What the new funding code means for investment

You’ve probably already had numerous emails, webinar invites and more on the new DB Funding Code.  At over 100 pages, there’s a lot to digest – and more takeaways than your local chippy on a Friday night.

Given this, we thought it would be helpful to do something a little different. Rather than setting out (another) comprehensive list of what the Funding Code says, we’re going to pull out three of the most interesting and relevant angles from an investment perspective.

In particular, we want to do some myth-busting – to help make sure the big picture is clear before you get into the detail with your advisers.

Myth 1: You will need to take action to get to a strong funding position quickly

Reality: You’re probably already there; or if not, you’ve probably got plenty of time

A cornerstone of the new funding regime is that schemes must reach a secure position (“low dependency”) before it’s too late (by the time the scheme is “significantly mature”).

But there are two reasons why this may not have a huge impact on many schemes:

• Firstly, lots of schemes have already reached a sufficiently secure position.  Analysis of our clients shows around two-thirds already have a surplus on a gilts + 0.5% pa basis, which is likely to be acceptable to TPR; and
• Secondly, many of the schemes that haven’t yet reached a secure position have plenty of time to get there. Analysis of our clients shows only 10% may need to achieve low dependency within the next 6 years; and 40% of our clients may have 15+ years to get there.  That’s a long time.

So overall, whilst the new funding regime is a great catalyst to review your journey plan, it’s unlikely to force most schemes to radically change tack with your existing plan.

Myth 2: Once you reach low dependency, you should expect your assets to deliver low investment returns

Reality: You have flexibility to hold growth assets for the long term

By the time you reach “significant maturity”, you need to be targeting an investment strategy that is “highly resilient” to adverse market movements. This might make you think of a portfolio that is almost wholly invested in high quality bonds.

However, for schemes that want to, we believe it’s actually possible to justify a long-term portfolio with a reasonable allocation to growth assets (e.g. 30%) – perhaps targeting an overall expected return of gilts + 1.5% - 2.0% pa.

That’s because the test of high resilience is measured over a relatively long period (six years), which allows some breathing space for growth assets to recover from a potential downside shock. This is illustrated in the below chart, where the “more volatile” portfolio, which has 30% in equities, may still pass the test of high resilience.

Now in practice, there are plenty of good reasons why many trustees and sponsors will prefer the more stable blue line rather than the more volatile pink line. Equally, trustees and sponsors may prefer the pink line, which is expected to outperform over the long-term (by around 1% pa).  But the point is there may be some wiggle room for those schemes that want to target a bit more long-term growth for the benefit of members and/or the sponsor.

Plus, bear in mind, there are a number of additional areas of flexibility, which may help schemes to hold growth assets for the long term:

1. Trustees have full flexibility on how any surplus above full funding on the low dependency funding basis can be invested (e.g. it can be 100% equities if you like), without jeopardising whether a scheme is highly resilient.
2. TPR has been clear that – if there are good reasons – trustees can invest differently to what they have written down as their low dependency investment allocation. This may be particularly helpful for schemes with stressed sponsors, for example.
3. You don’t need to value your low dependency liabilities with reference to gilts, and you can instead use a “dynamic” discount rate that reflects the actual assets you hold. For many schemes, this could be a helpful way to reduce short-term market noise artificially affecting your funding position, and reduce sub-optimal investment decisions including unnecessary leverage.

Myth 3: The new funding code is all about scheme funding

Reality: There’s also a big focus on other areas, including the liquidity of your investments

They say that generals are always prepared to fight the last war.  Well at the time when TPR was drafting the new Funding Code, it’s worth remembering that the 2022 mini-budget was wreaking havoc on the gilts market. It’s clear TPR is keen to ensure some lessons have been learned.

Perhaps as a result, there are over 60 mentions of liquidity in the new Code(!) – with lots of sensible expectations on trustees on understanding the liquidity of the investments held, planning for unexpected cashflows, quantifying liquidity in stressed market conditions, and documenting protocols.

Now is a good time for trustees to undertake a liquidity health-check, to ensure your assets are well-positioned and you are meeting TPR’s expectations.