I recently enjoyed discussing the implications of the new DB funding regime on employers with Matt Gibson from BDO, to work through both the funding and covenant implications of the new regime.

The principles of the new regime are well trailed. Employers and trustees will have to choose between a Fast Track and Bespoke funding approach. Fast Track requires meeting minimum standards to avoid regulatory scrutiny. These Fast Track standards are expected to include:

• funding to a Long Term Objective which is 10-15% stronger than an average Technical Provisions target;
• having a Technical Provisions that trends to the LTO, and a Technical Provisions recovery plan of no more than 6 years for stronger employers and 12 years for weak employers; and
• restrictions on the amount of investment risk, with risk levels decreasing over time as schemes mature and covenant visibility declines.

The regime is well intentioned, but will only achieve its potential to focus TPR resources if the majority of schemes go down Fast Track route, as a Bespoke approach will require more TPR scrutiny. So, what factors will influence the valuation path for schemes with weak and strong covenants going down Fast Track?

Read our summary below or watch our videos for more detail: 

Impact on schemes with a weak covenant     

Impact on schemes with a strong covenant 

Weak covenants

The challenge with Fast Track for weak covenants is affordability – will it lead to affordable deficit contributions? 

Some schemes with weaker covenants have been taking more investment risk than they probably should as well as using out performance over the recovery plan and sometimes back end loading of contributions.This leads to lower funding targets and therefore lower funding levels. 

Meeting the Fast Track requirements is likely to mean less flexibility causing a higher funding target, with less investment risk, and therefore higher cash contributions. 

In some cases, meeting Fast Track requirements may lead to increased contributions although this could be at the expense of investment in the business and consequently the covenant. However, in other cases, particularly at the very weak end, there will insurmountable affordability constraints, which will force schemes down Bespoke. It's simply not clear at this stage how TPR will regulate those schemes that go down Bespoke, given that they may not have unencumbered assets or other ways to provide contingent asset support.

It seems likely that the new regime will flush out the schemes with the weakest employers by forcing them down Bespoke, and into TPR’s spotlight. This is probably a good outcome. However, the funding consultation regime does not yet provide any clear solutions for schemes in this situation. If the covenant can’t support investment risk, and cash contributions are constrained, then the only lever left to pull is to take more time to target full funding.

Strong covenants

A key part of the new regime for strong employers is the impact of covenant visibility. Fast Track does not allow retention of investment risk over time, in part because of scheme maturity, but also in part because, according to TPR, the ability of the covenant to support investment risk over the long term is uncertain. This risk is real – our 2020 FTSE350 analysis shows that nearly a quarter (22%) of FTSE350 schemes with rated sponsors have a 50% chance of employer default before reaching buy-out. Nearly a half (43%) of these schemes have a 33% chance of employer default before reaching buy-out which is never more apparent than amidst the potential future fall out from the pandemic. So, it's right that the funding regime should draw out this issue.

But this mandatory restriction of covenant visibility would impact stronger covenants more than weaker covenants because they have more to give up. Choosing Fast Track for strong employers means short recovery periods, de-risking the scheme over time, and therefore also significant increases in deficit contribution levels.

It therefore seems likely that strong employers may also want to choose Bespoke to keep down cash contributions. Keeping a reasonable level of investment risk on for the long term, perhaps with a cashflow driven investment strategy, will only be possible under Bespoke. 

Interestingly, for the first time, this new regime will provide employers with very clear value from grating security to their pension schemes. This is because security can support a lower funding target or a longer recovery plan, thereby ensuring a Bespoke strategy meets the Fast Track equivalence requirements and stands up to regulatory scrutiny. I therefore expect to see more security being granted to schemes under the new funding regime to mitigate this covenant visibility issue.

Conclusion

There are clear cases for both weak and strong employers choosing the Bespoke funding route despite the additional governance and costs of doing so. It seems that a critical point for TPR in finalising the regime will therefore be where to set the final parameters for Fast Track. They need to be set at a level where the majority of schemes opt for Fast Track, as otherwise the new regime will be unmanageable from a resourcing perspective. Given this, it seems likely that some of the parameters will need to change to encourage more schemes to go down Fast Track.

Which approach is right for you?

Try our free interactive tool to quickly identify whether your current strategy is more suited to the ‘Fast Track’ or ‘Bespoke’ route.