Draft funding Code offers some flexibility to DB schemes and sponsors

The Pensions Regulator has launched its long awaited consultation on a new funding Code of Practice for defined benefit (DB) pension schemes. The draft Code sets out the Regulator's views on how the new statutory requirements regarding the need for trustees to put in place a long-term funding and investment strategy for their scheme are intended to interact with the existing statutory funding regime. Alongside the draft Code, the Regulator has set out the parameters a scheme's valuation and funding arrangements would need to meet to be deemed 'acceptable' under the light touch fast-track assessment route.

Encouragingly, the draft Code indicates there will be more flexibility under the new regime than had been indicated in previous consultations. However, it is still not always clear how to reconcile the approach outlined in the Code with the draft Regulations.

The current intention is for the new funding requirements and Code to come into force on 1 October 2023, meaning they will apply to valuations with an effective date on or after that date. In an attempt to deliver on this timetable, the draft Code has, unusually, been published for consultation before the relevant regulations have been finalised. However, this timetable may still slip. Some aspects of the draft Code may also need to be updated to reflect any changes contained in the final regulations.

Immediate actions

• Trustees should consider with their advisers the potential impact of the new funding requirements and the Code on their scheme's funding and investment strategy and how it may impact the approach to future valuations.
• Sponsors should consider with their advisers the potential impact of the new funding requirements and the Code on matters such as pace of funding, payment of dividends and business investment and the merits of granting their scheme new or additional contingent security.
• Trustees and sponsors should also consider responding to the consultation (which closes on 24 March 2023) where the contents of the draft Code do not cater for the needs of their scheme.

How will the new funding regime work?

The draft Code sets out how the Regulator sees the new funding regime working in practice. In short, under the new regime trustees will be required to put in place a long-term funding and investment strategy for their scheme, setting out:

• the planned long term funding objective for their scheme;
• the investments they intend to hold on the relevant date; and
• the journey plan they intend to follow to get from their current funding position to their long term objective.

In most cases, trustees will be required to agree the funding and investment strategy with their scheme's employer(s).

As a minimum, a scheme's long term funding objective must be calculated on a "low dependency funding basis", which means:

• further employer contributions would not be expected to be required to make provision for accrued rights to pensions and other benefits under the scheme once the target is met; and
• it must be calculated on the assumption that the scheme's assets are invested in accordance with a "low dependency investment allocation" (see below).

Going forwards, trustees will be required to calculate their scheme's technical provisions (at each statutory valuation), in a way that is consistent with their scheme's funding and investment strategy.

The draft Code and accompanying materials contain a lot of detailed information on how this will work in practice. We have summarised some of the key points below.

Key points

Significant maturity

A scheme's long-term funding and investment strategy must be set by reference to what the legislation refers to as the "relevant date". A scheme's relevant date is to be set by the trustees. It must be no later than the end of the scheme year in which the scheme is expected to reach (or did reach) "significant maturity" (though, based on the draft regulations, it can be set at any date in advance of this).

According to the draft regulations, a scheme will reach significant maturity on the date it reaches the duration of liabilities in years specified by the Regulator in its Code. The Regulator has indicated that the relevant duration may be set at 12 years. However, this may be revised in light of potential changes that may be made to the draft regulations in response to the fact that the duration of liabilities for most DB schemes has reduced significantly due to the increase in gilt yields over the past year and a half.

Low dependency investment allocation

A scheme's low dependency funding target needs to be calculated on the assumption the scheme will adopt a low dependency investment allocation from the relevant date. A low dependency investment allocation is one that complies with an objective that further employer contributions are not expected to be required to make provision for accrued rights to pensions and other benefits under the scheme, where the assets of the scheme are invested in such a way that:

• the cash flow from the investments is broadly matched with the payment of pensions and other benefits under the scheme; and
• the value of the assets relative to the value of the scheme’s liabilities is highly resilient to short-term adverse changes in market conditions.

In its draft Code, the Regulator indicates that schemes will be able to invest in a broader range of assets than many people expected and still comply with the requirement for assets to be invested in a way that the cash flow is "broadly matched" with the payment of pensions and other benefits. The Code also indicates that schemes will be permitted to retain a greater level of exposure to growth assets after the relevant date than had been expected.

Somewhat surprisingly, the Code also indicates that trustees are not required to invest in line with the low dependency investment strategy set out in their long-term strategy and that there may be circumstances in which it is appropriate for them to deviate from this. For example, where a scheme has a weak sponsor, adopting additional investment risk may be justified on the basis that offers the best chance of ensuring that members' benefits can be paid in full (without taking undue risk).

While this flexibility is welcome, it is difficult to reconcile this with the draft regulations which require a scheme's statement of strategy to set out the investment strategy the trustees intend to hold at the relevant date. However, we hope this will be clarified in the final regulations.

Affordability

Consistent with the draft regulations, the draft Code makes clear that when putting in place a recovery plan trustees must follow the overriding principle that funding deficits must be recovered "as soon as the employer can reasonably afford".

When assessing what is reasonably affordable trustees will be expected to consider whether it is reasonable for their employer to be putting its available cash to alternative uses such as:

• investing in the business
• covenant leakage (e.g. distributions to shareholders or intercompany loans)
• discretionary payments to other creditors (e.g. early repayment of a loan).

The Regulator indicates that covenant leakage or discretionary payments will be considered less reasonable where:

• a scheme has a low funding ratio;
• a scheme is running risks that are not supported by the employer covenant;
• an underfunded scheme is approaching significant maturity; and/or
• this would mean deficit repair contributions will continue to be needed after the period in which trustees have reasonable certainty that cash will be available.

