On 16 December 2022, the Pensions Regulator launched the second consultation on its revised draft defined benefit (DB) funding code of practice together with a consultation document on its Fast Track and twin track regulatory approach and a response to the first consultation. The consultation period will close on 24 March 2023.
The 200+ pages provide the much-awaited detail on the operation of the revised scheme funding regime and how the Regulator interprets compliance with the new funding and investment requirements of the Pension Schemes Act 2021 and the draft funding and investment regulations (the Regulations) (see our insight).
The principles of the new funding framework have long been heralded by the Regulator and the draft code is broadly as envisaged, albeit the Regulator has not included the twin track approach in the code itself. The Regulator also helpfully interprets numerous parts in a more flexible way than some thought the Regulations might permit. This flexibility may go some way in dealing with industry concerns as to the potential restrictiveness of certain areas, in particular, the meaning of low dependency.
The draft code has unusually been published based on draft, rather than finalised, Regulations. This means that any amendments to the Regulations will need to be reflected in the code so there may well be changes to both before they come into effect.
There is a huge amount of material to sift through – we summarise the main points that trustees and employers of DB occupational schemes need to know about, including:
- the key actions,
- an overview of the new scheme funding legislation,
- how the Regulator interprets the key legislative concepts, and
- its new twin track regulatory approach.
Overview of the new funding and investment legislative framework
The funding and investment strategy (the FI Strategy)
DB schemes will need to have a FI Strategy setting out the trustees’ long-term objective, its funding level and investments to be held at the date the scheme reaches significant maturity.
By the time a scheme is significantly mature, it should have, at least, low dependency on the sponsoring employer – both a low dependency investment allocation and full funding on a low dependency basis. Schemes will need a clear journey plan to show how they will reach this point.
Statement of Strategy (the Statement)
The FI Strategy must be set out in a written Statement signed by the chair that will need to be sent to the Regulator along with the triennial actuarial valuation.
Employer agreement and consultation
Employer agreement will be required to the FI Strategy as set out in Part 1 of the Statement. The employer must be consulted with when preparing or revising Part 2 of the Statement (supplementary matters including implementation success and the main risks of implementing the FI Strategy).
TPs, the recovery plan and employer affordability
The technical provisions of a scheme will need to be calculated ‘consistent with’ the FI Strategy and, when assessing recovery plan appropriateness, any deficit “must be recovered as soon as the employer can reasonably afford”.
Employer covenant strength
How much risk can be taken during a scheme’s journey plan depends on employer covenant strength. This is defined for the first time in legislation and expanded upon in the draft code.
The draft code and the Regulator’s interprentation of the key concepts
The draft code provides further detail on these key legislative concepts set within a new twin-track compliance regime:
- Fast Track for those schemes that adopt set parameters for a valuation, and
- Bespoke for those that cannot or do not wish to use Fast Track.
What is significant maturity?
Maturity in the Regulations is measured by reference to ‘how far a scheme is through its lifetime’ in years, using a specified duration of liabilities measure which will be set out in the code.
Duration is the weighted mean time until benefit payments are expected to be made weighted by the discounted value of those payments. The draft code sets significant maturity as being when duration reaches 12 years.
The Department for Work and Pensions (DWP) is considering the approach that should be taken to significant maturity following stakeholder responses and recent market events. In particular, duration is sensitive to gilt yield movements and the increases over 2022 mean that the date that many schemes will reach or have reached significant maturity has come forward. There may well be changes in this area in the final version of the regulations.
What does low dependency at significant maturity mean?
Low dependency investment strategy
The Regulations refer to having a highly resilient and broadly cash flow matched investment strategy at significant maturity. The objective is to remove reliance from any future need for employer contributions – cash flow matching involves schemes’ assets having cash flows which track the scheme’s expected benefit and expense payments.
The draft code provides some useful guidance as to exactly what this concept means including the assets that the Regulator believes would be suitable and how the Regulator construes ‘broadly matched’.
Cashflow matching assets may include typical ones such as government and corporate bonds and cash, others such as interest rate and inflation derivatives, and also some illiquid investments, for example, property and infrastructure.
