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In the November 2014 edition of PMI News our Director of Pensions, Simon Kew, was asked for his thoughts on the Pensions Regulator’s revised Code of Practice for Defined benefit funding. We attach a copy of the article “Code Words” here, for you to read.

On 29 July 2014 we saw the formal adoption of the Pensions Regulator’s revised ‘Code of Practice 03 – Funding Defined Benefits’. Pre-dating that somewhat is a quote from the Nobel Prize-winning scientist Francis Crick, back in 1962: “If the code does indeed have some logical foundation then it is legitimate to consider all the evidence, both good and bad, in any attempt to deduce it.” Admittedly, Crick’s comments were in reference to the Genetic Code, rather than the output of a long-departed former regulator, however I do believe that a little deduction in relation to the regulator’s modified Code is merited.

Let me first debunk a myth. The regulator has always looked at the long-term viability of an employer, and has said previously that it believes the “best security for a scheme is a healthy sponsor”. I don’t, therefore, believe that the regulator’s new objective “to minimize any adverse impact on the sustainable growth of an employer” will lead to any major or fundamental change in the regulation of schemes and their sponsoring employers.

Indeed, I have seen recent evidence that the regulator is quite willing to apply pressure to the trustees of schemes where there is Pension Protection Fund (PPF) drift (i.e. the PPF deficit is increasing year-on-year) to trigger the wind-up of the pension, PPF assessment and, ultimately, the insolvency of an employer. Sponsors are likely to rely on the new objective as a means to strengthen their negotiating position, which trustees should be mindful of, although that will have little bearing on the regulatory view. PPF drift remains, to my mind, the most substantial danger to the solvency of an employer, as there is a triple threat from cashflow, trustees and the regulator.

An integrated approach to risk management sits at the heart of the regulator’s new Code, and this is where we have seen the most varied and, in some cases, wild interpretation. The basic premise is sound, and one that trustees should be taking already – look at the three main risk types holistically.

They are:

1. Employer covenant
2. Investment
3. Funding

The suggested approach is to understand the risks across each of these areas, and define schemespecific parameters for each, to allow trustees to balance the needs and risks associated with them. A change in one is likely to impact on the other two, which is why there is such focus on balance and the integrated approach.

A word of caution is needed at this point – an integrated approach does not mean a single scheme adviser to cover all three areas. It is widely accepted that we should not have a single trustee, no matter how experienced, to maintain a scheme. From a governance perspective it is unsavoury, and because of conflicts of interests it is equally unpalatable. That position is no different for a scheme’s advisers. In law, the American Bar Association (ABA) has gone as far as to define this issue in its Rules of Professional Conduct by saying: “While lawyers are associated in a firm, none of them shall knowingly represent a client when any one of them practising alone would be prohibited from doing so”.

Closer to home, the regulator states:

There are two main types of adviser conflicts that may arise:

1.An adviser may have a conflict of interest if he or she (or the same firm) is also advising the employer or, in certain circumstances, acting for another scheme or employer with whom the trustees are engaged eg an actuary, auditor or lawyer; and/or

2. Advice provided by the adviser is biased due to financial or non-financial benefits derived by the adviser, or the adviser’s firm

In defence of the ‘one adviser approach’, I often hear two arguments based on cost and the installation of ‘Chinese walls’. Tackling the latter point first, I would say that these firewalls are, at best, paper-thin in all but the most stringent of conditions. Whether one person, or three, from a single advisory organisation is appointed, there are inherent conflicts – as the ABA and the regulator have recognised. I would also question the apparent cost savings, if an adviser from each discipline is supplied and a fully-working firewall is in place, as there has to be duplication of effort from that organisation. This duplicated effort comes without the additional benefit of a full and frank discussion, challenging appropriately and creating ‘professional tension’, that individual advisers from three separate companies would provide.

I am not oblivious to the perception of higher costs for separate advisers, although I do see this as a perception rather than reality – if trustees and employers push for targeted support, when required, appointing the blend of advisers to best suit the needs of the scheme – there can be a healthy discussion, with little or no conflict, to help arrive at the most appropriate solution for the members,trustees and sponsor.

In the previous paragraph I use the word ‘targeted’, in relation to the support provided by advisers, and I intentionally draw your attention to it. Covenant in its basic definition is the ‘employer’s legal obligations to a defined benefit (DB) scheme, and its ability to meet them’. The legal obligation part is relatively simple – who is on the hook for the scheme and its deficit? Ability is slightly trickier when there is some ambiguity concerning the strength of a sponsor. I have always said that, where there is a very strong or very weak employer, a covenant assessment is unnecessary, and a costly exercise in stating the bloomin’ obvious. The key issue then is affordability – What money is available? When and what security can be sought to mitigate any extended recovery plan? Admittedly, the process of identifying each of these elements can be a tad complex, especially in a multi-national group company, but the elementary questions remain the same for every scheme and every employer.

The regulator states in the revised Code that: “It is not necessary to eradicate risks completely”, which is refreshing to see. Of course, we should seek to manage and mitigate risks where we can, although that is not always possible. Put simply, ‘worry about what you can change’. Acknowledge that there is a risk, assess if management or mitigation of that risk is feasible, practicable or appropriate, then act accordingly – with suitable advice if required. That’s where a targeted, proportionate covenant assessment can help. It also provides the bedrock for the integrated approach to funding, as I have set out in Figure 1.

Lastly, I will look at the ‘what if?’ question – it is all very well putting a Recovery Plan and Schedule of Contributions in place, but what if something changes?

Assuming a positive outcome, namely an upturn in fortunes for a sponsor, trustees should seek to have in place some uplift elements to their funding plans such as:

1. a split of profits over certain levels n
2. an improvement in scheme share of dividend payments
3. increased levels of contributions
4. a stake in new businesses/products

For a less rosy outcome, trustees may look for some of these options:

1. negative pledges
2. ways to improve the scheme’s position on insolvency
3. support from other group entities
4. contingent assets n cash in an escrow account

In summary, the new Code of Practice doesn’t revolutionise the way schemes and trustees are regulated, it simply provides a little more clarity on how regulation is being approached. My synopsis, in much fewer than the 15,000 words in the Code, is this:

1. Identify risks
2. Mitigate and manage those risks where appropriate/proportionate to do so
3. Seek professional help if you are unable to action one and two effectively.

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Category : Savants in the News — admin @ 6:50 am November 11, 2014