UK: Soft but firm
The UK Pensions Regulator has a new statutory objective and is encouraging funds to adopt an integrated approach to risk. Jonathan Williams outlines the implications
Over the last year, the UK’s Pensions Regulator (TPR) has noticeably softened its language towards pension fund trustees. Instead of prescriptive guidelines, it has opted to stress the importance of implementing certain procedures to guarantee a scheme meets governance standards, and it is at pains to ensure its approach does not increase the cost burden facing sponsors.
The kinder, less confrontational approach is easily explained. Following calls from industry, most notably the employer representative group the Confederation of British Industry, for TPR’s statutory objectives to be amended, March’s Budget saw confirmation of “a new requirement to have a regard for the growth prospects of companies”. Wording for the objective was not published until after TPR released its second annual funding statement in May, but its impact can be seen throughout.
Instead of telling trustees what they should do to monitor covenant and investment risk, 2013’s statement rather says: “We are encouraging trustees to take an integrated approach to addressing covenant, investment, and funding risks and to be in a position to evidence how this has been done before.”
Huw Evans, senior consultant at Towers Watson says the change in wording away from expecting trustees to compile a financial management plan – as the 2012 funding statement demanded – is borne from a desire to not appear to increase the burden on schemes.
However, he stresses that paperwork is still required, despite the change in tone. “If you look through the 2013 statement, it’s actually quite careful to say that you should document what you’re doing,” he says. “It’s almost by the back door.
“Without being directive and saying that you need a financial management plan, by the time you’ve got an integrated approach and written it up, then you’re in much the same place – it just doesn’t look as if TPR is imposing a requirement on you.”
Fiona Frobisher, defined benefit (DB) regulation manager at TPR, however, again stresses that the regulator is simply encouraging trustees to consider the integrated approach.
“We recognise that the way in which schemes adopt integrated risk management should be proportionate,” she explains. “Evidence of integrated risk management does not need to be unduly burdensome and could be part of the development of good governance by demonstrating a sound risk management approach for the scheme.”
Lawyers, such as Sackers partner Faith Dickson, unsurprisingly prefer the less prescriptive approach now pursued by the regulator, but Dickson does not think that should stand in the way of more forceful intervention when required.
“My own personal view is that I’d like to see them excising their powers,” she says. “They are bound to get pushed back in some cases, but I think until we see them more regularly excise their powers, they won’t gain the confidence on what they should and shouldn’t, or can and can’t be doing.”
Dickson believes this would result in a “more confident” regulator overseeing the sector, but admits that it is hampered by the current approach to enforcement. “If you’re not in the position to excise your powers on a regular basis, then it’s pointless being too hard and fast on what you require, because if you’re hard and fast about it and don’t actually excise your powers, then people will listen to you less.
“I think having this more flexible approach and focusing on the outliers means they can probably be more effective,” she concludes.
While Dickson may believe that the occasional show of force would increase the regulator’s credibility, Evans thinks it is already quite able to influence investments even without direct intervention.
“Where they think the investment strategy is too aggressive,” he explains, “rather than using direct powers to try and change the investment, what they are trying to do is encourage trustees to get better information that shows them how big the risks are in the investment strategy, by reference to the covenant.”
This is best demonstrated in the 2013 statement that any investment strategy need to be “compatible with the employer’s ability to address investment underperformance” – not at all a rallying cry for a wholesale shift to liability matching, says Evans, who notes repeated statements from high-ranking TPR officials that they do not want to reduce “the overall level of risk in the system”.
The sentiment is echoed by Frobisher, who stresses that an integrated approach simply means that the interests of members and employers should be balanced at all times. “The scheme specific funding framework does not expect schemes to be run on a risk-free basis,” she says, in a reference to the shift away from return-seeking assets. “We believe that being able to understand and manage the interdependent scheme risks enables trustees and employers to be more confident about the degree of risk they are able to take.”
Underlining the point once more that a risk-free approach is not required, Frobisher echoes comments from the regulator’s chairman Michael O’Higgins that the risk taken should be “neither overly prudent nor overly optimistic”. O’Higgins had previously spoken of the danger of a “recklessly prudent” approach during deficit reduction negotiations and said that a liability matching approach was not required where a strong covenant remained in place.
The comments come in light of the steady decline in equity exposure across the UK fund universe – down from 61.1% to 38.5% according to the 2006 and 2012 editions of the Pension Protection Fund’s (PPF) Purple Book. However, the consultancy LCP believes there has been a slight reversal in fortune. While its figures relate solely to FTSE 100 firms, its 2013 Accounting for Pensions report saw an increase in the allocation to stocks – up by 1.6% percentage points to 36.4%, although market effect may explain some of this rise.
There are, nonetheless, other ways for schemes to address that are outside investment strategy, or even apart from additional cash contributions by sponsors – such as the use of contingent assets.
This is not a new approach. Diageo previously underwrote its UK plan with maturing whisky and, more recently, Dairycrest decided to award its fund control of maturing cheese as a funding solution should the company become insolvent. These are among the most eye-catching contingent asset deals; most involve assets like property, plant or machinery.
John Towner, director of the investment consultancy team at Redington thinks this a solution worth considering for many. “From a sponsor’s perspective, you haven’t committed cash to the pension scheme, and you are reducing the probability of their being a surplus that becomes trapped,” he notes.
He says the asset-backed approach has been used “very effectively”, adding: “If you look at what some of the banks have done, both in terms of providing assets to the pension scheme outright in lieu of cash, as well as using that as additional security, these are true win-win outcomes for both sides.”
Towner was referencing Lloyds TSB’s transfer of a residential mortgage-backed security portfolio to its pension fund that recently netted the scheme £360m, but simultaneously allowing the sponsor to de-leverage once the portfolio had been transferred to the fund. A similar approach was used in Ireland by Allied Irish Banks when it wished to provide additional security in light of a forthcoming redundancy programme that offered employees the opportunity to take early retirement.
Despite approaches such as these, and the regulator’s previously recommended use of escrow accounts, TPR has, nonetheless, warned that it is vital trustees understand all potential risks with the structures. It said in late May that contingent assets are not necessarily preferable to conventional investments due to the additional risk involved.
Despite this, Dickson is a firm believer that a more flexible approach to communications should be maintained. “I think it’s actually more useful to have a slightly looser set of guidelines that can accommodate the different experiences of schemes, experiences in the economic marketplace as time goes on,” she says.
“From my perspective, it would be helpful to just have a consistent approach – whether it be more rigid or more flexible, changing between the two can make things difficult for schemes.”