Dealing With tPR's New Scheme Funding Code

Teach-In Dealing with tPR’s New Scheme Funding Code October 2014

Dealing With tPR’s New

Scheme Funding Code22nd October 2014


An Evolving Pension Landscape

2

Time2006 2014


1.“Schemes must minimise any adverse impact on the sustainable

growth of an employer, with risks being understood and managed

appropriately.”

2.“Emphasis on collaboration between trustees and employers in

regards to the scheme’s risks.”

tPR’s New Scheme Funding Code

3


Peter Ford, Partner Norton Rose Fulbright

Peter Ford is head of the pensions department at Norton Rose.

His experience includes pension scheme mergers and reorganisations, scheme

winding-up, investment and custody and pensions litigation.

Peter has previously been a director of two trustee companies and has recently

been re-elected as a member of the Main Committee of the Association of Pension

Lawyers. Peter was the lead legal adviser to the Government sponsored Pickering

Review into the simplification of private pensions and is a member of a number of

pensions organisations.

Peter is recognised as an ‘excellent analyser and communicator’ and ‘a

heavyweight in the field’ who ‘finds solutions rather than problems’ by Legal 500

UK 2013. He is noted “as a strong and dynamic performer” in Chambers UK 2010.

4

T:+44 20 7444 2711 F:+44 20 7283 6500 Email: [email protected]

mailto:[email protected]

The Pensions Regulator’s New DB

Funding RegimePeter Ford

Partner

Norton Rose Fulbright LLP

Wednesday 22 October 2014

Introduction

• New DB Scheme Funding Code

• Regulator’s Statutory Objectives

• Key Funding Principles

• Key Themes

• Practical Issues

6

New DB Scheme Funding Code

• Issued with effect from 29 July 2014.

• Replaces previous (2006) Code.

• Reflects Regulator’s new statutory funding objective:

“to minimise any adverse impact on the sustainable growth of the employer.”

7

Statutory Objectives

The Pension Regulator’s statutory objectives are:

• to protect the benefits of pension scheme members;

• to reduce the risk of calls on the PPF;

• in relation to scheme funding only, to minimise any adverse impact on the sustainable growth of an employer;

• to promote and improve understanding of, and good administration or work-based pensions; and

• to maximise compliance with the duties and safeguards in the Pensions Act 2008 (i.e. Auto-enrolment).

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Balanced Approach

TPR has stated that the same weight will be given to new statutory funding objective as to other objectives including protection of members benefits and reducing risk of call on the PPF.

Clear desire to promote a more balanced approach between employers and trustees

“in particular, the Code recognises that a strong ongoing employer alongside an appropriate funding plan is the best support for a well

governed scheme.”

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Key Funding Principles

The Code sets out 9 key funding principles for DB schemes:

• working collaboratively;

• managing risks;

• taking risks;

• taking a long term view;

• proportionality;

• balance;

• good governance;

• fair treatment of the scheme by the employer; and

• reaching funding targets.

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Key Themes

• Proportionality and balance.

• Collaborative approach.

• Integrated approach to risk management.

• Less prescriptive intervention.

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Key Themes – Proportionality and Balance

Requirement for proportionality and balance permeate the Code. Trustees should balance the need to pay the promised benefits whilst minimising the adverse effect on the employer’s sustainable growth – but paying the promised benefits remains the key objective for scheme trustees.

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Key Themes – Collaborative approach

Key emphasis on collaboration between trustees and employers to achieve the appropriate funding outcome.

Balancing the need to pay promised benefits against potential adverse effects on employer’s sustainable growth will require co-operation. However, it is clear that sustainable growth will mean different things to different employers:

“for some growth is a real prospect whilst for others it may be more about maintaining their position or slowing a business decline.”

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Key Themes – Integrated Approach to Risk (1)

• Clear focus on the interaction between employer covenant, investment and funding risk.

• Recognition that a change in one of these three key risks will affect the other two.

• Requirement for trustees to identify, assess, monitor and address these risks appropriately and effectively – but not necessary to eradicate risk completely.

