Regulator issues DB Funding Code

News alert 2024/03

At a glance

The DB Funding Code has been laid before Parliament, filling in important aspects of how the new funding regime is to operate.

In this News Alert we take stock of the new regime which is to apply to all scheme funding valuations with effective dates on or after 22 September 2024 and which marks the most significant change in regulatory oversight of DB pension scheme funding, investment and the approach to covenant assessment in nearly 20 years.

Key actions

Trustees

• Where not done already, undertake training to ensure you understand the details and requirements of the new regime.
• Where an actuarial valuation is imminent, take action to ensure the approach is compliant with the new regime. If your valuation date falls before 22 September 2024 there is no requirement to comply with the new regime (the current regime still applies), but the Regulator has encouraged the approach to be aligned.
• Trustees and employers will in general need to agree a formal long-term funding and investment strategy. This is an opportunity to consider your objectives for the scheme, along with those of the sponsor, and to develop a journey plan for your scheme accordingly, taking account of any restrictions necessary because of the sponsor’s ability to support funding or investment risk.
• Assess to what extent your current approach to funding and investment will need to change to fit with your long-term strategy and to comply with the new regime. Is your existing approach largely compliant, or does it require a significant shift? Additional covenant advice will be needed in many cases.
• Come to a view on whether the scheme’s next valuation should fall within the Fast Track filter and so minimise Regulator scrutiny on valuation outcomes.
• Consider the potential impact of additional support such as contingent assets, particularly if the scheme is likely to be relying on a Bespoke approach. Contingent assets can help if, for example, there is significant reliance on the sponsor covenant or if there is a desire to keep assets above the low dependency level to a minimum to avoid trapped surplus.
• Consider how best to meet the new data requirements proposed by the Regulator for the Statement of Strategy (including for example covenant information such as the reliability period), and whether this will require further work or advice.

Scheme sponsors

• Assess the extent to which your scheme is impacted and the likely consequences for cash contributions. Consider the potential implications for your usual business activities such as payment of dividends and corporate spending on plans for growth. Be aware that the trustees may ask for significantly more financial information than has previously been requested, particularly forward-looking forecast information.
• Consider your long-term objectives for the scheme and feed that into discussions with trustees on the funding and investment strategy, which generally requires sponsor agreement. Consider carefully the implications of different potential strategies – e.g. could there be accounting implications if you agree a formal target to buy-out? Ensure you are well-positioned to influence the other aspects of the regime where sponsors have a role, for example the “low dependency investment allocation”.
• Proactively put forward your views to the scheme trustees on key areas such as free cash flows and covenant reliability and longevity periods to best position the employer covenant, in particular in relation to the new areas that trustees need to consider and report on to the Regulator.

The detail

On 29 July 2024 the Pensions Regulator’s long awaited DB Funding Code was laid before Parliament, starting the clock ticking on the 40-day period after which, assuming neither House objects, the Regulator will issue the Code in final form. Because of summer and conference recesses we do not expect the Code to come into force formally until early November 2024.

Nevertheless, this Code, together with the amendments made to the Pensions Act 2004 by the Pension Schemes Act 2021, the new Funding and Investment Strategy Regulations and the amended Scheme Funding Regulations, now enables the new funding regime to fully come into being.

To accompany the Code the Regulator has published its response to its earlier consultation on the draft Code. It has also published its response to its consultation on its Fast Track and regulatory approach, which includes how the Regulator has finalised its position on Fast Track (but, disappointingly, no further information on the Bespoke approach).

As well as aiming to improve funding levels, the new regime is intended to enable the Regulator to intervene more effectively than before where schemes are not complying with the funding requirements. We consider below how the whole package is likely to impact on schemes and their sponsors. The regime is however extensive and complex, and we are also still missing a few pieces of the jigsaw including the long-awaited refresh of the Regulator’s covenant guidance which we expect will provide more detail on the new covenant concepts in the new regime.

Because of the delay in laying the Code there will be a regulatory gap between when the Regulations start applying and the Code is in force. The Regulator says that schemes with valuation dates in this period can use the new Code to inform their approach and that it will be communicating with affected schemes to give the support needed to limit disruption.

Highlights of the new funding regime

The Pension Schemes Act 2021 sets out the framework for the new funding regime. The Funding and Investment Strategy Regulations 2024 came into force on 6 April 2024 and provide the legal trigger for the new regime to operate for valuations with effective dates from 22 September 2024.

The key requirements of the new regime are as follows:

