the Code) is absolutely the right way to think about risk management and should result in better outcomes for members and a better understanding from the trustees and sponsor of the issues they need to overcome in order to get their scheme to a fully funded position. There is also no reason why the Code should present any difficulty for trustees, as with the right advice this shouldn’t result in significant additional cost – and will almost certainly help make their decision making and monitoring processes a lot clearer.”

Integrated Approach to Risk Management and Contingency Planning

A key task for trustees in governing their schemes is to identify, assess, monitor and mitigate against the various risks their schemes are exposed to.

The risks schemes face fall into three main categories;
-Employer covenant
-Investment
-Funding

Employer covenant, funding and investment decisions interact. The regulator expects that where significant changes occur to either one of these influencing strands that appropriate adjustments are made to the others.

The Code emphasises the need for trustees to establish contingency plans where risk is being taken, to identify what action needs to be taken if certain scenarios materialise.  Again, the regulator highlights the value of a collaborative approach in setting contingency plans and dialogue between the trustees and employer is encouraged.

Integration of risk management will assist trustees to identify and balance the interacting sources of risk within their schemes.  Clearly monitoring is very important, as changes to any of these areas can happen quickly and trustees need information in order to react to those changes appropriately.

Emphasis on Seeking Balance and the Importance of the Employer Covenant

The new Code refers to the concept of balance throughout; that is trustees and employers working collaboratively to achieve a balance between the needs of all parties.

Trustees will need to assess and have a good understanding of the employer’s position, their plans and their attitude to risk. Trustees can help employers identify the risks they face from their funding plans and investment strategies and determine options for addressing them.

Trustees must ensure that they consider the needs of the employer supporting the scheme and  that their decisions do not:
-compromise the needs of the scheme
-impact on the employer’s long term growth plans or long term ability to support the scheme (beyond reason)
-involve taking excessive risk.

The code encourages trustees to use the flexibility of the new regime. Indeed, the requirement for deficits to be eliminated ‘as quickly as the employer can reasonably afford’ has been replaced by any shortfall needing to be dealt with over an ‘appropriate period’, taking into account the needs of the sponsor and the trustees’ assessment of the risks associated with the investment and the funding strategy.

Quantitatively and Qualitatively Assessing Risks

Trustees are encouraged to use a variety of qualitative and quantitative approaches to determine the impact of adverse events on potential employer covenant, investments and funding plans.

Whilst the Code brings additional flexibility, the onus is on trustees to ensure that, in setting funding and investment strategies, they have a documented process to demonstrate that they have considered and understood the risks associated with the sponsoring employer and any strategy which has been implemented.

Additional Considerations

Data
The Code explains that the trustee should discuss any concerns they have over the quality of the valuation data with the actuary. One of the key elements of successful integrated risk management comes down to correct, well verified data.

Monitoring Process
The Regulator recognises that effective risk management should be an ongoing process and states ‘Material changes can occur between actuarial valuations.’

Trustees therefore need to ensure that they have a proportionate process in place for regular monitoring of the employer covenant, the funding position and the performance of their investment strategy so that material deviations from their plans can be identified early and dealt with.

 

If you would like to discuss any of the issues above in greater detail, please do not hesitate to contact us.

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