There were concerns that being broadly cash flow matched would require significantly mature schemes to invest solely in bonds. However, the Regulator’s interpretation is more accommodating, and some growth assets will be permitted.
In particular, the Regulator considers that up to 15% of growth assets would meet the ‘broadly matched’ requirements with growth asset allocation of up to 20-30% with leveraged liability driven investment (LDI) for a significantly mature scheme. Such an investment strategy would need minimum interest rate and inflation hedging levels of at least 90%.
When resilience testing, as a minimum, schemes should test for a one year, 1-in-6 stress scenario, with the results being limited (assuming full funding on low dependency funding basis) to a funding level change of 4.5%. For many schemes this will represent a market tightening from the typical one year 1-in-20 value at risk/stress calculation.
Low dependency funding basis
Low dependency at significant maturity also means a scheme being fully funded on a low dependency basis – the assumptions must be set presuming that the scheme has a low dependency investment allocation and is already fully funded – this means no further employer contributions being needed in ‘reasonably foreseeable’ circumstances.
Although the Regulator does not prescribe the actuarial assumptions to be used, with the focus being on choosing prudently and an overall assessment as to appropriateness, there are detailed expectations on the principal assumptions (see Appendix 3) and an expense reserve must be included (see Appendix 4.)
Funding and investment strategy
The FI Strategy requires employer agreement. This has led to questions regarding the potential impact on trustees’ investment powers. The draft code addresses this. The Regulator notes that the investment elements in the Statement require employer consultation rather than agreement and trustees retain their investment powers so that if agreement cannot be reached, they can still exercise them.
How should employer covenant be assessed?
Although funding and investment risk being dependent on employer covenant strength already forms an integral part of the Regulator’s current expectations, this is the first time that the meaning of employer covenant and a requirement to assess it has been set out in legislation.
The Regulations define employer covenant strength as being the employer’s financial ability to support the scheme together with legally enforceable contingent asset support. Certain matters should be considered when assessing financial ability such as insolvency likelihood, cash flow and other factors that may impact business performance or development.
So, what does the Code have to say on assessing covenant?
There is a move away from the existing four covenant gradings to an assessment, in line with the legislative definition, of (1) financial ability to support based on cash flows and prospects (made up of performance and development factors including the likelihood of employer insolvency), and (2) contingent asset support.
The assessment should cover three primarily forward-looking periods:
- visibility over employer forecasts: usually over the short term, 1-3 years;
- reliability over available cash: where there is reasonable certainty as to available cash – it will typically only cover the medium term; and
- longevity of covenant: this is the maximum period in which the trustees can reasonably assume the employer will be around to support the scheme.
The draft code provides more in-depth commentary on all of the above, and some guidance around multi-employer schemes and not-for-profit organisations. Revised covenant guidance is also expected from the Regulator during 2023.
What does recovering the deficit “as soon as the employer can reasonably afford” mean for recovery plans?
The scheme funding legislation already prescribes what trustees must consider when setting an appropriate recovery plan. The Regulations add to this – they will require trustees to follow the principle that the deficit “must be recovered as soon as the employer can reasonably afford”.
The draft code explains that trustees should consider whether to take account of post-valuation experience and whether to allow for investment outperformance, and after doing so, the overarching principle that the deficit must be recovered as soon as the employer can reasonably afford comes into play.
Determining the level of reasonably affordable contributions will involve an assessment of available cash, its reliability over the short, medium and long term and whether there are ‘reasonable alternative uses’ for that cash.
Alternative uses will typically fall into one of three categories: (1) investment in sustainable growth; (2) covenant leakage such as shareholder distribution and intercompany loans; and (3) discretionary payments to other creditors.
When determining reasonableness, trustees should consider certain matters such as scheme maturity, funding level and how prudent the technical provisions are. There are also certain principles that should be followed, for example, the lower the funding the less reasonable it will be to use cash for discretionary payments, more mature schemes will have a greater need for cash in the near term and available cash should not be used for discretionary payments or covenant leakage where it means DRCs will be paid beyond the period of cash reliability.
