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DB funding code - what is going to change?

The Pensions Regulator (TPR) is currently consulting on the way we undertake actuarial valuations, and agree funding plans, for defined benefit pension schemes. The review follows on from the government’s white paper on Protecting Defined Benefit Pension Schemes in 2018 and the Pension Schemes Bill currently making its way through parliament. 

The process could cynically be viewed as being largely driven by a few high-profile corporate insolvencies, such as Carillion, resulting in material calls on the Pension Protection Fund.  It is interesting that TPR’s previous defined benefit funding code review (that revised code came into force July 2014) was brought about by the introduction by the government of the further objective for TPR to minimise any adverse impact on the sustainable growth of an employer. What goes around comes around.

So what changes are we expecting?

Long-term objective (LTO)

If a scheme doesn’t have one already, the Trustees will be required to set out an LTO for the scheme.  This is a funding position and investment strategy that, in the words of the legislation, ensures pensions and other benefits under the scheme can be provided over the long term.  This is not to be confused with the traditional ongoing funding target we have been using in valuations, known under legislation as the Technical Provisions (TPs).  TPs will also continue to exist and be relevant as we discuss later.

TPR says that the LTO should at least be a ‘low dependency’ funding basis.  That is, the scheme would pay out benefits while continuing to be sponsored by its employer(s) but with funding and investment strategies such that there would be a low chance of requiring further employer support and, to the extent that such support is required, it would be low relative to the size of the scheme. 

Think of this as a high long-term funding target, certainly higher than many schemes’ current TPs, but probably not quite as high as that needed for a full buy-out of the scheme.  For those of a more technical bent, it is proposed to be equivalent to using a discount rate of between gilts plus 0.50% and gilts plus 0.25% both before and after retirement. 

Crucially the scheme will also be expected to have a low risk investment strategy at this stage.  That is one with a high proportion of gilts/bonds/LDI and a low proportion of growth assets, probably in a ratio of around 80/20.

Note that there is no reference to the employer covenant in determining the LTO.  The idea is that in the long-term the scheme shouldn’t be expecting to rely on the employer covenant, as it can change over time and most employer covenants only have “visibility” over the short to medium term.

Does this mean that the scheme will no longer be reliant on the employer at all once it reaches its LTO?  No.  You will see that the funding LTO is determined in terms of “low” dependency or risk, not “none”.  In reality, if the employer were to go insolvent after the scheme reached its LTO, there may still not be enough money to buy out members’ benefits in full with an insurer, although one would assume any call on the Pension Protection Fund would be relatively small if any, which perhaps is the point. 

When does the scheme target to reach its LTO?

So how long is long-term?  TPR suggests it should be when the scheme has reached “significant maturity”.  A scheme matures, particularly once it has closed to new entrants (and maybe future accrual), as the proportion of its liabilities that relate to pensions in payment increases and the average term to the payment of benefits decreases.  In TPR’s eyes the more mature a scheme, the shorter timeframe it has to make good any deficit from volatile investment outperformance.  Similarly, the more mature a scheme, the more likely it is to be cash flow negative, i.e. having to make material disinvestments to meet pension payments.  This increases the risk from investment volatility.

TPR has suggested a range for the significant maturity measure of a weighted average term to payment (the “duration” of the scheme’s liabilities) of 14 years to 12 years.  TPR says this is broadly equivalent to a point at which the scheme will be paying out 5% or 6% of its liabilities each year as benefits.  The “average” scheme with a current maturity duration of around 21 years may be 15 or more years away from significant maturity.  Of course, this will vary quite widely depending on specific scheme circumstances.

What about TPs?

TPs are now considered something of a stepping stone between the scheme’s current funding position and its LTO.  If you think this makes TPs something of an arbitrary construct, I would tend to agree with you.  However, as a fundamental part of the current legislation and in determining current contribution requirements, I can see why we have got to this position.

So TPs, the scheme’s current funding target, will be set as something less than the scheme’s LTO, where the “less” is determined by:

  • scheme maturity (less mature means lower TPs as can take higher investment risk and assume higher investment return), and
  • employer covenant (strong covenant means lower TPs as can take higher investment risk and assume higher investment return, although length of covenant “visibility” should also be taken into account).

How the “less” is reflected in the definition of the TPs is open for debate but could include using higher discount rates, particularly pre-retirement. 

Recovery plans

Recovery plans will still be based on TPs and not on reaching the LTO (unless you are getting near that required maturity level).  There is a slight toughening of approach compared to the current regime as the recovery plan should now be as short as employer affordability allows, provided doing so does not impede the employer’s sustainable growth.  TPR has indicated that it could be expecting recovery plan lengths of 6 years or shorter, unless there are affordability issues. 

Backend loading of contributions in the recovery plan is still likely to be frowned upon and assumed asset performance in excess of that allowed for in the TP discount rates is likely to be treated the same way.

Two possible approaches for valuation approval

Trustees will still have to submit their valuations to TPR for analysis (also now including those where the valuation shows a surplus).  TPR is proposing that there will now be two routes via which the valuation may go to be analysed.  The Trustees can elect to take a “Fast Track” route or a “Bespoke” route.

One of the aims of the new funding code is to be more transparent with what TPR expects from valuations.  The “Fast Track” route provides this by laying out criteria which, if the valuation follows them, will then mean little further analysis by TPR will be needed.  Many of the criteria are as described in the various sections above.

The “Bespoke” approach is for schemes doing something different from “Fast Track”.  However, TPR has indicated that it will judge “Bespoke” submissions against “Fast Track” criteria, so it is not just a means of watering down the valuation approach.  Where “Bespoke” might be valid is if there are offsetting factors, e.g. a longer recovery plan but with additional security provided, or a lower than “Fast Track” assumption in one area is offset by a higher assumption in another. 

Going down the “Bespoke” route automatically results in a deeper analysis from TPR.  As such, the Trustees will need to be confident in their approach and be well prepared in terms of supporting information to provide to TPR.

So, where does that leave us overall?

In summary then, TPR is continuing its push for higher funding targets, lower investment risk and less reliance on employer covenants.  The revision of the legislation and funding code is an opportunity to formalise this and effectively ensure that Trustees take notice of these trends where they have not done so already.  As is often the case in pensions, it is just a bit of a shame that change comes with added complexities rather than simplifications.


"Crucially the scheme will also be expected to have a low risk investment strategy at this stage"

"TPR has indicated that it could be expecting recovery plan lengths of 6 years or shorter, unless there are affordability issues"