Scheme funding: Code of practice and regulations

New scheme funding requirements came into force with effect from 30 December 2005. These requirements apply retrospectively to any scheme valuation with an effective date later than 22 September 2005 and signed off after 30 December 2005.

The Regulator's Code of Practice, "Funding defined benefits", and the Scheme Funding Regulations have finally been published. Consultation continues on the Regulator's paper detailing how it proposes to implement the new funding requirements.

This briefing note outlines the details of both the Code of Practice and the regulations. A separate briefing note, "Scheme funding: how the Regulator will regulate defined benefit funding", outlines the Regulator's proposed approach to the new regime.

Which schemes are exempt from the scheme funding requirement?

The regulations provide which schemes are exempt from scheme funding requirement (SFR). These include schemes that are being wound up.

When must a scheme have its first SFR valuation?

The effective date for the first SFR valuation is:

• Schemes subject to the minimum funding requirement (MFR) on 29 December 2005, not later than three years after the effective date of the last MFR valuation.
• Schemes previously exempt from MFR (but not exempt from SFR), not later than one year after 30 December 2005.
• Schemes established on or after 30 December 2005, not later than one year after establishment.

How should trustees approach the valuation process?

The Code suggests that trustees should have an action plan to manage the process. They should monitor the process against the action plan and should, where necessary, prompt relevant parties to take action. Trustees should also keep records of the steps they have taken to ensure adherence to both the action plan and the legislative requirements.

What is the trustees' and employers' relationship with the actuary?

The regulations provide that the trustees must determine the methods and assumptions used for the SFR. Trustees will need to discuss the scope of the advice they will need with the actuary. The Code states that trustees should also ask the actuary to advise on any matters the actuary considers relevant, even if the trustees have not expressly requested advice on the issue. Trustees should also be alert to circumstances in which they may need further advice.

The Code recognises that the employer may also want actuarial advice. Where the actuary gives advice to both the trustees and the employer a conflict of interest may arise. The trustees should discuss any potential conflict with the actuary to reach a clear understanding on how to resolve the conflict. The Code confirms that it is reasonable for the trustees to insist that if the actuary is conflicted he will cease to act for the employer.

What is the trustees' relationship with the employer?

The trustees must obtain the employer's agreement to a number of matters. However, agreement is not required:

• Where the trustees have the power to determine the contribution rate and no other person has the power to reduce or suspend contributions. Trustees are obliged only to consult the employer; agreement is not needed.
• Where the trustees have, subject to conditions, the power to determine the contribution rate and no other person has the power to reduce or suspend contributions. If the conditions are satisfied, the trustees are obliged only to consult the employer; agreement is not needed.
• Where the contribution rate is determined by, or on the advice of, a person other than the trustees or the employer (usually the actuary). Trustees are obliged to get the employer's agreement. However, the trustees must take into account the other person's recommendations both on the methods and assumptions to be used to calculate the technical provisions and the preparation of the recovery plan. If, under the rules, the actuary sets the contribution rate, the actuary must not certify the schedule of contributions unless the rates shown are no lower than he would have provided if he had been responsible for preparing the schedule, the SFP and any recovery plan.

The Code provides that the trustees must form an objective assessment of the employer's financial position as well as the employer's willingness to continue to fund the scheme. The Code makes it clear that while the employer must, on request, provide information to the trustees, the trustees should consider using commercially available services or other sources of information to form this assessment.

How should the trustees meet their statutory obligations?

The trustees are to meet the SFR as follows:

Statement of funding principles (SFP)

The regulations set out when the SFP must be prepared and the additional information it must include. The Code provides that trustees may review and revise the SFP at any time. The SFP must record any trustee decisions (including the assumptions) on the manner and period within which a shortfall is to be eliminated. Trustees may also combine the SFP in one document with the statement of investment principles.

Calculation of technical provisions

The regulations and the Code set out the factors that the trustees have to take into account when setting both the method and assumptions for calculating the scheme's technical provisions. The Code makes clear that the actuary's estimate of scheme solvency on the buy-out basis is a useful reference point for the trustees and employer when considering the adequacy of the technical provisions. The Code does not itself require schemes to fund to buy-out levels.

Trustees should choose individual assumptions with a level of prudence consistent with the overall confidence they want to have that the resulting technical provisions will be adequate to pay benefits as they fall due. The Code confirms that the technical provisions should be a prudent reserve and that the trustees are not obliged to try to eliminate all risk that they will fail to be sufficient.

Changes in methods and assumptions at future valuations are acceptable. However, trustees should keep a record of the reasons for any change.

Actuarial valuation

The Code provides that the trustees should discuss with the actuary any concerns either they, or the actuary, have over the quality of the data.

The valuation must include a certificate from the actuary of the calculation of the technical provisions and the actuary's estimate of the scheme's solvency. The Code makes it clear that the actuary is only certifying the calculation done in accordance with the regulations. The actuary is not giving an opinion on the trustees' choice of methods and assumptions. Generally, the valuation process must be completed within 15 months from the effective date.

Recovery plan

The regulations and the Code set out the matters that trustees should take into account when preparing a recovery plan. The length of the plan will depend on the trustees' assessment of the employer's covenant. The plan should also state the date (except where the plan is only for 12 months) when half the contributions due under the plan should have been made.

Modifying future accrual

Where the trustees and the employer cannot agree on one or more of the funding matters the trustees may, with the employer's agreement, modify future benefit accrual. This power overrides scheme rules.

The Code confirms that the Employer Consultation requirements apply to this change. Our July 2005 briefing note, "Future service changes to pension schemes Pensions Act 2004: requirement for employers to consult", provides more information.

Any modification must be agreed before agreement is reached on funding matters. The Code states that trustees should build the possibility of a scheme modification into the timetable for complying with the funding timetable.

Schedule of contributions

The Code sets out the principles trustees should follow for preparing or revising a schedule of contributions. The Code (as well as the regulations) also lists the items the schedule should contain.

Trustees must ensure that a robust procedure for monitoring receipt of contributions is in place. They may wish for independent verification from the employer's auditor. The trustees should investigate any failure to adhere to the schedule. A report to the Regulator may be required.

What do trustees have to do between valuations?

Trustees must have an annual actuarial report where they do not have a full valuation every year. The annual report is to provide an approximate update of the scheme's funding position. The report should reflect significant changes to the scheme's liabilities. The Code states that the trustees should question the actuary to understand the factors used to prepare the report.

Can trustees commission an early valuation?

Yes, the Code states that trustees should be alert to events which lead them to think it is unsafe to continue to rely on the current valuation as the basis for the current contribution rate. An example in the Code is where the actuary advises the recovery plan is significantly inadequate. The trustees should consult with the employer before going ahead with an out-ofcycle valuation.

When should trustees review the SFP, recovery plan and the schedule of contributions?

The Code provides that trustees should consider a review and, if necessary, a revision of the SFP, the recovery plan and the schedule of contributions where there is a significant decline/improvement in the employer's covenant or there is a change to scheme rules affecting any of these documents. However, it states that where the employer wishes to pay the shortfall off more quickly, trustees may treat the additional contributions as payments in advance rather than revising the schedule. Any arrangement of this sort should be agreed by an auditor and must make clear which payments are being made in advance.

What information should be provided to members?

Members must be given a summary funding statement within a reasonable period from the date the trustees receive the valuation/annual report. While this reasonable period will vary from scheme to scheme, the Code states that the report should be provided within three months. The Code also sets out both the principles to be considered when drafting the statement as well as additional information the trustees should consider including.

What information do trustees need to give to the Regulator?

The Code states that certain information (for example recovery plans and schedules of contributions) should be given to the Regulator within a reasonable period. The Code suggests what period may be considered reasonable, but it makes it clear that, depending on the circumstances of the case, what is reasonable may be either a longer or shorter period of time.

Comments

The SFR is built around assumptions to calculate technical provisions which are prudent. Despite lobbying, the Government has resisted the call for a statutory definition of prudence. Trustees have to decide what is prudent in the context of their own scheme. Instead, the Code provides some guidance as to factors, like equity out-performance, trustees may take into account and still be considered prudent. It is important to note that the Code makes it clear that trustees do not need to target buy-out as the funding measure. This approach is welcome. However, trustees will need to ensure that they have carefully documented why they chosen the assumptions they have. This will help them justify any changes to the assumptions at future valuations.

Scheme contribution rules vary. Some require the trustees to set the rate; some, trustees with employer consent; and others give the power to the actuary. Where employer consent is not required, trustees only have to consult the employer. However, where employer consent is not required, but some person (presumably including the employer) has the power to reduce or suspend contributions, employer consent is still required. Trustees will need to look carefully at their rules to see whether employer consent is still required. Where the actuary sets the rate, the trustees must now get the employer's agreement as well as take into account the actuary's recommendations. The scheme's balance of power is still altered in such circumstances.

The Code provides that trustees may commission an out of cycle SFR valuation at any time where they consider it is unsafe to rely on the current one. It is interesting to note that neither the Code nor the regulations specifically address the circumstances when a first SFR valuation may be brought forward for schemes currently subject to the MFR. The Regulator's consultation paper on how it will regulate SFR makes it clear that the first SFR valuation can only be brought forward where the trustees have power under the rules to do so.

Where trustees and employer cannot agree on one or more funding matters, the trustees may, with employer agreement, modify future accrual. It will be interesting to see whether or not employers try to use a failure to agree on a funding matter to engineer a reduction to future accrual.

The draft Code required employers to give information about itself to trustees and encouraged them to enter into confidentiality agreements. The Code still includes this requirement but it has dropped the need for a confidentiality agreement. Instead, the Code states that employer's are required by the Scheme Administration Regulations to provide trustees (and their advisers) with information to enable them to carry out their duties. The Codes makes clear that this includes information on the employer's covenant.

We find it surprising that the Regulator is citing these regulations as authority for saying there is no need for confidentiality agreements. We think it is unlikely that the draftsman had such a situation in mind when those regulations were drafted. In any event, it is unlikely that trustees (especially corporate trustees) would need a confidentiality agreement since it is unlikely they would resolve to disclose information about the employer.

New scheme funding requirements: a reminder

The new scheme funding requirement replaces the MFR for defined benefit schemes. The MFR required schemes meet a minimum level of funding. In contrast, the SFR does not require schemes to achieve a particular level of funding. Instead, the trustees are responsible for decisions on funding. Trustees will, after actuarial advice and (usually) with the consent of the employer, set prudent actuarial assumptions to fund the scheme's liabilities (technical provisions). This will be the scheme's funding target, which must be set out in the statement of funding principles.

As now, a scheme must have a triennial actuarial valuation and the trustees and employer must agree a schedule of contributions. However, where the funding target is not met, the trustees must put a recovery plan in place setting out how and when the funding target will be achieved.

This note is based on the Regulator's Code of Practice: Funding defined benefits and the Occupational Pension Schemes (Scheme Funding) Regulations 2005