Good news for employers – DB pension scheme trustees should use an integrated risk management approach
The Pensions Regulator has recently published new guidance for trustees of defined benefit (DB) pension schemes. In it, the Regulator says that trustees should make risk management a priority and that ‘integrated risk management’ forms an important element of the overall governance of the pension scheme.
Integrated risk management (IRM)
The Regulator says that IRM is a process for helping trustees and the employer understand the risks in their DB pension scheme. There are three key factors that are inter-linked: the employer covenant, the scheme’s investment strategy and the scheme’s funding arrangements (both the funding target and pace of funding). And it is clear from reading the guidance that the Regulator believes that the employer’s covenant is the primary driver for the investment strategy and the funding arrangements.
This message has been repeated several times in recent years so much so that covenant advice is now the central consideration for DB pension scheme trustees.
Some commentators have even argued that the Regulator’s focus on the covenant has now created a whole new industry for covenant assessors to feed off pension schemes.
In practice, most schemes already consider funding strategy and investment strategy together. They will usually look at the covenant on a more ad-hoc basis perhaps at the time of a triennial valuation. The guidance encourages trustees to look at all three aspects together and to do so on a much more regular basis.
The Pensions Regulator says that the strength of the employer’s covenant will influence the investment strategy (the stronger the employer then the more risk that can be taken with the investments), and that the strength of the employer’s covenant will influence the agreed funding arrangements (the stronger the employer the less that has to be paid in now). The guidance illustrates this idea in the form of an equilateral triangle with covenant at the top, investment in the bottom left corner and funding in the bottom right corner. Interestingly, the document is more or less silent on the interaction between funding and investment on the bottom edge of the triangle although we all know that this is an equally important consideration for all trustees. Perhaps the Regulator thinks we already understand this particular interaction well enough.
The guidance also makes it clear that IRM should apply to all schemes however large or small they may be. The Regulator also suggests that trustees should lean on all their advisors (actuaries, investment advisors and legal advisors) when developing an IRM framework as their experience of applying IRM processes for other schemes will reduce the burden on their own scheme.
The employer’s perspective
The new guidance could provide an opportunity for the employer to help trustees with their assessment of the covenant and hence influence trustees’ decisions on investment and funding. Earlier guidance from the Regulator encourages trustees to obtain independent assessments of the covenant but in many cases, the employer can provide the trustees with at least as good if not better information on the covenant than an independent assessor can. Being collaborative with trustees on the covenant will ensure they do not take an unnecessarily negative view of the position and ask for money that could be better spent elsewhere.
The employer should welcome trustees taking a view on its covenant for various reasons. For example, there may be occasions when the covenant assessment position is helpful to the employer whatever the outcome. If the assessment is ‘strong’ then the employer could argue for lower payments to the scheme and more investment risk in the scheme’s strategy – after all it is a strong employer that can cover any downside risk. If the assessment is ‘weak’ then the arguments flip and the employer could ask for recovery periods to be extended which again reduces the payments to the scheme.
One aspect of the guidance that employers should be wary of is the cost. There is quite clearly a steer on the advice needed and external professional advice could be expensive. Similarly, there can be a significant amount of ‘soft cost’ involved in providing information to the trustees and working with them to agree their assessment. After-all, well-run businesses do not have under-utilised resource available to dedicate to the Trustees’ IRM framework. A mitigating comment made by the Regulator is that the advisors should work collaboratively together to make the IRM framework work more easily.
Some commentators have argued that the Regulator’s guidance on IRM simply reflects what many schemes are already doing. From the employer’s perspective, it represents an opportunity to influence the actions trustees take in investment and funding. With the right input, employers can make sure trustees are not investing too prudently and that the employer will not be asked to pay in potentially excessive contributions..