Pension Schemes Bill – Government pressed to review DB funding rules

27 Jan 2021

The government has agreed to review criticism of its proposed DB funding code, in order to push the Pensions Bill through the House of Lords.

Following four years of debate, the Pensions Schemes Bill has been approved by the House of Lords and is set to receive Royal Assent from the Queen. The framework sets more detailed rules for the launch of collective defined contribution (CDC) schemes, the pensions dashboard, regulatory powers, climate change governance and a hotly contested review on the funding code for defined benefit (DB) schemes.

While an amendment on the DB funding code was withdrawn, the government pledged to review plans on funding rules in response to criticism across the pensions industry that it could lead to final salary schemes closing prematurely.

The government had launched the consultation on funding standards for DB schemes last year to prevent systematic underfunding, thus avoiding repeats of the Carillion and BHS scandals. The initial proposals included restrictions on investments in riskier assets, amid concerns that these could be misused by employers as an alternative to higher deficit contributions. In the case of Carillion, the investment strategy was profitable, but the scheme struggled due to insufficient sponsor contributions.

In a bid to streamline the process of how schemes secure regulatory approval, the new funding code gives schemes the option to choose a generic fast-track route to funding consultation or adopt a bespoke route.

Expensive accrual

Critics of the new DB funding rules point out that the fast-track approach was too simplistic in its investment prescriptions and could lead to unnecessary de-risking.

The PLSA warned that by failing to account for the different time horizons DB schemes have, remaining open to further accrual would become “prohibitively expensive” even though payments of benefits were not due until much later.

The PLSA also highlighted that the new proposals included linking investment risk to scheme size, without factoring in the health of the respective covenant.

While only 11% of pension schemes in the Pension Protection Fund’s universe are open to further accrual, the new rules will affect some of the largest schemes in the country, including USS, Railpen and local government pools, which rely on a more risk-oriented investment strategy to book returns for active members, compared to mature schemes which are closed to further accrual.

Labour peer Baroness Sherlock raised this in the House of Lords debate. She urged the government to recognise that many open schemes are sustainably funded and have different investment requirements from closed schemes. “Unless that difference is recognised, The Pensions Regulator (TPR) and the regulations from the Secretary of State could perversely pose a threat to open but relatively mature sustainable schemes,” she warned.

Baroness Stedman-Scott, parliamentary under Secretary of State for Work & Pensions, responded on behalf of the government by acknowledging that it would be wrong to treat all DB schemes the same. She added that the legislation should allow “flexibility that arrangements can be adapted as economic conditions change. We absolutely do not want to see good schemes closing unnecessarily”.

The government’s increased willingness to engage follows the publication of an interim response by TPR on the DB funding consultation (14 Jan), just days ahead of the House of Lords vote. In this response, the regulator acknowledges the need to establish a clearer distinction between the different circumstances between open and closed DB schemes.

Another factor that could drive the government’s willingness to engage is the fact that stricter rules on the liquidity of assets could stand in the way of the government’s push to encourage institutional investment in infrastructure. The 2016 National Infrastructure Delivery plan identified a £483bn funding gap and private capital from pension funds, especially LGPS pools, were key to addressing the shortfall.

But Stedman-Scott also made clear that the issue of DB funding standards was far from settled and would be addressed in secondary legislation. “These are complex and interdependent metrics most appropriate to be considered in secondary legislation rather than in the bill. The bill provides delegated powers for secondary legislation that will set out in some detail what the new funding and investment strategy will look like. Interested parties will have the opportunity to contribute to consultation on draft regulation,” she said during the House of Lords debate.

Critics of the initial proposals, including RPMI Railpen, which would be hit hard by tighter investment rules, welcomed the government’s openness to dialogue but also made it clear that they planned to intervene in the upcoming consultation.

John Chilman, RPMI’s chief executive, told portfolio institutional: “We welcome clarifications given by the minister in the House of Lords following on from those of Guy Opperman in the Commons that acknowledged the distinct position of open, immature pension schemes like ours. We have been encouraged by the collaborative and cross-party approach of the government and their engagement with schemes that remain open to new members to address some of the key concerns that we and other stakeholders have raised during the legislative process. We look forward to that approach continuing during the formulation of the subsequent regulations in the months ahead.”

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