United Kingdom

Aon sees multiple challenges in Funding Code consultation

LONDON (3 March 2020) – Aon, a leading global professional services firm providing a broad range of risk, retirement and health solutions, has said that while it welcomes the launch of the consultation on a new defined benefit (DB) funding code - and many of the concepts within it - there will be numerous challenges to turn those concepts into a practical regime.

The consultation on a new code of practice for DB pension scheme funding was launched at Aon's Pensions Conference in Bristol.

Paul McGlone, partner at Aon, said:
"It’s good news that the consultation has finally been published and that the industry can start to make progress on this important issue. The consultation is very long, with lots of detail and lots of questions. It will take time for all concerned to digest it properly.

"Given that the 2018 White Paper said that the funding regime "works well on the whole" it's perhaps surprising that the consultation proposes such a fundamental change, with implications for almost all DB pension schemes and sponsors."

Paul McGlone continued: “When we surveyed clients in February 2020, around 67% expected the new funding code to have a positive impact on them. Now that the consultation has been launched it is clear that, although the principles are there, the detail is missing. While that makes it difficult to reach conclusions, it does show that this is not a done deal. There is plenty still to examine and we look forward to engaging with the Pensions Regulator (TPR) to do that - and we would encourage all schemes and sponsors to make their views known."

Picking out just some of the key issues in the consultation, Aon commented as follows:

Three tests in one
The consultation proposes a Fast Track test which serves a number of purposes.

Paul McGlone said:
"The Fast Track test was primarily expected to be a simple set of rules that would enable schemes to know they are compliant, with Bespoke compliance permitting much more flexibility.

"The consultation now makes clear that Bespoke cases will also be tested against the Fast Track approach, and only approved if they can justify how they deviate from Fast Track. TPR has introduced the phrase "tolerated risk" to describe Fast Track, implying that it will not willingly tolerate anything too different. That could substantially raise the bar for schemes which don't meet Fast Track.”

Paul McGlone continued:
"The third use of Fast Track relates to the s231 powers being amended by the Pension Schemes Bill. Those give TPR the right to impose a funding approach, and the implication in the consultation is that Fast Track could be the approach that they impose.

"There is danger with the same Fast Track model being used for all three purposes - is what is right for one purpose right for the other purposes?"

Reliance on covenant
Much of the consultation considers the role that covenant plays in funding, but without a clear view of how it should be recognised in technical provision assumptions, investment policy or long-term targets.

Ryan Cox, senior covenant consultant at Aon, said:
"The starting point for the Fast Track tests, and by implication the Bespoke approach, appears to be the covenant assessment, which is recognised as a somewhat subjective measure, and a vast simplification of the complexities that underlie covenant strength. The fact that such a rigid funding structure is built on such a foundation is surely a cause for concern.

"There is also the surprising suggestion of ignoring covenant when assessing technical provisions in Fast Track tests. This is on the basis that this would provide greater transparency and that there is generally poor visibility of covenant strength beyond the next three to five years. While this is an unlikely course of action, the increased focus on limited covenant visibility will reduce the importance of covenant on funding assumptions.

"In practice, even if covenant were removed from the assessment of technical provisions, trustees would still need to engage with covenant assessment when considering affordability, to determine contingency actions if the employer's fortunes change, and in the event of corporate events."

Progression of responsibility
The consultation is set to put decision-making on assumptions firmly within the remit of TPR, in a way which has not happened since the Minimum Funding Requirement in the 1990s.

Matthew Arends, head of UK Retirement Policy at Aon, said:
"With the advent of scheme specific funding in 2005, the power to set actuarial assumptions moved to trustees. The proposals in this consultation now effectively move a substantial power to set assumptions into the hands of TPR.

"Although Fast Track was originally envisaged as a simple test purely for those schemes which wanted a simplified approval process, it threatens to become the default for far wider purposes, particularly as Bespoke compliance will be determined by the proximity to Fast Track.

"Given the decision not to construct the funding regime as a ‘risk free’ arrangement, TPR is putting itself firmly in the firing line in the event of future failures of schemes which had met all its Fast Track tests yet still left members without benefits in full."

Lack of detail
Although the consultation is extensive, much of it covers questions and the pros and cons of different approaches, rather than giving proposed parameters.

Paul McGlone said:
"While there are some definite clues in the consultation, there is noticeable lack of information about where Fast Track will be set, and how much Bespoke will be able to vary from Fast Track.

"It's understandable that a consultation should be open, and not final, but it's very difficult to comment helpfully on a concept alone, with just a few clues as to where the parameters will be set."

Substantial Investment concepts
Although this is nominally a funding code there is a lot of material on investment, including comments on security, quality and liquidity of assets, as well as the introduction of an asset stress test and mandatory de-risking over time.

Daniel Haxby, senior risk consultant at Aon, said:
"While TPR states its role is not to direct how trustees should choose to invest, it is difficult to see how the combination of prescriptive journey plan parameters and maximum tolerated risk will not have a major impact on schemes' asset portfolios. While funding level de-risking is not ruled out, time based de-risking is definitely ruled in – and the extent to which covenant gives any leeway to investment strategy is uncertain.

"The investment community will need to engage with this consultation - it cannot be left purely to actuaries."

Clearer ability for TPR to use powers
Although the consultation itself does not propose new powers, the proposals in the Pension Schemes Bill to beef up s231 of the Pensions Act 2004 could be significant.

Matthew Arends said:
"The increased clarity on what TPR expects, introduced by a new funding code, means that TPR should be much better able to deem a scheme non-compliant and to use its powers. To date, that has proved difficult as the measure of what is acceptable has been unclear.

“Where TPR concludes that a scheme is not meeting the stated principles, not meeting Fast Track, and, in TPR's view, has not put in place suitable risk mitigation, then use of powers should be more easily justified. When this is combined with the additional powers proposed in the Pension Schemes Bill, which give TPR the power to impose a funding strategy or investment strategy, we expect it to have a real impact on less well funded schemes - and therefore on UK plc."

Timescales longer
While the industry was expecting the code to be in place for April 2021 valuations, the proposed timescale of December 2021 is substantially longer.

Paul McGlone said:
"With most schemes having March or April valuations, it is those in 2022, 2023 and 2024 which will be the first under the new regime. For some schemes, that is still four years away, effectively meaning a very long transition period.

“Although that is some time to wait, it's important to get this right. Having an extensive lead time means that TPR can learn on the job by testing its ideas on valuations this year, while trustees have plenty of time to get their schemes in shape."


About Aon

Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retirement and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance.

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