Regulator consults on new DB funding code

News Alert 2022/07

At a glance

The Pensions Regulator has published a draft Code of Practice on DB funding, following on from an earlier DWP consultation on draft funding and investment regulations (see News Alert 2022/05).  Much of what is set out in the draft Code is as expected, but although we are now starting to see the all-important detail of how the new regime is intended to operate, further refinements will be necessary, including quite possibly to the draft regulations.

In this News Alert we examine how the Regulator’s proposed Code is building on the draft regulations and what the overall package could mean for schemes and their sponsors.  The material published is extensive and complex, covering more areas than we report on.  Schemes will need to take early advice on what the whole package means for them.

Key Actions

Trustees

• Consult with actuarial and investment advisers to assess to what extent the scheme’s current ‘scheme-specific’ approach to DB funding and investment needs to change to comply with the proposed new regulatory environment
• Come to a view on whether the scheme should seek to fall within the Fast Track filter and so minimise Regulator involvement in valuation discussions
• Consider the implications for covenant advice and contingent assets, especially if the scheme is more likely to be relying on a Bespoke approach
• Consider responding to the consultation, especially if the proposed new regime does not meet the scheme’s needs

Scheme sponsors

• Take advice in relation to the potential impact of the proposed new regulatory environment on matters such as pace of funding and potential implications for dividends, other covenant leakage, and corporate spending on growth plans.
• Weigh up the pros and cons of seeking to agree with the trustees a Fast Track or Bespoke approach to valuation compliance.
• Consider responding to the consultation.

The Detail

On 16 December 2022, the Pensions Regulator set out, in a draft Code of Practice, how it intends to regulate DB funding under the new powers given to it through the Pension Schemes Act 2021 and associated regulations that are currently in draft.

The consultation package comprises the consultation document, draft Code, a further consultation document that focuses on the Fast Track parameters and a response to the Regulator’s first consultation of March 2020 (see News Alert 2020/02).  At some point in the New Year, the Pensions Regulator intends to issue extensive new covenant guidance that will form an important backdrop to the new regime.   

How the Regulator intends to interpret key aspects of the scheme funding legislation

The main purpose of the existing, old Code is to set out the Regulator’s interpretation of the current scheme funding legislation, although some will argue that it has gone significantly beyond this, on such matters as integrated risk management and covenant on which the current legislation is silent.

Its proposed replacement, which is utterly different to the current Code, continues to fulfil this interpretative function but set against a backdrop of a significantly changed legislative requirement – in particular the need to target being fully funded, with a low-risk investment strategy by the time the scheme is significantly mature.  We look at some of the key aspects of the new regime and how the Regulator intends to interpret the law.

Scheme maturity

The draft regulations require that by the time a scheme reaches “significant maturity”, it follows the principles of low dependency on the employer in relation to both the investment and funding strategies. 

The draft Code adds some colour to this, including the following:

• Significant maturity – defined as being the point at which the scheme has a 12-year technical “duration”, which is as expected, but in recognition of challenges raised by recent volatility in bond markets, the Regulator is consulting on alternative approaches to the measurement of duration – as such this is an area where the draft regulations could also change
• Low dependency investment allocation – the draft Code contains some useful interpretations of the draft regulations, including the nature of the assets it thinks are acceptable for cashflow matching purposes (more than one might have thought) and what seems to be a liberal interpretation of what it means for cashflows to be ‘broadly’ matched. In particular, schemes will be allowed to hold a reasonable level of growth assets at significant maturity, perhaps even up to 20-30% where accompanied by some form of leveraged liability-driven investment.  Whatever is settled upon, as a minimum, a one-year, 1-in-6 stress test will need to be carried out, showing no more than a 4.5% change in funding level
• Low dependency funding basis – the Regulator chooses not to be prescriptive in the Code itself, asking only that trustees have a prudent and evidence-based approach to delivering on the expectation that no further employer contributions would be required under reasonably foreseeable circumstances. In particular, it chooses not to set a discount rate limit (although see discussion on Fast Track below).  Separately, it strongly encourages (and in some cases requires) that an expense reserve is set up, covering all future costs including PPF levies.  It also sets out its expectations across a number of individual assumptions

Journey planning

The draft regulations provide that schemes with strong covenants or ones that are less mature will be able to take more risk on their journey to significant maturity.  They also contain a requirement that where funding deficits emerge along the journey (and beyond), recovery plans must follow the principle that the deficit is recovered “as soon as the employer can reasonably afford”. 