The draft code does not contain specifics as to recovery plan length (but see below for Fast Track requirements).
What does the Regulator expect of a journey plan?
The journey plan details how the scheme will get from its current position to its long-term funding target.
The Regulator expects trustees to look at two separate stages when setting a journey plan; the period during which the trustees can be ‘reasonably confident’ about the employer’s available cash, and the period after this up to reaching significant maturity. The plan must detail the low dependency investment allocation date, the de-risking strategy and details of the intended approach to technical provisions’ assumptions during the plan.
Risk should be dependent on employer covenant strength (with more risk permitted where covenant is strong) and scheme maturity (generally, the more immature a scheme is the higher the levels of risk that can be taken).
How should technical provisions be set?
Technical provisions are the amount required, as actuarially calculated, to make provision for the scheme’s liabilities. Under the revised funding regime, they must be calculated consistent with the FI Strategy. This means that before significant maturity they must be consistent with the journey plan and after this date they must be the same as or stronger than the low dependency funding assumptions.
Fast track and bespoke – twin track regulatory approach
How will the twin track approach operate?
Under the new regime, schemes will submit a valuation using either set Fast Track parameters or a scheme-specific Bespoke approach. Fast Track does not form part of the legislation and, consequently, is not included in the draft code but contained in a separate consultation. Keeping Fast Track out of the code means that changes can be made more easily and quicker.
Instead of acting as a benchmark for considering a scheme’s funding and investment strategies as initially proposed by the Regulator, Fast Track will act as a ‘filtering’ mechanism. Schemes using this approach are unlikely to see further Regulator involvement in their valuations because they can demonstrate they are meeting Regulator expectations. Schemes that do not meet individual parameters will be treated as Bespoke, but it is likely that Regulator engagement will concentrate solely on the non-compliant areas.
The Regulator’s modelling shows that, as at March 2021, over 50% of schemes would meet all Fast Track parameters, with nearly 95% of schemes meeting those in at least one of the three areas (technical provisions, recovery plan and stress).
The Fast Track parameters and assumptions will be reviewed triennially with consultation (with different options for interim annual reviews which will be subject to industry engagement before publication) and, when appropriate, reviewed after significant alterations in economic and market conditions.
Bespoke valuations that meet legislative requirements and Regulator expectations will be compliant, but schemes will need to provide suitable supporting evidence and explanation in the Statement, the detail required will depend upon the “level and complexity of the risk being undertaken”. Regulator involvement with Bespoke schemes will vary depending upon circumstances.
How will the new funding regime apply to open schemes?
Schemes open to new entrants and/ or future accrual may make allowance for new entrants and future accrual and in so doing, assume that reaching maturity will take longer and take account of this in the journey plans and technical provisions. However, there is an overriding principle that past service should have the same level of security as in a closed scheme.
A future accrual assumption should not typically look beyond the date that there is a high level of confidence that the scheme will remain open, and the employer covenant can support ongoing accrual – this is set as six years in Fast Track.
The use of LDI
The consultation documents reference liability-driven investment (LDI) and the systemic risks of using leveraged LDI as highlighted by recent market events. The Regulator notes that schemes using LDI “may be in a better position to evidence that they can meet our expectations, as this will reduce funding volatility from changes in interest rates and inflation expectations”. Fast Track use of leverage is “materially lower than current market norms” being set at a maximum of 2X leverage. Schemes are ‘encouraged’ to make sure that suitable governance and operational processes are in place with adequate levels of liquid collateral. You can read more about the Regulator’s current expectations for schemes using LDI here.
The pensions industry has been given plenty of notice of the new funding regime and, in its recent annual funding statements, the Regulator has been clear about its expectations for long-term funding which means that there are few surprises in the newly published materials. However, the revised DB funding documents are wide-ranging and contain a significant amount of detail. At the very least all DB occupational pension schemes will need to assess where they stand against the new requirements and produce the new suite of strategy documents. There may be a limited impact for those schemes that are already funding in line with a low dependency target at significant maturity, but others may see a more significant effect.