On 3 March 2020, the Pensions Regulator published a consultation on the principles it proposes to adopt in regulating DB pension scheme funding and investment strategies (see our News Alert for our initial summary and analysis).

The final detail of the new regime won’t be clear for some time, but it is likely to be a significant change with the Pensions Regulator regulating investment strategy directly for the first time. The consultation sets out the details of a potential stress test of assets vs. liabilities, similar to that currently used by the Pension Protection Fund.

The immediate question we’re answering for our clients is what does this development mean for their investment strategy?

This leads on to three questions:

1. The long-term target - where are you going?

It seems that the consultation document very much continues the theme from the 2019 Annual Funding Statement; ushering in the era of a “long-term funding target” as a statutory measure alongside the Technical Provisions. So, for all schemes, early consideration should be given to getting specific about the longer-term investment strategy for the scheme.

This has become best practice among many schemes over the last decade, so is already widespread, but some schemes may want to ensure their long-term target remains relevant and up to date and is specific enough around how the trustees plan to invest when they reach a significantly mature state. In my experience many long-term strategies have remained high-level and vague when it comes to the specifics of investment strategy. In some ways this is understandable, it is far off and impossible to say for sure today which assets will be suitable. But we can make some progress on setting out what the strategy may look like, and we think trustees will want to table a discussion of this issue at a timely point in the lead-up to the next valuation.

The consultation makes clear that the Pensions Regulator envisage the investment position at a significantly mature state to consist mainly of matching assets, which hedge liability risks, with an allocation of around 20% to growth assets.

It also looks likely that in the new regime all schemes will need to agree a joined up long-term investment and funding plan. On the funding side, this will involve agreeing a long-term discount rate target, for example Gilts+0.5% pa. In turn, this will have implications for long-term investment strategy, and the trustees and sponsor will wish to discuss and agree the nature of the investment strategy that is expected to back that discount rate in (say) 10 years’ time, and the agreed way of trending to that strategy over the coming years, including any market-based triggers for de-risking.

2. The journey - when and how should you get there?

It might well be the case that your scheme will be getting close to the maturity point at which the Regulator expects the long-term target to be reached (we estimate that around 40% of the schemes we cover could reach this point within the next two valuation cycles). So, we recommend that trustees take a good look at the journey plans they have in place to evolve the investment strategy toward the target to ensure this remains relevant, realistic and achievable. This includes any market-based or funding-based investment de-risking triggers that the journey plan relies on.

3. The investment risk in the strategy - where are you now?

The Regulator is consulting on a new regime that will likely require all schemes to test their investment strategy using standard “stress tests”. The level of risk that a scheme is permitted whilst remaining “Fast Track” will likely depend on the scheme’s maturity and the strength of the sponsor’s covenant. A mature scheme will be required to have very low investment risk, whereas an immature scheme with a strong covenant is expected to be allowed by the Regulator to take on more risk within Fast Track. 

It will be possible for schemes to choose a “Bespoke” approach to meeting the new requirements, rather than Fast Track.  This may enable a scheme to take on more risk if the trustees wish. However, the trustees will need to justify that decision to the Regulator, with good reason, and explain why the level of risk being taken is acceptable, relative to Fast Track. The consultation highlights CDI (cashflow-driven investment) as one possible approach that might breach the Fast Track risk requirements for a mature scheme but will be allowed under bespoke.

Therefore, either way, it will be important for trustees to understand their Fast Track position and understand the extent of any changes needed in their investment strategy in order to meet the Fast Track requirements.

It is likely that one of the biggest risk drivers under the proposed stress tests will be the interest rate hedge levels (relative to the long-term liabilities), so those schemes with relatively low hedge levels - below 50% say - are those most likely to be at risk of falling outside the Fast Track risk parameters.

Where it appears that a scheme may currently be in breach of Fast Track, trustees and sponsors should discuss and agree the way forward.  We envisage that schemes in this situation will typically fall into three categories:

1. Some will have good reason to remain invested as they are, and will wish to begin to build their case for being Bespoke under the new regime;
2. Others will agree that it is likely that they will need to further de-risk their investment strategy in due course, but will wish to await further detail of the new regime before considering this further and implementing any changes;
3. Yet others will wish to start a program of de-risking shortly, to spread the implementation of any desired changes over time, to reduce the risk of trading at inappropriate times.

So, whenever you last reviewed your investment strategy, we recommend you look at it again soon to consider whether changes are needed now and in the future, asking the following key questions:

• Would my investment strategy meet the Fast Track test today?
  • What about in five years’ time? What if the covenant got downgraded?
• How are we planning to be invested when we reach a significantly mature state?
• How is the investment strategy going to evolve to get there?
  • Does this align with the evolution of the Technical Provisions discount rate?

One possible consequence of the new regulatory funding regime could be increased sponsor engagement on investment strategy, so trustees ought to be ready to respond thoughtfully to sponsor proposals, or to plan to get on the front foot with their own proposals and negotiate a mutually agreeable position and journey forward where possible.