UK Pensions Briefing: The Pensions Regulator consults on its new DB funding code

Introduction

The current DB scheme funding regime is being fundamentally reformed, with wholesale changes expected to come into force in October 2023. 

In July 2022, the DWP published its consultation on the draft Occupational Pension Scheme (Funding and Investment Strategy and Amendment) Regulations 2023 but they are still to be finalised. Much of the finer detail was left for the Regulator’s Code to clarify. The draft Regulations were the subject of our September briefing. 

On December 16, 2022, the Regulator published its second consultation on the long-awaited draft DB Funding Code, which closes on March 24, 2023. This briefing looks at some of the detail in the new draft Code.

The Regulator’s current consultation

Four documents are published in the 200+ page consultation pack:

• Response to the March 2020 consultation. 
• Draft DB Funding Code of Practice – sets out the Regulator’s interpretation of the legislation and how it expects trustees to comply.
• DB Funding Code consultation document – explains the approach in the new draft Code. 
• Fast Track and regulatory approach consultation document – explains the Regulator’s twin track approach to valuations. 

Rather than being embedded in the draft Code, the twin track consultation has now been published separately, to allow greater flexibility for any future changes. 

The Regulator plans to lay the final version of the Code before Parliament in June 2023, together with the final Regulations. The new regime would then come into force for actuarial valuations with effective dates on or after October 1, 2023. Given this ambitious timetable, the Regulator accepts that there could be some slippage and of course it is still possible that both the draft Regulations and the draft Code could be further amended as a result of industry feedback. 

The new funding regime in a nutshell

The draft Regulations require DB schemes to have a “journey plan” aiming for “low dependency” on the sponsoring employer by the time they reach “significant maturity”. Trustees need to develop a “funding and investment strategy” and to submit a “statement of strategy” to the Regulator. By “significant maturity”, assets should be invested in a “low dependency investment allocation” and the scheme should then be fully funded on a “low dependency funding basis”. For the first time, the draft Regulations set out how the strength of the employer covenant is to be assessed and they stipulate that scheme deficits must be recovered “as soon as the employer can reasonably afford.” 

Below, we unpack each of these terms and look at the Regulator’s expectations. First though, a reminder of the two new documents the trustees must produce under the draft Regulations: the funding and investment strategy (the FIS) and the statement of strategy (the Statement).

An overview of the new documents required

The FIS

The trustees must agree the FIS with the sponsoring employer and it must be determined within 15 months of the effective date of the first valuation produced after the new regime comes into force (probably October 1, 2023).

In the FIS, the trustees need to:

• Determine the date of significant maturity and decide on a relevant date which must not be later than the end of the scheme year in which significant maturity is reached.
• Explain how they intend to provide benefits in the long term (their long-term objective). 
• Set out the funding level they intend to have reached and the investments they intend to hold at significant maturity (or did hold if the scheme is already significantly mature). The funding level at the relevant date must be calculated on the low dependency funding basis. 

The Regulator expects the FIS to be highly resilient to short-term adverse changes in market conditions. It also expects trustees to consider the FIS and the valuation together as one, and for them to work collaboratively with the employer to produce it. 

The Statement 

The trustees and employer must consult to produce a written statement of strategy (the Statement) explaining their progress in achieving the FIS aims. The first part of the Statement records the FIS detail and must be updated to reflect any changes. 

The second part sets out various supplementary matters, such as the journey plan, the extent of FIS implementation and how any risks to the strategy are being managed. 

The Statement must be submitted to the Regulator along with a copy of the actuarial valuation.   

More detail on the key terms in the new regime

What is meant by a journey plan?

The journey plan in the FIS is the trustees’ bridging proposal from the current funding position to the long-term funding target. They must decide on the investment strategies to adopt as the scheme moves towards significant maturity, reflecting the scheme’s and employer’s circumstances and incorporating a proportionate level of risk.

What does the Regulator say about significant maturity and the relevant date? 

