Introduction
The Pensions Regulator (“the Regulator”) is expected to introduce the new Defined Benefit (DB) funding code (“the Code”) in summer. The Code will apply to valuations with an effective date on or after 22 September 2024. The draft code can be found here: Draft DB Funding Code of Practice.
Long term planning
A significant aspect addressed in the Code is long term planning for schemes. Trustees are required to establish a plan for the long term funding of their scheme, which includes:
Setting a long term objective detailing how benefits are to be provided and the funding level to be attained by the ‘relevant date’; and
Creating a journey plan outlining the path to achieving the long term objective from the current funding position.
The target funding level must be at least 100% on a ‘low dependency’ basis, i.e. a basis under which no further employer contributions would be required if the scheme was fully funded. The trustees will determine the ‘relevant date’ which must be no later than the scheme year in which significant maturity is reached, as estimated by the scheme actuary.
The journey plan should consider the employer covenant and scheme maturity whilst ensuring adequate liquidity. A higher level of risk will be acceptable if the employer covenant is strong.
After the ‘relevant date’, trustees should invest in line with a ‘low dependency’ asset allocation. Cashflows should be broadly matched between assets and liabilities, and the funding level should be resilient to short term adverse changes in the market. The asset allocation must be set using prudent assumptions and include sufficient liquidity to ensure no further contributions are expected from the employer once the scheme is fully funded. Scheme liabilities must be calculated on a basis consistent with the ‘low dependency’ strategy.
Employer covenant
Another area of focus is on employer covenant, i.e. the ability and willingness of the employer to fund the pension scheme. Previously, covenant considerations have been backwards looking, focusing on past performance. The Code encourages trustees to engage in more detailed, reliable and forward-looking covenant assessments, as it is the future cashflows of the company that actually determine its ability to contribute to the pension scheme when required.
The Code emphasises that the following areas should be considered:
Covenant visibility: the period for which reliable forecasts are available;
Covenant reliability: the period for which the trustees have reasonable certainty over the employer’s level of available cash; and
Covenant longevity: the maximum period over which the trustees can reasonable assume the employer will be able to support the scheme.
The length of these three periods should help to inform decisions around the level of risk to take and the length of the journey plan. The Code reaffirms the overriding principle that any funding deficit should be recovered as quickly as the employer can reasonable afford.
Statement of strategy
Trustees must prepare a statement of strategy outlining the decisions taken, with the required level of detail depending on the amount of risk being taken. Some parts, such as the general funding and investment strategy, must be agreed with the employer. Other parts, such as supplementary details, must be set after consulting the employer, though the employer’s agreement is not required.
Trustees will not be required to invest in line with the ‘low dependency’ asset allocation immediately. Immature schemes with a strong funding position and strong employer covenant may justify taking more risk in growth-seeking assets. However, the Regulator expects trustees to transition towards a strategy consistent with low dependency on the employer after the ‘relevant date’, though this doesn’t mean completely excluding growth assets.
The Regulator is expected to consult on the statement of strategy in March 2024.
Regulatory approach
In addition to the Code, the Regulator will update its regulatory approach and introduce a new twin-track method: ‘fast track’ and ‘bespoke’.
Schemes qualifying for ‘fast track’ will see less scrutiny on their submission and the Regulator is unlikely to question the trustees. Qualification is generally based on the funding basis and recovery plan length relative to the scheme duration.
If a scheme does not qualify for ‘fast track’, it will need to take the ‘bespoke’ approach. Trustees can also choose to adopt the ‘bespoke’ approach even if their scheme qualifies for ‘fast track’ if they prefer greater flexibility or want to select an approach that suits the specifics of their scheme. This approach requires a more detailed valuation submission and could face greater scrutiny from the Regulator.
Further details of the fast track approach, including the parameters a scheme needs to meet in order to use this approach, are given in the appendix.
Further information
If you would like any more information or wish to discuss the implications for your scheme, please contact us.
Appendix – fast track approach
The fast track parameters are outlined here: Fast track parameters. Some key information is given below. The information is based on the consultation document and so is subject to change.
Technical provisions funding level
A scheme’s technical provisions when expressed as a percentage of a scheme’s low dependency liabilities must hit a certain minimum level. This minimum percentage varies by the duration of the scheme (calculated on the low dependency basis), for example:
12 years and below: 100%
20 years: 85%
30 years: 72%
Funding and investment stress test
Schemes need to demonstrate that, if fully funded, the scheme’s funding level wouldn’t fall by more than a certain percentage. The maximum percentage tolerated varies by the duration of the scheme (calculated on the low dependency basis), for example:
12 years and below: 1.9%
20 years: 13.1%
30 years: 18.7%
The change in the funding level will be calculated as 1 – stressed funding level / unstressed funding level where:
Unstressed funding level = the low dependency funding level
Stressed funding level = the low dependency funding level with certain stress factors applied to both the assets and liabilities, which have been prescribed
If the results of the calculation show a lower fall in the funding level than the tolerated percentage, the scheme passed the funding and investment stress test.
Recovery period
The recovery period, if any, must be no longer than 6 years for a valuation that is being completed before a scheme’s ‘relevant date’, and 3 years for a valuation that is being completed after the ‘relevant date’. The annual increase in contributions must be no more than the CPI inflation assumption used under the technical provisions basis, and there must be no allowance for asset outperformance.
Assumptions
The discount rate and inflation assumptions must use a yield curve for schemes with more than 100 members. For smaller schemes, i.e. those with 100 or fewer members, a single discount rate and single inflation rate may be used, as long as the Bank of England yield is used at a duration nearest to the duration of the scheme. Requirements for specific assumptions are as follows:
The addition to the gilt yield curve, or single gilt yield, must be no more than 0.5%
There must be no adjustment to the RPI assumption
The CPI assumption must be no lower than 0.8% below RPI before 2030 and no lower than RPI from 2030
The mortality assumption should use a recent CMI core or extended model
The marital assumption should be at least as strong as PPF Section 179 guidance
Options can only be allowed for to the extent that they increase the liabilities in the low dependency funding basis
