The Pensions Regulator (TPR) has published its draft Funding Code of Practice for defined benefit (DB) pensions schemes, alongside consultations on the code and its proposed fast-track and twin-track regulatory approach.

The new code, which is expected to come into force from October 2023, aims to support trustees, sponsoring employers and their advisers to manage their DB pension schemes and will replace the current code, introduced in 2014.

However, as the code is forward looking, only schemes with valuation dates on or after commencement will be affected, with TPR confirming that trustees currently working on a valuations should continue using the code currently in force.

In the code, TPR stressed that schemes are expected to set a long-term objective and a journey plan to get there, and that it expects schemes to reduce reliance on their sponsoring employer as they reach maturity.

The code will also require trustees to improve risk management and “raise the bar” for evidencing supportable risk taking.

In particular, the code has also outlined the regulator’s key expectations in relation to trustees setting a plan for how they will achieve low dependency on the employer, setting a journey plan to reach that point, assessing the employer covenant as a key underpin for the level of risk that is supportable on that journey, and setting their funding assumptions consistently with those plans.

The code also outlines expectations in relation to assessing reasonable affordability when determining the appropriateness of recovery plans, and on open schemes allowing for future accrual where they can justify their approach.

Assessing the details

In relation to assessing reasonable affordability when determining the appropriateness of recovery plans, TPR outlined three key steps that it expects trustees to go through: Assessing the employer’s available cash, assessing the reliability of that available cash over the short-, medium-, and long-term, and determining whether any of the available cash could reasonably be used by the employer other than to make contributions to the scheme.

Although TPR acknowledged concerns that the principle of deficits being paid off as quickly as reasonably affordable could lead to trustees pushing for much higher levels of deficit repair contributions (DRC) and much shorter recovery plans, it argued that this principle allows room for trustees and employers to agree recovery plans that take full account of the sponsor’s needs to invest in its business and use its available resources for appropriate means.

In relation to employer covenant, meanwhile, TPR identified three periods trustees should consider when assessing an employer’s ability to support the scheme: Visibility, reliability, and longevity.

TPR also agreed that it was “reasonable” for open schemes to make some allowance for future accrual, confirming that this will be set to six years in the fast track approach, although schemes will be able to provide justification for a longer period, if they have the confidence and can provide evidence that this is the case, through the bespoke route.

Commenting on the code, TPR executive director of regulatory policy, advice and analysis, David Fairs, stated: “In line with DWP’s draft regulations, our draft code is clear that all DB schemes should have the necessary long-term funding approach to ensure savers have the best chance of receiving the benefits they expect. 

“We want to provide schemes with the continued flexibility around funding to suit their circumstances, while requiring trustees to think carefully about risk management to improve security for their members.

“We have worked hard to ensure the draft code’s principles reflect the 127 responses we received to our first consultation on the code, the clarity we now have on the draft regulations, and our modelling and analysis. The code sets out our expectations in relation to how trustees should comply with legislative requirements.

“I urge trustees and their advisers to read our consultation and respond.”

A twin-track approach

Alongside the core DB Funding Code, TPR has launched a second consultation on its proposed fast-track and a twin-track regulatory approach, which is designed to help TPR filter out schemes that require minimal engagement.

Indeed, TPR estimated that around half of schemes, as March 2021, will need minimal engagement via the fast-track approach, allowing TPR to instead focus on identifying and intervening when there are concerns schemes are not complying with regulations.

Under the new system, trustees following fast track will be asked to evidence how their scheme meets three criteria: Surrounding technical provisions, an investment stress test and prescribed recovery period.

The bespoke approach, meanwhile, will be available for those unable to meet fast track criteria and, according to the regulator, may also be more appropriate for schemes following a more complex funding and investment path.

TPR stressed that this is an “equally valid” approach, which aims to provide trustees with the flexibility to select scheme specific funding solutions if the funding approach and actuarial valuation meet legislative requirements and key principles set out in the code.

The consultation explained that TPR’s approach has evolved since its initial consultation, in light of the draft Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023, industry feedback via consultation responses, as well as further modelling and analysis.

In particular, TPR noted that although the fast-track approach was initially expected to be embedded in the code of practice, this separation from the legislation is expected to provide greater flexibility to change fast track without requiring an amendment to a code of practice.

Yet other areas have remained consistent. For instance, although TPR acknowledged that market conditions have materially changed since the last consultation, it argued that the discount rate for fast track represented an “appropriate long-term target”, and has therefore remained unchanged.

However, the consultation does include a section on system risk, and how the draft code may acknowledge this, highlighting the risks in relation to the use of liability-driven investment (LDI), pointing out that “events in 2022 have highlighted the potential systemic risks from the use of leveraged LDI”.

Adapting to change

It stated: “Schemes that are planning to use or are 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.

“Similarly, our proposals for fast track in relation to the stress test included some specific allowance for leveraged LDI. For the fast track stress test, only a relatively small level of leverage has been factored in. For an immature scheme we have used an example portfolio with around 60 per cent growth, 15 per cent corporate bonds and 25 per cent gilts and using 2x leverage.”

Indeed, TPR confirmed that, overall, the level of leverage assumed throughout fast track is “materially lower than current market norms, even after LDI de-leveraging seen from September 2022”.

“Improved governance and operational processes, lower leverage in matching assets, and higher levels of liquid collateral will mean that schemes are much more resilient to significant increases in gilt yields,” it stated. “We are encouraging schemes to ensure these elements are in place.

“We are also encouraging schemes to consider their position in stressed scenarios, including what assets would be sold and how those assets may behave in the stress scenario.”

Although TPR suggested that more information on the level of leverage and collateral is needed to help monitor and control this risk further, it argued that it is not likely that the expectations in the code will increase or exacerbate these risks.

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