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Draft DB funding code of practice: 10 things you should know

  • United Kingdom
  • Pensions

22-12-2022

The Pensions Regulator delivered a pre-Christmas gift in the form of its draft DB funding code of practice (the Draft Code). This was issued alongside a consultation document, a separate consultation on the twin track approach and a response to the Regulator’s first funding code consultation in 2020 – altogether a sizeable festive bundle. 

The general thrust of the Draft Code is broadly as expected but there is more flexibility in some areas than the draft funding regulations (described in our speedbrief) suggested. There is, however, a lot of detail and the materials do not always make for easy reading.

This speedbrief highlights 10 points that trustees and employers of DB schemes should be aware of in relation to the Draft Code and suggests some actions.

Background

The Pension Schemes Act 2021 (the Act) requires DB occupational pension scheme trustees to put in place a funding and investment strategy to ensure benefits can be provided over the long term. A written statement of strategy (which must be revised at least every three years) must be provided to the Regulator. These provisions of the Act are not yet in force.

The draft Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023 (Draft Regulations), which will be made under the Act but have not yet been finalised, set out how the DWP sees this new funding regime working.

The Draft Regulations say that schemes should have a journey plan that aims for “low dependency on the sponsoring employer” by the time they are “significantly mature”.  This means that assets should be invested by this time in a “low dependency investment allocation” and fully funded on a “low dependency funding basis”. The Draft Regulations also say that the deficit must be recovered “as soon as the employer can reasonably afford”. The meaning of those terms is explained below.

The Draft Code sets out how the Regulator envisages the new regime working in practice.

10 things you should know about the Draft Code

1. What does “significantly mature” mean? As the DWP previously hinted, the Regulator has defined this as the point at which a scheme reaches a duration of liabilities of 12 years. However, recent market developments have highlighted the volatility of this measure and it is quite possible that a different approach will be taken in the finalised regulations and/or Code.

2. What does a “low dependency investment allocation” mean? This means the scheme is not expected to rely on further employer contributions to provide for accrued liabilities.

There were some fears that this would result in significantly mature schemes having to invest exclusively in government bonds or be fully cashflow matched. The Regulator has, however, interpreted the phrase more flexibly and says that, whilst schemes should be predominantly cashflow matched, they could retain some growth assets.

The fast track approach (discussed below) allows for a 15% allocation to growth assets but the Regulator says 20-30% could be appropriate provided the risks are well-managed. It also says that cashflow matching assets could include some illiquid investments, such as property and infrastructure.  

3. What does a “low dependency funding basis” mean? This means that actuarial assumptions should be consistent with low dependency on the employer and a low dependency investment allocation.

The Regulator has not adopted a prescriptive approach here. Echoing current requirements, it says assumptions should be chosen prudently. It leaves it open to trustees to include a high level of prudence in some assumptions with others closer to a best estimate approach.

4. What does recovering the deficit “as soon as the employer can reasonably afford” mean? The Regulator will expect trustees to assess the employer’s readily available cash over the short, medium and long term and determine whether any of it could be put to “reasonable alternative uses”.

Reasonable alternative uses could potentially include investment in the sustainable growth of the business and distributions to shareholders. In determining what is reasonable, trustees should consider factors such as the maturity and funding levels of the scheme and fairness of treatment as between the scheme and other creditors. This is likely to be a source of significant debate between trustees and employers.

5. Are fast track and bespoke routes provided for? Yes, trustees can opt for either a bespoke or a fast track approach. The fast track will act as a filter for the Regulator’s assessment of valuations. If a valuation meets fast track parameters, the Regulator is unlikely to scrutinise it further and less likely to engage with trustees. It will be for the scheme actuary to confirm that a submission meets fast track criteria.

The bespoke route offers trustees greater flexibility and scope to select an approach that suits their scheme. For a bespoke valuation, the evidence and explanation required in the statement of strategy will depend on the level and complexity of the risks being taken.

6. What does fast track look like? The draft fast track parameters are set out (and being consulted on) separately to the Draft Code.

They include: a maximum recovery plan length of six years for schemes that are not yet significantly mature and three years after that; a low dependency funding target of gilts+0.5% with prescription around certain assumptions; technical provisions above a minimum low dependency level; and an investment stress test using PPF levy methodology.

There are some simplifications for small schemes with 100 or fewer members. The Regulator estimates that around half of schemes would have met all the fast track requirements as at March 2021.

7. What about covenant? The Draft Regulations set out a proposed statutory definition of covenant – the financial ability of the employer to support the scheme and support from legally enforceable contingent assets.

The Draft Code expands on this. It says the Regulator expects all DB scheme trustees to assess covenant support over the short and long term by looking at cash flow, likelihood of insolvency and other factors likely to affect the employer’s business – these include market outlook, position within the wider group and ESG factors.

There is more to come on this front – updated draft covenant guidance is expected to be published for consultation “in the coming months”. The focus on covenant assessment by trustees and whether it meets these new requirements will sharpen significantly.

8. Are there any easements for open schemes? Yes, schemes which remain open can make a reasonable assumption for new entrants and/or future accrual. They will be assumed to take longer to reach significant maturity than an equivalent closed scheme. This means that investment risk may be taken for longer and this will feed through into the journey plan. Trustees must be satisfied that this does not compromise the security of accrued benefits.

9. Does the Draft Code say anything about liability driven investments (LDI)? Yes, the Regulator acknowledges that events this year have highlighted the potential systemic risks from the use of leveraged LDI. However, it says that schemes using LDI may be in a better position to evidence that they can meet its expectations. The fast track proposals include some allowance (though lower than current market norms) for leveraged LDI. The Regulator emphasises that trustees should ensure there is sufficient liquidity to meet margin payments and cash calls in relation to LDI funds.

10. When will the new regime come into force? The Regulator says the earliest the final regulations and code will come into force is 1 October 2023 but recognises that slippage is possible. The new rules are forward looking and will apply to valuations with an effective date after they come into force. The current regime will continue to apply before that. In practice, schemes with earlier valuation dates may well start to move in the direction of the new draft rules.

Next steps and action points

This consultation closes on 24 March 2023. Interested trustees and employers should consider responding.

The Regulator hopes that the final version of the Draft Code will be laid before Parliament in summer 2023 and come into force on 1 October 2023, alongside the new funding and investment regulations. This is an ambitious timescale, which could potentially be delayed.

Based on the Draft Code and the volume of responses to the Draft Regulations consultation, we can expect to see some changes to those regulations (and potentially to the Draft Code) before they are finalised. 

In addition, the Regulator has promised a consultation next year on new employer covenant guidance. It will also engage with industry on the form of the new statement of strategy and how this fits in with other documents that trustees are required to produce. The Regulator’s new Single Code of Practice (including the effective system of governance and own risk assessment) that is expected early in the new year will also be relevant here.

The new regime is not yet finalised but the direction of travel is clear. Trustees should speak to their actuarial and investment advisers for an initial view on how this may affect their scheme’s funding and investment approach and discuss whether a fast track or bespoke approach is likely to be suitable. Trustees should also consider seeking legal advice on the enforceability of contingent assets.

For some trustees, the new regime will mean largely “business as usual” save for new governance and documentation requirements. For others, it may mean very significant changes to funding and investment approaches, together with additional advisory costs.

DB scheme employers should consider the potential implications for corporate growth and other spending plans. They should also be prepared to share detailed financial information and plans with trustees.

For more information, please contact your usual Eversheds Sutherland adviser or: