This update applies to deferred benefit schemes and concerns the recently published Pensions Authority Financial Management Guidelines for Defined Benefit Schemes.
- Review governance arrangements for compliance with the guidelines.
- Revise business plan to ensure an annual check against the guidelines occurs.
- On 22 May 2015 the Pensions Authority (the "Authority") published financial management guidelines for defined benefit schemes. The guidelines set out what the Authority sees as good practice for trustees to follow in order to understand and manage the funding and investment of their defined benefit scheme.
- Trustees should ensure that they have access to adequate actuarial and investment advice. However, the responsibility for the scheme always rests with the trustees, who should therefore ensure that they understand the advice they receive and the decisions they as trustees are required to take.
- Where in the guidance it is stated that action should be taken, this refers to recommended good practice. The guidelines supplement the Authority's Trustee Handbook and do not set out all of the trustees' compliance obligations.
- The provisions are divided into four parts:
- Data about the scheme that the trustees should have available to them
- Governance practices relevant to financial management
- Processes that the trustees should follow
- Analysis that the trustees should undertake in order to arrive at decisions
The guidelines contain a sensible set of good practice recommendations. Many Schemes will already have processes that meet many of the requirements.
One point that may not have been addressed with the full formality the guidelines suggest, concerns a written agreement between trustees and employers who meet scheme costs. If there is a flaw in the recommendations it is that they do not take full account of the employer's interests as funder and stakeholder. This is a difficult balance to maintain and trustees will want to work with employers in complying with the guidelines.
There is a significant focus on risk management which may be new to some trustees but which is at the heart of good scheme governance. We have experience of reviewing, auditing and developing governance arrangements, risk assessments and mitigation procedures. If these are not already part of the Trustees' business plan, they are likely to be from now on. If you have queries on risk issue or any aspect of the guidelines, please get in touch with any of the pension team or your usual Arthur Cox contact.
GOOD PRACTICE RECOMMENDATIONS IN DETAIL
Scheme funding data:
The minimum information the trustees of defined benefit schemes should have available to them are the following:
- Scheme asset value at least annually and within one month of year end
- Investment return relative to benchmarks and targets annually and within three months of year end
- Investment allocation relative to strategy annually and within three months of year end
- Scheme liabilities and solvency position (including progress relative to funding proposal, where relevant)1 at least annually2 and within three months of year end
- Costs compared to budget (where borne directly by the scheme) annually and within three months of year end.
The trustees should ensure that:
- there are regular scheduled trustee meetings (quarterly for larger schemes) and that all decisions about financial management are approved at formal trustee meetings with written records of same;
- the trust deed and rules of the scheme permits the trustees to delegate their powers and that such delegation is formally decided at a trustee meeting of which a record is kept;
- appropriate advisors and a scheme actuary are engaged that there is no conflict of interest with and that occasional rotation of such advisors occurs where it would be in the best interests of the members to do so;
- where the employer bears some or all of the costs of running the scheme that there is a written agreement between the trustees and the sponsoring employer setting out the terms of such agreement;
- there is a written statement of investment policy principles which describes the scheme investment strategy;
- trustees have a full understanding of their investment powers under the scheme rules and statutory investment regulations; and
- that trustees have a clear understanding of the contribution provisions under the trust deed and rules of the scheme and ensure these are properly followed.
In addition to their responsibilities under the Pensions Act, the following tasks should be undertaken by trustees periodically:
The reviews of investment strategy and contribution adequacy should be undertaken sooner in the event of any major change to the circumstances of the scheme.
The trustees have responsibility for the ongoing management of the scheme and subject to the Scheme's provisions must obtain and invest contributions with a view to providing the money necessary to meet the benefits set out in the scheme rules.
The guidelines draw to the trustees' attention to two important aspects of financial management:
- Are the scheme contributions adequate to provide the benefits of the scheme in the short and long term?
- What is the risk that the benefits cannot be paid?
In consultation with the scheme actuary, the trustees should consider the following:
- What contribution rate is needed to provide current and future benefits as set out in the scheme rules?
- Given the current contribution rates by members and employers, what rate of long-term investment return will be required to pay benefits?
Trustees should consider whether the required return is consistent with the current investment strategy.
- If the scheme currently meets the funding standard, what combination of contribution and investment return will be needed to maintain solvency relative to the standard over the next three years? If the scheme does not meet the funding standard and has a recovery plan in place, are the assumed rates of contribution and investment return in that plan sustainable and achievable?
- How willing and able is the sponsoring employer to maintain the contribution rates needed to pay the benefits? Trustees should have discussions with the employer around what would happen in the event that deficits occur in the future.
As well as assessing whether the scheme is adequately funded, the trustees must understand the risks to which the scheme is subject, i.e. what events may harm the scheme's ability to meet its obligations.
The trustees should undertake an annual risk assessment which identifies the biggest risks, assesses how likely they are to occur, assesses what impact they would have if they came to pass, and examines what the scheme should be doing to limit the risk.
There is a wide range of risk management templates available: the following is a high level overview of the process that trustees should follow, in consultation with their advisers and, where appropriate, the employer:
- Identify the greatest risks. The greatest risks for a typical defined benefit scheme are:
- Longevity increasing by more than expected
- Investment losses or lower than anticipated returns
- Liabilities increasing because of falling interest rates
- The sponsoring employer being unable or unwilling to pay the necessary contribution rate »» Scheme liabilities increasing because of unexpected growth in member earnings
Although it is rarely possible to put a meaningful numerical value on any risk, trustees should at least be able to assess likelihood as high, medium or low.
Trustees should make a broad estimate of the likely impact on the scheme solvency and cost of any of the risks, in consultation with the scheme actuary.
Where a risk is such that the future of the scheme would be threatened, trustees should decide what steps they should take to limit the impact. This may involve reducing the likelihood or the impact of the risk arising or deciding on the steps that will be taken if the risk comes to pass.
RESULTS OF THE ANALYSIS
The purpose of the above analyses is to identify threats to the ability of the scheme meet its liabilities and to allow the trustees to consider what they should do in response. Trustees need to recognise and be knowledgeable about risks and to make a conscious, informed decision of what action, if any, is being taken – taking no particular action to mitigate a risk is also a decision provided consideration has been given to how one will deal with the outcome if the risk materialises.
Trustees should bear in mind their responsibility to balance the financial interests of all members of the scheme. Some risks will have different effects on different classes of members. This is a challenge for trustees given their responsibility to balance the interests of all members of the scheme.
1 For larger schemes estimates of membership numbers should be used where appropriate in order to avoid delay. For all schemes, liability estimates should be used where appropriate.
2 In the event of major investment losses or increases in liabilities the scheme should review its funding position as soon as practicable.
* The 'Analysis' section below considers these tasks in more detail.
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.