DB Funding Code Consultation – our thoughts
The twin-track “comply or explain” approach at the heart of the Consultation seems like a major shake-up; but, since the Government’s 2018 White Paper concluded the system is working largely as intended, it shouldn’t make much difference to those schemes already following best practice. Either way, TPR has left some key questions to address in the follow-up consultation:
1. How will Fast Track be calibrated?
Calibration of the Fast Track parameters will be key to the effectiveness of the proposed approach. TPR must be CLEAR whether Fast Track represents the ‘gold standard’, ‘good enough’, or something in-between. Setting the bar too high or low carries risks and it may be necessary for the Fast Track parameters to vary over time.
2. What is the Long Term Objective (“LTO”)?
A ‘low reliance’ LTO may not be the right end game for many schemes, as they will still rely on their covenant to continue without regulatory intervention and to underwrite residual risks. This will not be appropriate where there are doubts over the long-term reliability of the employer.
Trustees and employers should not be lulled into thinking that an LTO on this basis represents the ultimate target, rather it may act as a staging post on the way to a covenant-appropriate end game. Clearer guidance is needed on how the LTO might integrate with a superfund consolidator strategy.
3. What is the role of covenant?
Covenant remains at the core of the UK’s scheme specific funding regime, enabling schemes to take investment risk to lower the costs of benefit provision to members and employers (which would otherwise be prohibitively expensive).
Covenant should therefore remain the key dimension in both Fast Track and Bespoke, driving the level of supportable investment risk over the course of the journey plan and leading to funding assumptions – we see no reason to break this integrated approach to risk management.
4. How should covenant be assessed?
Covenant cannot be assessed in a purely quantitative way. Stochastic credit models ignore the undiversifiable covenant exposure that each scheme faces, while formulaic approaches are too simplistic to handle a multi-faceted problem (and can be ‘gamed’). Covenant needs to evolve to inform the entire journey plan, including:
i) affordability and risk capacity
ii) visibility over how long this may be sustained
iii) longer-term reliability to inform choice of LTO.
This can be included in the Fast Track model journey plans through a holistic covenant rating but will also be key to supporting Bespoke valuations where a simple 4-box covenant rating will not be enough to justify a diversion from Fast Track parameters.
5. What about stressed schemes?
Following recent events, it is likely that more schemes are now in the ‘stressed’ zone raising many challenging questions for different stakeholder perspectives. We believe the proposed framework may put stressed schemes under the spotlight, which will hopefully encourage earlier and constructive regulatory engagement. The key to achieving better outcomes for stressed schemes will be utilising flexibilities in the regulatory architecture.
Despite the many outstanding points of detail, the importance of putting in place an appropriate journey plan that reflects the level of covenant support remains a central theme that trustees and sponsors will need to address, even in these uncertain times.
Alex Hutton-Mills quoted: “The twin-track approach offers the flexibility to address the disparity between schemes but much of the success of the approach will depend on how fast track is calibrated, and TPR’s objectives underpinning that calibration. If the intention is to set the bar such that all but the riskiest schemes achieve fast track, many schemes with headroom over the fast-track requirements could slip backwards; conversely, if the bar is set too high, most schemes will end up as bespoke, and there will be limited efficiency gains.”