Where an underfunded scheme has past significant maturity, the Regulator indicates deficit recovery contributions should be prioritised over all alternative uses, including investment in an employer's business, where the trustees are not confident this investment will result in growth within a period consistent with the scheme's liability profile.

Employer covenant and contingent security

Generally speaking, trustees will need to be able to demonstrate the investment and other risks their scheme is running are supported by the employer covenant (referred to in the draft Code as the "principle of supportability"). The Code contains guidance on how trustees should assess the strength of their employer covenant by reference to an employer's cash flow and future prospects and the value of any contingent security (which meets prescribed requirements) that the scheme has been granted.

The Regulator's expectations as to the length of time an employer's current covenant strength can be relied upon to support a scheme's funding and investment risks may be significantly shorter than many schemes were expecting. This may mean that in future there will be even more focus on the use of contingent assets and asset backed liability arrangements to, for example, enable schemes to:

• run higher levels of investment risk for longer; and/or
• make allowance for investment outperformance in their scheme's recovery plan (thereby reducing the amount of the deficit that needs to be cleared through deficit repair contributions).

Contingent security could also be used to reduce the risk of trapped surplus, which is likely to be exacerbated by the new funding requirements.

The Regulator plans to consult on updated guidance on assessing employer covenant, which will build on the guidance contains in the draft Code, in the coming months.

Fast track or bespoke?

As expected, the Regulator has confirmed it intends to adopt a twin-track approach to assessing valuations in the context of the new funding regime – fast-track and bespoke.

Where a scheme's valuation submission meets a series of fast-track parameters, the Regulator is unlikely to scrutinise it further. The bespoke route offers trustees and sponsors greater flexibility and scope to adopt an approach that is more suited to the circumstances of their scheme. However, trustees going down this route will need to be able to demonstrate that:

• the total risk run by their scheme is supportable by the employer covenant and in line with the maturity of the scheme;
• they cannot meet the fast-track recovery plan length based on demonstrable affordability constraints; or
• they have genuinely unique employer circumstances that necessitate a different approach.

The level of evidence and explanation required will depend on the nature and level of complexity of the risks being taken.

Helpfully, the Regulator makes clear that fast-rack and bespoke are both valid options and that, where a scheme goes down the bespoke route, it will not be judged by reference to the fast-track parameters (as had been suggested in its previous consultation).

Fast-track parameters

The parameters schemes will be required to meet to go down the fast-track route will be set out alongside the Code rather than being set out in the Code itself. This will make it easier for the Regulator to modify the parameters in future should this be necessary.

The Regulator is proposing to prescribe parameters in relation to the financial assumptions used in a scheme's valuation, the level of investment risk a scheme is running, the length of a scheme's recovery period and the terms of a scheme's recovery plan. Key parameters include:

• a discount rate of gilts +0.5% (with consistent inflation), when a scheme’s remaining duration is 12 years;
• technical provisions being at least a prescribed percentage of a scheme's long-term funding objective depending on the remaining duration (e.g. 85% at 20 years);
• a funding stress test of up to 4.5% for asset risk, based on a 1 in 6 Value at Risk using the PPF’s methodology;
• a maximum recovery period of 6 years, for a valuation before the relevant date and 3 years for a valuation on or after the relevant date;
• no allowance for future investment outperformance in a fast-track scheme's recovery plan or schedule of contributions; and
• annual increases to deficit recovery contributions should not exceed the assumed level of CPI inflation.

The Regulator will leave trustees to set demographic assumptions that are appropriate for their scheme, taking account of guidance set out in the Code and its fast track guidance.

The Regulator is at pains to stress that the fast-track parameters are not risk-free and they do not represent minimum compliance. Rather they represent the Regulator's view of tolerated risk and it does not remove the need for trustees to consider whether a more (or less) conservative approach is appropriate in the context of their scheme.

Open schemes

Concerns have been expressed about the impact of the new funding requirements and the Code on the cost of funding open schemes. Although the Code reiterates that trustees of such schemes should comply with the principle that past service in an open scheme should have the same level of security as an equivalent closed scheme, it makes clear this does not mean that the same level of technical provisions is needed for an open and equivalent closed scheme.

In particular, the Code recognises that, for the purposes of journey planning, it may be appropriate for trustees of an open scheme to assume an allowance for future accrual and new entrants, which will delay the point at which the scheme is expected to reach significant maturity. This means when setting their technical provisions trustees of open schemes can allow for higher levels of investment risk to be taken over a longer period of time than an equivalent closed scheme with an equivalent employer.

Comment

The draft funding Code will alleviate some of the concerns trustees and employers may have had following the Regulator's previous consultation and the publication of the draft regulations. That said, there are so many elements to the new regime (and how it interacts with the current scheme funding requirements) that it will take trustees and sponsors (and their advisers) some time to understand the full implications. These will only become fully apparent as schemes begin to go through the statutory valuation process once the new requirements are in force.

For some schemes and sponsors this may mean that the fill impact of the new regime will not be felt for a number of years. However, where that is the case, sponsors would be well advised to consider the potential impact of the new regime at an early stage as, in most cases, the time by which their scheme will need to be fully funded on a low dependency basis is already running down.

If you would like to discuss how the new funding requirements may impact your scheme or organisation speak with your usual HSF adviser or contact one of our specialists.

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