• All schemes will need to develop a “funding and investment strategy” – that is, how trustees intend the scheme to provide benefits over the long term (the long-term objective) along with a journey plan that targets de-risking and full funding on a low-risk basis. All schemes will need to document this strategy in a “statement of strategy” and revisit this at least every three years alongside the triennial valuation. In most cases this strategy will need agreement between trustees and sponsors, the exception being where trustees have unilateral contribution setting powers under their Rules (though legal advice should be sought here).
• The journey plan must target the low-risk state by the time a scheme is “significantly mature”. For a scheme to be significantly mature, the vast majority of the membership would typically be pensioners. The Code defines this measure to be the point at which the scheme’s liabilities have a 10-year “duration” (8 years for cash balance benefits). The methodology tries to ensure this is robust through time by basing this on economic circumstances at a fixed point, 31 March 2023.
• There may be situations where trustees need to target reaching a low-risk state earlier than significant maturity. This would be where the potential covenant reliability and longevity periods are shorter than the time to significant maturity.
• From significant maturity, the scheme must follow the principle of low dependency.
  • The “low dependency investment allocation” is a notional asset allocation in relation to which the funding level is highly resilient to short-term adverse changes in market conditions (importantly there is not a requirement to invest in line with this strategy, though the Regulator does not expect material departures);
  • The “low dependency funding basis” is consistent with the low dependency investment allocation and the scheme must be fully funded on this basis;
  • However, any surplus on the low dependency funding basis does not need to be invested in line with the low dependency investment allocation and therefore provides schemes with greater investment flexibility.
• Open schemes can include an allowance for future accrual and new entrants in the calculation of significant maturity. This allowance is limited to the period where the trustees have reasonable certainty over key aspects of covenant such as employer cash flows, and potentially as long as the “covenant longevity period”. This is more accommodating than the draft Code.
• During the journey to significant maturity, the risk in the scheme must be supported by employer covenant strength, and the Code includes important new covenant concepts. Therefore, covenant analysis is more important than ever before. Some schemes will need covenant advice for the first time, and many will need to expand current advice, although the Regulator is clear that trustees can take a proportionate approach. Reliability over future cash flows (likely to be only over the medium term which the Regulator regards as three to six years) and longevity of the covenant (being the period over which trustees can be reasonably certain the employer will be able to continue to support the scheme and which the Regulator has said in most cases will be up to ten years), may constrain scheme journey plans – so are central to the new regime.
• Deficits must be repaired “as soon as the employer can reasonably afford”, taking account of the sustainable growth of the employer. The more rigorous assessment of affordability will be a further important aspect of the new regime.
• A “dynamic discount rate” can be used to calculate technical provisions when the scheme’s actual investments are held in cash flow generative matching assets – with the rate based on the observed yield on those assets held, allowing for potential defaults.
• There are two routes for the Regulator to assess valuations – Fast Track or Bespoke. Fast Track is a regulatory filter, under which if various tests are passed, the trustees can expect limited scrutiny. Bespoke is an equally valid route but trustees must justify their approach.
• There will be more paperwork for trustees and for advisers, including various new submissions to the Regulator in connection with the Statement of Strategy relating to the scheme’s long-term objective, journey planning, investment strategy and in particular the covenant where to date only very limited information has been required to be submitted to the Regulator.

What changed following consultation

The draft Funding Code was issued for consultation in December 2022  (see our News Alert 2022/07) and the new Code has been amended in a number of areas. Significant changes include:

• Setting the duration of scheme liabilities measure at 10 years (8 years for cash balance benefits) as noted above. There is some detail on how the Regulator would typically expect this to be calculated, although there is a potential range of interpretations, and as such this may cause some debate between stakeholders.  
• A new section on open schemes that signposts to topics such as the allowance for future accrual and / or new entrants in calculating significant maturity.
• Much more detail on employer covenant, such as on covenant reliability and longevity periods.  Previous references to covenant visibility have been removed.  The importance of assessing and monitoring the employer covenant after low dependency is reached and in the context of a scheme’s solvency deficit is made clearer.
• Updates on risk taking during the journey plan, including a move to a more principles-based approach rather than the formulaic test which appeared in the draft Code. This element will pull together covenant strength, investment risk and actuarial assumptions and as such is a key “integrated risk management” step.
• Clarification that the “Low Dependency Investment Allocation” and the asset allocations set out in the “funding and investment strategy” are notional allocations used to derive actuarial assumptions and do not constrain a scheme’s actual asset allocation.
• An expectation that the affordability of recovery plans should be assessed on a year-by-year basis, with steps taken to reduce the deficit set in line with this assessment.

The final Code has also been re-expressed as a series of modules, almost certainly so that it can fit into the General Code that the Regulator published in January 2024.

The Regulator’s proposed Fast Track parameters were issued for consultation at the same time as the draft Funding Code (see also our News Alert 2022/07) and the final set of parameters have been published, with adjustment in some areas. Key points include:

• The low dependency discount rate remains gilts + 0.5% pa.
• The underlying discount rate for the technical provisions test is gilts + 1.75% pa (from the previous gilts + 2.0% pa) at the immature end of the curve, reflecting changes in market conditions.
• Significant maturity has been set at 10 years to align with the Code.
• Recovery plans should be no more than 6 years (3 years if beyond significant maturity).  No allowance for investment outperformance, although post-valuation experience can be taken into account.
• The funding and investment stress test remains in place, consistent with the draft Code. This includes a helpful adjustment for better-funded schemes.
• The definition of a smaller scheme, that can use a proxy to calculate future duration rather than producing cashflows, has been expanded to those with up to 200 members (from the previous 100 members).
• For open schemes the assumed period for new entrants and/or future accrual in determining significant maturity is now set at nine years (up from six years).

The Regulator estimates that as at March 2023, 62% of schemes meet all Fast Track parameters and a further 19% could change their funding approach at no extra cost (and without needing to change their investment allocation) and meet all Fast Track parameters. On this basis a significant majority of schemes are likely to adopt the Fast Track approach.

What are we still waiting for?

Statement of Strategy: we await final details of the new formal documentation that all schemes will need to submit to the Regulator, including those which are well funded, when finalising their valuation. The Regulator is currently considering responses to its consultation which closed in April 2024 which generated much consternation in the industry due to concerns around both how onerous the data requested will be to provide and whether much of it was really needed (see Pensions Bulletin 2024/15).

Covenant guidance: further details to that set out in the Code are expected in a consultation on covenant guidance to be published “in due course”.

Other guidance: will be provided on maximum affordable contributions and affordability for recovery plan purposes. The Regulator’s existing DB funding and investment-related guidance will also be reviewed.

Regulatory approach: the Regulator will communicate more about its regulatory approach in due course, which will include more detail on the Fast Track and Bespoke submission routes, as well as the regulatory filters it will use when assessing valuations to find which schemes’ statement of strategy it may want to look at in more depth or trustees it wants to engage with to understand the funding approach in more detail.