Maturity is the measure of how far a scheme is through its lifetime. The draft Regulations give the Regulator discretion on the calculation of significant maturity of a scheme in years, using a measure of duration of liabilities. As widely expected, the draft Code provides that a significantly mature scheme is one in which the duration – that is, the average time to payments of future benefit instalments – is 12 years. In a significantly mature scheme, most members would therefore be pensioners. However, the Regulator acknowledges that the DWP may yet alter its approach to measuring duration. 

Which assets does the Regulator consider acceptable for a low dependency investment allocation? 

From the point a scheme reaches significant maturity, investments should be held in a low dependency investment allocation, removing reliance on further employer contributions. 

However, the Regulator accepts that there may be good reasons for not investing in accordance with the low dependency investment allocation:

• Where the scheme has a funding surplus after the relevant date.
• If the employer does not agree to a strengthening of the low dependency investment allocation being recorded in the FIS. 

The Regulator recognises that significantly mature schemes have less opportunity to repair negative investment outcomes and, in most cases, a low dependency investment allocation after the relevant date is appropriate.

The assets should be sufficiently liquid to enable the scheme to meet expected cash flow requirements, with a reasonable allowance made for unexpected needs. Hedging is acceptable in relation to the unmatched portion of the cash flow liability. 

What is a low dependency funding basis according to the Regulator?

In a low dependency funding basis, the scheme’s actuarial assumptions should be consistent with low dependency on the employer at significant maturity and the low dependency investment allocation. There is no prescriptive approach but assumptions are expected to be chosen prudently.

More detail on what the Regulator means by “broadly matched”?

Under the draft Regulations, cash flow from investments must “broadly match” the payment of benefits. There was some concern that significantly mature schemes would need to be invested exclusively in bonds or to be entirely cash flow matched. However, the draft Code interprets this idea more flexibly. 

The Regulator interprets “broadly matching” for the purposes of Fast Track (see more details on Fast Track below) as allowing for 15 per cent growth assets, and accepts that where risks are well-managed, that allocation could be 15-20 per cent. While the main suitable cash flow-matching assets include cash, government and corporate bonds, the Regulator also accepts the use of illiquid investments like property and infrastructure.

How does the Regulator expect trustees to assess the employer covenant?

For the first time, legislation sets out a definition for the strength of the employer covenant as the financial ability of the employer to support the scheme, together with any legally enforceable contingent assets. The level of risk that can be taken by a scheme moving on its journey plan is dependent on the strength of the employer covenant, and this approach continues to underpin the Regulator’s concept of integrated risk management.

Instead of the current four covenant grades, the Regulator will expect trustees to assess covenant on the three fundamental pillars of employer’s cash, contingent assets and prospects. Under the draft Code, the trustees’ assessment of covenant strength should consider:

Visibility over the employer’s forecasts, typically covering the short term of one-three years.

Reliability over available cash, considering the historical accuracy of management forecasts and the employer’s prospects in the medium term. 

Longevity which is the maximum period in which trustees can reasonably assume the employer will remain in existence to support the scheme. 

The Regulator accepts that there are other reasonable uses for the employer’s available cash, such as investment in the sustainable growth of the employer, payments out like dividends and discretionary outlays such as the early repayment of a loan. Trustees will need to consider whether any alternative use of cash is appropriate, or whether the scheme should take priority. The Regulator expects the employer and the trustees to conduct collaborative discussions and new covenant guidance is due to be published for consultation in early 2023.

Recovery plans and the Regulator’s view of “reasonable affordability”?

In determining any recovery plan, the trustees must consider the reasonable affordability of proposed contributions for the employer. The Regulator also mentions allowing for investment outperformance and post-valuation experience. While there are no benchmarks for the length of recovery plans in the draft Code, the Regulator has set a limit of six years for schemes using the Fast Track regime where the scheme is not yet significantly mature, and three years after significant maturity. Where a recovery plan is longer than six years, trustees will need to justify their approach.

Other aspects of the draft Code and the new DB funding regime

What does the Regulator say about open schemes?

