New DB funding regime: six things you should know (UK)

The Pensions Regulator’s new funding code of practice (the Code) has now been laid before Parliament. We also have the final “Fast Track” parameters and two consultation responses, on the Code and on the Fast Track.

This speedbrief highlights six points trustees and employers of DB schemes should know about in relation to the Code and the new funding regime, and suggests some actions.

In a nutshell

The Code is broadly as we expected but there is more flexibility in some areas than under the previous draft code. It is very technical, and introduces a lot of new terminology.

We are still waiting for some additional guidance. However, trustees and sponsors of DB schemes now have enough information to enable them to start planning for their first valuation under the new regime. Although there may be a small regulatory gap before the Code comes into force, it will broadly apply to all valuations with effective dates from 22 September 2024 onwards.

Background

The Pension Schemes Act 2021 (the Act) and the Funding and Investment Strategy Regulations 2024 (the Regulations) set out the legislative framework of the new funding regime. The Code describes how it will work in practice. The new requirements largely add to rather than replace the previous funding regime.

DB occupational scheme trustees will have to put in place a funding and investment strategy (FIS) aimed at making sure benefits can be provided over the long term. After deciding on the FIS, trustees must prepare a “Statement of Strategy” (SoS) that describes their FIS and other matters, and then send it to TPR.

Trustees must have a “journey plan” that aims for low dependency on the sponsoring employer by the time the scheme reaches “significant maturity”. By then, assets should be invested in a “low dependency investment allocation” and the scheme should be fully funded on a “low dependency funding basis”. Any deficit must be recovered “as soon as the employer can reasonably afford”. The meaning of these terms is explained below.

1. The terminology: what does it all mean?

Journey plan: the journey plan reflects the trustees’ “end game” for the scheme. This could be running off the liabilities over time, buying them out or transferring them to another scheme such as a DB consolidator (or a combination). The journey plan depends on the strength of the employer covenant and how close the scheme is to significant maturity – the closer it gets, the less risk can be taken. 

Significant maturity: TPR has defined significant maturity as the point at which a scheme reaches a duration of liabilities of 10 years (or eight years for cash balance benefits). In the previous draft code this was set at 12 years and broadly means schemes will have more time before they reach significant maturity.

Low dependency funding basis: this means that actuarial assumptions used to calculate the liabilities should be consistent with low dependency on the employer. The Code says low dependency “is not no dependency” but trustees should be satisfied that the likelihood of requiring further employer contributions is small and, to the extent required, they are small relative to the size of the scheme.

Low dependency investment allocation (LDIA): this means that, from significant maturity, the scheme is not expected to rely on further employer contributions to provide for accrued liabilities. The value of the assets relative to liabilities should (except for any surplus) be “highly resilient to short-term adverse changes in market conditions”. Investments should have enough liquidity to meet expected cash flow requirements and make reasonable allowance for unexpected cash flow needs.

The Code says the LDIA is a “notional” investment allocation – so that the low dependency funding basis can be derived from it. Trustees can potentially deviate from the LDIA in the actual investments but they are generally expected to be the same.

As soon as the employer can reasonably afford: this involves assessing cash flow, its reliability and determining whether any of the available cash could be put to “reasonable alternative uses”. Reasonable alternative uses could include investing in the sustainable growth of the employer. Dividend payments, discretionary payments to creditors and contributions to other DB schemes may also, depending on the circumstances, be reasonable alternative uses. There is no prescribed length of recovery plan unless the scheme is using the Fast Track.

2. What is the timing for this?

The Act and the Regulations are already in force and the new requirements will start to apply to schemes with valuation effective dates on or after 22 September 2024. The scheme’s first FIS must be determined within 15 months of the effective date. The valuation and the FIS should be considered “together as one”.

The (still technically draft) Code will be laid before Parliament for 40 days. Due to parliamentary recesses, the Code is likely to come into force around early November. Schemes with valuation dates falling in this “regulatory gap” must comply with the new requirements. TPR says it will contact those schemes but it expects minimal disruption.

3. What about employer covenant?

“Employer covenant” has a new legal definition in the Regulations. It means broadly the financial ability of the employer to support its legal obligations to the scheme; and the expected level of support from any contingent asset, to the extent the trustees could reasonably expect them to be legally enforceable and sufficient to provide that support.

Trustees are now expected to assess the employer covenant and document their assessment. This should be done in a way that is proportionate to the circumstances of the scheme and the employer. Generally, this would involve a third-party adviser but that is not mandatory.

The covenant assessment is forward looking, and trustees must consider the “reliability period” – how long they have reasonable certainty over the employer’s cash flow (normally three to six years) – and “covenant longevity” – how long they can be reasonably certain the employer will be able to support the scheme (generally not more than 10 years).

4. Are open schemes treated differently?

There is a new “open schemes” module in the Code, signposting guidance and expectations. There is flexibility for trustees to take account future accrual and new members for a longer period when determining the maturity of the scheme. Investment risk may also potentially be taken for longer.

5.  What is the Fast Track?

There will be two routes for submitting funding information to TPR and demonstrating compliance with the new requirements, Fast Track and Bespoke. TPR says Fast Track will be used as a “regulatory filter”, rather than as a benchmark for the assessment of schemes choosing Bespoke. If the Fast Track is followed, trustees can expect less regulatory involvement on funding.

Some of the key Fast Track requirements include: a low dependency target discount rate no higher than gilts +0.5% and a recovery plan maximum length of six years (three years if beyond significant maturity). There is more information on the Fast Track requirements here. TPR estimates (as at March 2023) that 62% of schemes meet all Fast Track parameters and a further 19% could change their funding approach to do so at no extra cost.

6. What is still to come?

The two main outstanding pieces of the jigsaw are:

• covenant guidance – there is quite a lot of information on covenant in the Code but further details are due from TPR in a covenant guidance consultation, expected soon
• Statement of Strategy (SoS) – a response to TPR’s consultation on the SoS is expected in the autumn. The consultation envisaged trustees having to submit a significant amount of new information to TPR

In addition, we are expecting: new recovery plan guidance; updated versions of TPR’s existing DB funding and investment-related guidance; more from TPR on its regulatory approach including detail on the Fast Track and Bespoke submission routes; and (possibly) guidance on relevant benchmarks around liability driven investments.

Where to start: some action points

For many schemes, the next triennial funding and valuation process is likely to take longer than before. More documents must be gathered and prepared. Good collaboration between employers and trustees will be crucial.

• speak to your scheme actuary and other advisers. Work with them to put in place an action plan, including key dates and milestones. Schemes with valuation dates on or soon after 22 September this year will need to move fast
• appoint a trustee chair, if the scheme does not yet have one or suitable arrangements in place. The chair will need to sign off the SoS. Also consider establishing a specific trustee sub-committee for the purposes of the valuation and FIS
• organise funding training for both trustees and employers
• check the balance of power in relation to the FIS with your legal adviser. The FIS will need to be agreed with the employer in most (but not all) cases
• consider whether the scheme is likely to follow the Fast Track or Bespoke route. You may be surprised to find the scheme can already (or could reasonably easily) meet Fast Track parameters
• think about what new information will be needed to assess covenant and who might carry out the covenant assessment. Consider whether any new or amended contingent assets will be required
• consider what information will be needed for the SoS (once final SoS documents are available from TPR) and work out how it will be gathered