• Importance of understanding covenant in establishing funding targets and investment strategy is key.

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• Trustees should set an appropriate risk appetite.

• Need to recognise the importance of covenant over time and undertake scenario testing.

• Agree appropriate management actions and contingency.

• It is clear that covenant will be a key factor in developing investment strategy.

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Key Themes – Less Prescriptive Intervention

• Removal of trigger based approach (e.g. length of recovery period).

• Risk indicators:

– covenant strength (weak; tending to weak; tending to strong; strong);

– funding;

– investment risk; and

– governance.

• Target resources on schemes posing the greatest risk and where can have greatest impact.

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Comparison of Old and New Codes

2006 Code 2014 Code

Main focus on funding risk Integrated risk management

(covenant, funding and investment)

Prudent assumptions Balanced outcome

Mechanical approach to interventions Interventions based on assessed risks

Deficit eliminated as soon as the

employer can reasonably afford

Deficit eliminated over an appropriate

period

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Practical Issues

• Valuations – still a requirement for assumptions to be prudent but focus also on balanced outcomes. Issues still likely to exist for schemes with weak covenants/poor funding.

• Integrated approach to risk – to some extent reflects existing best practice. Regulator now asking to see VaR analysis.

• Covenant advisers will also start looking at VaR analysis.

• Helpful advice on dividends – recognition that dividend payments can be consistent with sustainable growth and funding objective.

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DisclaimerNorton Rose Fulbright LLP, Norton Rose Fulbright Australia, Norton Rose Fulbright Canada LLP, Norton Rose Fulbright South Africa (incorporated as Deneys Reitz Inc) and Fulbright & Jaworski LLP, each of which is a separate legal entity, are members (‘the Norton Rose Fulbright members’) of Norton Rose Fulbright Verein, a Swiss Verein. Norton Rose Fulbright Verein helps coordinate the activities of the Norton Rose Fulbright members but does not itself provide legal services to clients.

References to ‘Norton Rose Fulbright’, ‘the law firm’, and ‘legal practice’ are to one or more of the Norton Rose Fulbright members or to one of their respective affiliates (together ‘Norton Rose Fulbright entity/entities’). No individual who is a member, partner, shareholder, director, employee or consultant of, in or to any Norton Rose Fulbright entity (whether or not such individual is described as a ‘partner’) accepts or assumes responsibility, or has any liability, to any person in respect of this communication. Any reference to a partner or director is to a member, employee or consultant with equivalent standing and qualifications of the relevant Norton Rose Fulbright entity.

The purpose of this communication is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of any Norton Rose Fulbright entity on the points of law discussed. You must take specific legal advice on any particular matter which concerns you. If you require any advice or further information, please speak to your usual contact at Norton Rose Fulbright.

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Dealing With tPR’s New

Scheme Funding CodeRobert Gardner


Integrating Covenant, Funding And Investment

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tPR’s Approach To Measuring Covenant Strength

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Reducing Risk Budget for Investment & Demographic Risk

Strong Tending to Strong Tending to Weak Weak

Sustainable growth plans

Keep covenant strong through security in

place

Monitoring of covenant risks

Payments that weaken covenant a

concern

Likely to be in a position to handle risk

Managed

solutions

Maximise

covenant valueFunding plan to reflect covenant risks

Risk taking needs significant management

Strong target needed reflecting investment

strategy and weak support for risks

Scheme viability a

concern

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How Does Covenant Strength Impact A Scheme’s Ability To Take

Investment Risk?

25

0

20

40

60

80

100

120

140

160

CG1: Strong CG2: Tending Towards Strong CG3: Tending Towards Weak CG4: Weak

Limiting the Risk Budget

Risk Budget Maximum Covenant Load


What Levers Can We Pull?

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£(m)

Time

Liabilities

De

ficit

£10m

£15m


What Levers Can We Pull?