The draft Code allows open schemes to make a reasonable allowance for future accrual and new entrants, and accepts that will delay significant maturity in comparison to an equivalent closed scheme. The Regulator acknowledges that investment risk in an open scheme can be taken over a longer period of time and this will affect the scheme’s journey plan. In setting the technical provisions, trustees should ensure security for past service benefits, and consider whether any surplus should be used to fund future accrual. 

Does LDI get a mention in the draft Code?

The Regulator is aware of concerns raised relating to leveraged LDI and the impact such investments may have in future. Some discussion points are included in the consultation paper. The Regulator’s proposals for Fast Track include some specific allowance for leveraged LDI, and a small level of leverage is factored into the stress test.

A look at the key parameters in the Fast Track

As discussed in our March 2020 briefing, the Regulator is introducing a twin-track approach to future valuations: a ‘Fast Track’ regime which meets certain risk criteria to simplify compliance where this is appropriate; or ‘Bespoke’ which allows schemes to produce more tailored valuation proposals, and which the Regulator will examine more closely. The separate Fast Track consultation includes the following parameters to meet ‘Fast Track’:

• Recovery plans where the maximum recovery plan length is six years for a scheme not yet significantly mature, or three years otherwise.
• A low dependency funding and investment target of gilts +0.5 per cent measured against certain specific minimum financial assumptions. 
• Technical provisions are to be assessed as a proportion of the long-term funding target, depending on how far the scheme is from reaching significant maturity. 
• Investment risk to be assessed using a stress test similar to the PPF methodology.

Some of these requirements are likely to be simplified for small schemes with fewer than 100 members. 

Fast Track represents the Regulator’s view of tolerated risk rather than minimum compliance. The Regulator sees Fast Track as a “filter”, and it is unlikely to engage with the scheme’s trustees where the actuary has certified that the Fast Track parameters have been met.  

Where Fast Track is the chosen route, the criteria must be met regardless of the strength of the employer covenant. As mentioned, a Bespoke route is also possible and equally valid, although the Regulator will expect more justification for this approach depending on the complexity of the proposals.

Considerations for trustees and employers

There is a great deal to do for all concerned before the new regime comes into force. Despite changes of key personnel at the Regulator taking effect in March this year, trustees and employers should work on the basis that there will be a new funding Code and Regulations in place by October 2023.

Actions for both parties:

• Note that the draft Regulations require them to agree the trustees’ FIS, which must then be submitted to the Regulator.
• Approach the production of the FIS collaboratively.
• Seek advice from the scheme actuary on:
  • Whether the scheme is likely to satisfy the Fast Track criteria.
  • The scheme’s level of maturity as this will affect the FIS. If significant maturity has already been reached, the scheme investments may need to be changed quickly.
• Consider responding to the consultation by March 24, 2023.

Actions for Trustees:

• Consult with actuarial and investment advisers to assess how their current scheme-specific investment approach may need to change to accommodate the new regime.
• Consider whether the Fast Track valuation approach is likely to apply to their scheme. If a Bespoke approach is to be taken, covenant assessment and contingent asset advice may be required.
• If the scheme is likely to take the Bespoke approach to its next valuation, consider what extent of covenant and contingent asset advice may be required.

Actions for Employers:

• Start discussions with trustees on their low dependency and investment targets as soon as possible. 
• Note that additional advisory costs may be involved in compliance with the new regime.
• Be prepared to share detailed financial information and business plans with trustees.
• Consider the impact of any necessary scheme deficit payments on corporate growth and other spending plans.

Next steps

It is important for schemes to get on board with the new requirements without delay, so that all concerned understand what the new regime entails. For some schemes, although the new regime may mean “business as usual” as far as their investment approach is concerned, there is still the production of the new FIS and Statement to get to grips with. 

The significant maturity of the scheme will need to be assessed as soon as possible, even where a valuation is in process or has recently been completed. It is possible that the low dependency requirement may be closer than previously thought for some schemes and, if so, it is likely that the investment approach will need to be reconsidered in order to meet the low dependency provisions at the relevant date.

The DWP may yet change its views on how to measure duration. Schemes should stay in close contact with their advisers to be ready for any potential change, as well as to set in train other necessary preparations ahead of October.