Of interest to all DB schemes is the new guidance published by TPR to help trustees comply with the DB funding code and to manage the associated risks. A key part of the DB funding code is adopting an integrated approach to risk management. The new guidance is to be applied with the DB funding code and TPR’s employer covenant guidance. Together, the three documents comprise TPR’s core guidance on the fundamental risks to DB scheme funding. TPR intends to establish a system of integrated risk management (IRM) to help schemes focus on the interaction between different risks. More detail is set out below.
Managing scheme funding risk
The IRM guidance document clarifies how trustees can identify and manage the factors affecting a scheme’s ability to meet funding liabilities as they arise, particularly where one factor can affect risks in different areas, for example, where a weak employer covenant may impact on funding risk. The IRM guidance should be read and operated by schemes in conjunction with:
TPR identifies the key benefits of IRM as:
- helping schemes identify, prioritise and quantify material risks, and assessing the inter-relationships between these risks;
- promoting better decision-making due to greater trustee and employer understanding of material risks;
- encouraging greater employer and trustee collaboration though open and constructive dialogue about strategic material risks. TPR sees this as a useful starting point for future engagement on the parties' risk capacities and “risk appetite”;
- helping to promote a proportionate focus on the principal risks, and thus helping trustees to adopt a proportionate approach to risk assessment, contingency planning and material risk monitoring;
- assisting schemes to better manage the trustees' and employers' time on addressing scheme risk-management; and
- making it easier for trustees and employers to explain their decisions to third parties, including TPR, especially when the process for risk assessment and management has been documented.
Establishing an IRM framework
To assist trustees and employers in successfully establishing an effective IRM framework, TPR's guidance sets out a series of steps to follow:
Step 1: Initial considerations for putting an IRM framework in place
The guidance does not prescribe an IBM framework formula, as each will be shaped by a scheme's objective. Schemes should not wait until their next actuarial funding cycle to start the process. The responsibility for driving the process rests with the scheme trustees and they should ensure that their approach is “appropriate and effective” (paragraph 17). A key part of the process is collaboration between the trustees and the employer - one of the key principles of the DB funding code. Both parties should understand the other's risk capacity and the reasons why their positions may differ.
Step 2: Risk identification and the initial risk assessment
Initially, there should be a review of the scheme's current position and risks, which should reflect the trustees' existing funding and investment strategies. A key part of this is a current assessment of the employer covenant. Trustees should be aware of the range of material risks associated with the actuarial assumptions, the investment strategy and statement of investment principles, and the risks related to the employer covenant.
The risks should initially be viewed in isolation, but to develop a successful IRM framework it will be necessary for schemes to consider how the risks interact, for example, considering funding risk and covenant risk together (paragraph 31). The final stage of step 2 is for all of the risks to be considered together, re-addressing questions asked at the earlier stage, for example, what is the likely impact of this risk, is there a concentration of risk that affects more than one area, do any “risk themes” emerge?
Step 3: Risk management and contingency planning
Steps 1 and 2 will enable the trustees to assess if they are comfortable with the current risk position of the scheme's funding, investment and covenant positions. These are identified as forming three sides of the “triangle” of overall DB risk. Even if no action needs to be taken immediately to manage risk, the scheme's IRM framework should be developed to react to future changes in risk.
If necessary, the framework should first be applied to manage any current risks. Next, contingency plans should be developed to help schemes deal with material risks as they arise. This may require an assessment of how schemes would know where key elements change, for example, if the employer covenant deteriorates or the level of funding risk exceeds the agreed capacity. The framework should address whether the actions that such changes will trigger are sufficient to manage the risk to an acceptable level (paragraph 40).
Step 4: Documenting the decisions
The record of the trustees' decision-making process, and the final IRM framework document, is not subject to specific recommendations by TPR. Instead, TPR considers that, in accordance with their good-record keeping obligations, trustees should maintain a record of the development of the framework (paragraph 44).
Step 5: Risk monitoring
The guidance confirms that constant monitoring is vital to a successful IRM framework, allowing trustees to respond quickly and effectively to manage any future risks. The assessment of risk should not be viewed as a “hurdle to overcome”. The frequency of framework monitoring will depend on the materiality of the scheme's risks and the scheme's resources. TPR acknowledges there is a cost involved in this process and that, for many schemes, it will be possible to base the monitoring of the IRM framework's effectiveness on information that is already being produced.
How schemes should use the guidance
The guidance states that for the first draft of the IRM framework, the trustees may wish to ask their incumbent advisers to take the lead in putting a framework in place. However, to assist trustees in putting the guidance into practical effect, examples are offered in relation to each of the various steps. In addition, the appendix to the guidance provides examples of various risk assessment approaches that schemes may choose to use and which may inform their discussions with their advisers.
The IRM framework guidance builds on the principles established in the DB funding code and the employer covenant guidance. With the investment strategy guidance due in 2016, TPR's guidance framework for managing DB scheme funding will be reflected in five separate documents and several hundred pages for trustees, employers, and their advisers to digest.
However, the reaction from the industry has been predominantly positive. The non-prescriptive nature of the guidance, which recognises that there is no one-size-fits-all approach to monitoring scheme and corporate risk, is seen as sensible. There is a clear and practical requirement for trustees, sponsors and advisors to work together to establish the extent of their respective risk appetite and toleration level.