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Investment return

Contributions

Time3yrs 12yrs6yrs 9yrs

2.0%

2.5%

1.5%

0.5%

1.0%

£10m

£15m

£5m

Teach-In Dealing with tPR’s New Scheme Funding Code October 2014 28

How Do We Measure The Impact Of Investment Risk On The

Sponsor Using Contributions at Risk?


How The Covenant Load Varies As You Move The Levers

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£(m)

Contributions at

Risk

£30m

£ Contributions

£15m

Investment Returns

£30m

Contributions at

Risk

£20m

£ Contributions

£20m

Investment Returns

£20m

Contributions at

Risk

£16m

£ Contributions

£17m

Investment Returns

£17m

75

60

40

Increase

contributions

Extend Time

Horizon


Objective Measurement Performance Indicators Performance (30 Jun 13) Status

Primary Funding

Objective

To reach full funding by [2025] based

on discount rate of Gilts + 1.00%

(Technical Provisions basis)

Expected Returns (ER) > Required Returns

(RR)

RR: Libor + 275bps

ER: Libor + 200bps

Difference: -75bps

Secondary Funding

Objective

To reach full funding on a buyout basis

by [2035] based on a Gilts Flat discount

rate

Expected Returns (ER) > Required Returns

(RR)

RR: Libor + 250bps

ER: Libor + 200bps

Difference: -50bps

Risk Budget

The investment strategy should not risk

the deficit worsening by [20%] of

liabilities over a 1 year period

VaR95 < [20%] of liabilities VaR95: 30.0%

Covenant LoadThe sum of annual contributions and

the 1 year Contribution at RiskContributions at Risk < [£50 Million]

Contributions at Risk: [£100

Million]

Hedging Strategy

Nominal/Inflation hedge ratio should

be maintained within +/- 5% of the

funding ratio.

Funding Ratio (Gilts + 1.00%) 60%

Nominal Hedge Ratio (Gilts + 1.00%) 20%

Inflation Hedge Ratio (Gilts + 1.00%) 25%

Collateral

Maintain sufficient eligible for meeting

collateral requirements that may arise

from the Scheme’s current derivative

positions over a 1 year period.

Total available eligible collateral £300m

Remaining collateral after VaR95 event £200m

Integrating Covenant Into Your Pension Risk Management

Framework

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Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away


What Does This Mean In Practice?

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Covenant

Investment

StrategyFunding

Covenant strength

Downside

protection and

management of

volatility

Deficit

Contributions

Benefit changes

Security

arrangements

Asset

backed

fundingCash flows

needed to meet

member benefits


How Do We Get The Right Balance Of Growth, Risk Control And

Cash Flow Matching?

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Meeting the Gap

Assets with

Cash Flows

Smoothing

Volatility

Gilts

Index Linked Gilts

Credit

Equities

Private equity

Risk Parity

Vol Controlled

Equities

Multi-Asset

Illiquid credit

LDI hedging

Secured Leases


A Shift In Mind Set

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Conclusions

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Integrate your approachAn integrated approach to managing risk means taking account of employer covenant,

funding and investment risk when managing a pension scheme.

Categorised sponsor covenantsThe pension regulator has classified sponsor covenants in four levels from Strong to

Weak.

Constraints due to weak sponsors Weak sponsors will lead to significant constraints on risk budgets.

Different levers are availableIn order to reduce Contributions at Risk, contributions can be raised or the time

horizon extended.

Contributions at RiskContributions at Risk are a useful measure that enables a pension scheme to equate

existing risk budgets with risk to the sponsor through the potential requirement for

additional contributions.

The PRMFThe constraints can be built into an existing PRMF (Pension Risk Management

Framework).

Getting the balance rightFinding the balance between assets for growth, risk management and cash flow

matching.

Mind set A collaborative approach i.e. a shift in mind set from win-lose to win-win.


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Teach-In Dealing with tPR’s New Scheme Funding Code October 2014 36

The Endgame:

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CRE: Commercial Real Estate Debt

Economy & Finance

Dealing With tPR's New Scheme Funding Code