Since changes to the code of practice on how final salary schemes are funded were first proposed, sponsors’ revenues and the economy have come under pressure.
With the first phase of The Pension Regulator’s (TPRs’s) consultation on revising the defined benefit (DB) funding code drawing to a close, the economic damage caused by the Covid pandemic has further complicated the debate.
The proposals to streamline the funding code were launched in an attempt to fix the problem of final salary schemes being systemically underfunded, a position many have been in for years. The consultation came in the aftermath of a series of high-profile pension scheme defaults, including schemes sponsored by construction giant Carillion and former department store BHS collapsing.
Once the changes are implemented, the regulator hopes to move from individually assessing schemes to a more standardised, twin-track approach. Schemes will be given the choice whether to adopt this more generic fast-track route to funding consultation or adopt a bespoke route. But the consultation has been met with a mixed response by the industry. Only 7% of trustees feel that the new bespoke route offered by the regulator offers sufficient flexibility, according to a survey conducted by The Society for Pension Professionals.
Add to that the economic damages of the pandemic have further complicated the picture. Due to a combination of falling investment returns and weaker sponsor covenants, the average time for a DB scheme to reach a stage where it is ready for buyout has risen from eight years, two months at the end of December 2019 to nine years, two months just six months later.
This includes the Universities Superannuation Scheme (USS), which completed its valuation in the midst of the stock market crash in March and consequently now reports a £13bn funding shortfall, which is further aggravated by record low interest rates affecting the discount rate.
The proportion of FTSE350 schemes expecting to reach the buyout stage within the next 10 years has dropped to 55% from 65% since the start of 2020. To maintain the funding levels enjoyed at the start of the year, FTSE350 scheme sponsors would have to increase their contributions by a third, a consultancy warned.
Add to this that the new funding code could make running DB schemes more challenging. Critics, including the PLSA, point out that the fast track approach could lead to unnecessary de-risking. With the option of higher investment returns taken off the table, the proposals could “unintentionally hasten the closure of open DB schemes”, the industry body warns.
“The requirement to fund accrued benefits in the same way as benefits for retirees would place a significant burden on funding requirements and did not reflect the differing dynamics and time horizons of many such schemes. The proposals could mean new accruals may become prohibitively expensive, when in practice benefits would not come into payment for many decades,” the PLSA said.
Matthew Arends, partner and head of UK retirement policy at Aon, also warns that proposals for the investment policy of the fast track process could lead to disadvantageous asset allocation decisions. “Fast track’s investment simplicity may have the unintended consequence of encouraging investment changes by schemes to favour some asset classes – particularly low risk/low return liquid investments.
“This is because those asset classes may make it easier for schemes to pass the fast track test even though such asset class changes may not be in the broader interests of the scheme,” he added. With the first round of the consultation coming to a close in early September, the regulator is now awaiting the government’s draft regulation before launching the second stage of the consultation next year.
Considering the above, it appears likely that the watchdog will not push through these revised funding regulations to rigorously while the economy is stressed, especially as the government is reported to be preparing to increase taxes to fund its furlough scheme.