The draft Code expands on both as follows:

• Allowing for covenant – the Regulator asks trustees to focus on an employer’s financial ability to support the scheme by reference to three separate time periods, the periods of: visibility over employers’ forecasts typically between 1 and 3 years; reliability, which is the period (usually over the medium term) where trustees have reasonable certainty of available cash to fund the scheme; and longevity of the covenant, which is the maximum period trustees can reasonably assume that the employer will remain in existence to support the scheme.  More detail is in the Code, including limited guidance for not-for-profit organisations, but it will be the coming covenant guidance that will be all-important in determining exactly how to assess all three covenant limbs
• Application of covenant to journey plan – the Regulator intends that the de-risking path can be such that higher discount rates can be used for the technical provisions whilst the scheme is in a period of covenant reliability (assuming the required cash is available for the scheme), reducing in some manner (several are suggested) after this period ends. However, this is not intended to be a blank cheque; trustees are being asked to consider at least a 1 in 6 downside event during the covenant reliability period and compare this with the ability of the employer to repair any deficit emerging
• Addressing funding deficits – the Code sets out expectations for how trustees should approach the principle that the deficit is recovered “as soon as the employer can reasonably afford”. Three steps are suggested, including an assessment of whether any of the available cash could reasonably be used by the employer other than to make contributions to the scheme.  On this, the Code sets out a number of principles, including that the lower the funding ratio, the less reasonable it will be to use available cash to effect covenant leakage such as dividends, and the more mature the scheme, the greater the need for available cash to be paid to the scheme in the near term.  In terms of assessing the availability of cash, the Regulator suggests a maximum of six years. In a welcome change from the original consultation, allowance for future outperformance will be allowed, but only if the covenant can support it

The Fast Track Filter

In its March 2020 consultation, the Pensions Regulator spent some time setting out how it envisaged that its Fast Track framework would operate, without being too specific as to its likely parameterisation.  The Fast Track Filter now being put forward has a lot of similarities with that back in March 2020 but is more detailed and is now parameterised.  It includes the following aspects:

• Technical provisions – these will need to be no lower than an amount which is expressed as a percentage of the technical provisions on the low-dependency funding measure. In a departure from the 2020 consultation, these percentages are not covenant-dependent – in other words there is a single Fast Track basis dependent on maturity.  The percentages put forward are based on an investment strategy for immature schemes of up to 60% in growth seeking assets, assuming the gilt portfolio uses leverage of up to two times.  A low dependency basis is used for mature schemes Effectively this assumes an investment return of gilts+ 2% at 17 year and longer durations, reducing to gilts +0.5% at significant maturity (ie 12 year duration).  Open schemes are also assessed on this basis, except that limited allowance can be made for future service and new entrants, which will have the effect of making such schemes appear less mature than their closed scheme equivalents.  Alongside the discount rate, there is also prescription on inflation assumptions to be used within Fast Track. For other assumptions the Regulator offers commentary but no hard and fast rules, allowing a more scheme-specific approach where supported by evidence
• Investment risk – a test must be completed to demonstrate that, if fully funded on the low-dependency measure, the scheme’s funding level would not fall by more than set percentages under certain stresses. Stressing, for this purpose, is intended to be carried out using the same methodology as used in PPF levy calculations
• Recovery plan length – this must be no longer than six years (or three years if the scheme has reached the “relevant date” associated with significant maturity). Allowance for future outperformance is not permitted under Fast Track

There are some simplifications in the calculations for those schemes with less than 100 members.

As expected, if there is compliance with every aspect of the Fast Track framework, as evidenced in the statement of strategy, the Regulator states that it is unlikely to raise any concerns and the valuation will be ‘accepted’.  But if there is a conflict with any of the Fast Track boundaries, the Regulator will be looking to assess the valuation approach on a bespoke basis, which will need to be supported by more detailed covenant assessments.

Next steps

Consultation closes on 24 March 2023 and the intention is that the Pensions Regulator will lay its Code in mid-June 2023 alongside the final regulations, in order that the new regime can come into force for actuarial valuations with effective dates on or after 1 October 2023.  However, it is acknowledged that this timescale may slip.