The Pensions Regulator (TPR) has today published its second consultation on a revised defined benefit (DB) funding code of practice (the Code).
The consultation on the draft Code is being undertaken before the new regulations have been finalised, although there were significant representations made by the industry on those draft regulations. The consultation document highlights some areas that may be further considered in this regard.
TPR has also published a separate consultation setting out its proposals for its twin track regulatory approach to compliance and the proposed details of the Fast Track route that some schemes might choose to follow.
TPR anticipates that the new funding regime will come into effect no earlier than 1 October 2023 and will apply to actuarial valuations with effective dates thereafter.
The key principles set out in the Code are summarised below. In several areas TPR notes a proportionate approach can be taken, for example depending on scheme size, covenant strength and period to significant maturity. The Code is primarily for scheme trustees and the scheme’s sponsoring employer but that certain aspects apply to actuaries and will be of interest to covenant and investment consultants. While the Code is not a statement of the law certain matters have been delegated to the Code (eg/ the definition of significant maturity). Trustees may choose to follow an alternative approach to that set out in the Code provided they are satisfied the underlying legal requirements are met.
Low dependency asset allocation: Broad rather than exact cashflow matching is required and so a low dependency investment allocation (LDIA) can include a mix of ‘growth’ and ‘matching’ assets. Matching assets that can be used include government bonds and (mostly investment grade) credit, interest rate and inflation derivatives (including gilt repos) as well as other secure income assets such as some infrastructure and property, provided these produce predictable and stable income. The LDIA must have a “high resilience” to market movements, defined as a one year 1-in-6 shock to the assets and liabilities causing less than a 4.5% deterioration in funding level and expects that interest rate and inflation hedging should be in place of at least 90%. The principles would allow investment of up to around 25% to 30% in growth assets. The closer the scheme is to the date of significant maturity, the more granularity will be required when considering the low dependency asset allocation.
Low dependency funding basis: TPR has not taken an overly prescriptive approach to the assumptions to be used for the low dependency target. The legislative requirement that “no further (deficit) contributions are expected to be required” should be considered under all “reasonably foreseeable” circumstances and assumptions should be “chosen prudently” which mirrors some of the wording that has existed in the funding regime since 2005. Dynamic discount rate approaches can be considered as an alternative to a gilts (or swaps) plus a margin approach, where justified by the actual assets held. RPI assumptions must be market consistent with no allowance for an inflation risk premium, and unless the trust deed and rules provide for the employer to meet expenses, an expense reserve should be included. TPR notes that prudence can be considered in aggregate.
Significant maturity and relevant date: The draft Code sets out a fixed duration of 12 years for determining when a scheme is deemed to reach significant maturity, based on the assumptions in the low dependency funding basis. Trustees must choose a relevant date for reaching their low dependency funding and investment strategy that is no later than the end of the scheme year in which the scheme is estimated to reach significant maturity by the scheme actuary. In the light of the significant rises in yields during 2022, which will have caused the duration for many schemes to fall, the consultation document recognises that other approaches could be preferable, and the methodology will be reviewed once the DWP has decided its policy in this regard.
Employer covenant: TPR plans to move away from the four category approach used to date and instead defines three aspects of covenant which are relevant: covenant visibility (that is, the period for which valid forecasts from the employer are available), covenant reliability (the period over which there is reasonable certainty over available cashflow to fund the scheme) and covenant longevity (the maximum period the trustees can reasonably assume the employer will remain in existence to support the scheme). To assess these, there is a focus on employer cashflow, employer prospects and contingent assets. All trustees will be required to assess covenant but using a proportionate approach and having regard to the size of the scheme relative to the covenant, the level of risk and the scheme’s maturity. A consultation on detailed covenant guidance will be published in 2023.
Journey planning: Trustees must set out a plan for the evolution of the funding and investment strategy over the period to reaching the relevant date. The requirements for the journey plan are considered over two periods – the period of covenant reliability and the period afterwards. For the period of covenant reliability, TPR defines a maximum risk position that can be supported by available cash from the employer. After the period of reliability ends, linear de-risking is the least that should be assumed over the remaining period to the relevant date. Alternative journey plan shapes (eg a constant but lower risk approach throughout) are possible provided these are below the “maximum risk” position.
Statement of strategy: Detailed requirements are set out in the Code of the content that will need to be covered in the Statement of Strategy and signed on behalf of the trustees by the chair of trustees. However, TPR is not yet consulting on the form of the document that will be required.
Technical provisions: These must be consistent with the scheme’s journey plan and assumptions that relate to the period after the relevant date should be consistent with the low dependency funding basis.
Recovery Plans: Funding deficits must be recovered as soon as the employer can reasonably afford (including possible consideration of post-valuation experience and/or investment outperformance. In assessing what is reasonably affordable, trustees are able to consider “reasonable alternative uses” of employer free cashflow, including investing in sustainable growth, covenant leakage (such as dividend payments) or discretionary payments to other creditors. However, where funding levels are lower, or the period to significant maturity is short, less consideration should be given to the latter two elements, and using resources in this way should not lead to DRCs being required beyond the period when available cash is considered reliable.
Investment and risk management considerations: Trustees must plan to be invested in a low dependency manner from the relevant date in a low dependency manner, as agreed with the employer, from the relevant date, and must formulate a de-risking journey plan. However, the decision on actual investment strategy is for the trustee and the funding and investment strategy requirements do not limit trustees’ discretion over investment matters. The Code gives examples of situations where it may be justifiable for the actual investment strategy being followed to differ from that set out in the funding and investment strategy. However, TPR expects that in most circumstances the actual investment strategy adopted will be consistent with that set out in the Statement of Strategy.
Other aspects of interest include:
Open Schemes: Provided any assumptions made about new entrants and future accrual are justified by past practice and realistic expectations, open schemes may make some allowance for new entrants and future accrual over the period for which there is covenant reliability, thereby increasing the time period over which will be expected to reach a low dependency position. However, security for accrued benefits should be no lower for open schemes than for closed schemes of the same maturity.
Stressed Schemes: For a limited number of schemes a strategy which meets all the requirements of the funding regime may not be possible. TPR sets out the considerations for such schemes, including that it is unlikely to be appropriate for future service benefits to continue accruing.
Trustees may elect to use a Fast Track route to demonstrating compliance with the legislative requirements or a Bespoke route. The Fast Track requirements do not form part of the Code, since they do not form part of the legislative approach. A separate document will also allow TPR more flexibility to change parameters when required and it proposes to do a “deep-dive” review at least every three years.
If the Fast Track route is followed then trustees can expect minimum regulatory involvement, if any, on DB funding. The same Fast Track criteria apply to all schemes without any differentiation by covenant strength and it will be the responsibility of the scheme actuary to confirm to TPR that the Fast Track requirements have been met. The main requirements are:
The Fast Track assumptions were derived based on analysis as at 31 March 2021 and at this date TPR estimates that around 50% of schemes would have met all requirements.
TPR notes that it considered whether to have separate Fast Track parameters for very strong employer covenants although as this would apply to a minority of schemes, it considers that the Bespoke route provides the necessary flexibility and trustees of schemes whose funding and investment risks are assessed against a truly strong employer covenant should easily be able to provide the evidence that the employer can underwrite the risks.
The consultation will run for 14 weeks, with a deadline for responses of 24 March 2023. TPR will be actively engaging with stakeholders over this period on all aspects of the Code and its proposed regulatory approach.
