Navigating the new DB funding code

Last week The Pensions Regulator (TPR) stepped closer to ending six years of legislative reform, speculation and consultation over DB pension scheme funding by laying their final draft DB funding code of practice before parliament.

While TPR has taken steps to make some aspects of this final draft less prescriptive, much of the content within the Code has long been signposted. Trustees will now need to take the necessary steps to develop their funding and investment strategy as part of their next actuarial valuation process. 

How did we get here?

Key requirements for schemes

The main motivation of the new legislation was to improve the funding and security of DB pension schemes, and trustees must now agree a funding and investment strategy with the sponsor which will be reported to TPR within a statement of strategy.

The overarching requirement of the new legislation is that trustees must determine the endgame objective of their scheme, and set out a journey plan to bridge the gap between their current funding position and a position that has low dependency on the sponsor. This requirement comes into effect for actuarial valuations from 22 September 2024[1].

What might a journey plan look like?

The legislation introduces various new concepts with which trustees will need to familiarise themselves when agreeing their journey plan. These are ultimately centred around taking a proportionate amount of investment risk, depending on both the strength of the sponsor and the maturity of the scheme’s membership.

A key development since the initial draft Code has been a revised definition of significant maturity. As TPR now view this as when scheme duration reaches 10 years, rather than 12, trustees will have greater flexibility when it comes to setting their journey plan.

Each scheme’s funding and investment strategy will be unique. However, we illustrate below, how some of these new concepts might interact when designing a journey plan.

In this example, the trustees determine the covenant reliability period (i.e. the length of time they have reasonable certainty over the sponsor’s cash flows and prospects) to be three years and so retain their current investment strategy until the end of this period. They also test the impact of various stressed scenarios and are satisfied with the sponsor’s ability to make good losses, should they arise. At the end of this period, they intend to begin de-risking their investment strategy to reduce reliance on the sponsor.

While there is a minimum requirement for the scheme to be fully funded on a low dependency funding basis by the time it reaches significant maturity (2031), the trustees have agreed a long-term objective to achieve full funding on a more prudent basis. They therefore adopt a low dependency funding target of 110% funded on the low dependency funding basis and set the relevant date (i.e. the date they expect to achieve this) to be 2030.

The trustees will invest their assets in the low dependency investment allocation by no later than this relevant date, as is required. This approach provides the trustees with more flexibility to achieve their long-term objective. At the same time, it allows them to redefine their low dependency funding target and/or relevant date if funding growth is below expectations.

The agreed funding and investment strategy will need to be documented in a new statement of strategy document.  TPR has outlined a twin-track approach to reviewing the submissions using either a ‘fast-track’ or ‘bespoke’ approach.

The Code indicates that schemes that can demonstrate compliance with fast-track parameters are unlikely to face further scrutiny. The alternative route is a bespoke submission, which is just as valid, and caters for the many nuances of pension schemes. TPR are likely to take a proportionate approach when assessing bespoke submissions.

What could this mean for my investments?

Without defining the low dependency investment allocation itself, TPR has made clear that this notional allocation should be both sufficiently liquid to meet cashflow requirements and highly resilient to short-term adverse changes in market conditions. For many schemes therefore it’s likely that gilts/LDI and high-quality credit will feature heavily in these allocations.

The funding and investment strategy will also need to outline the intended de-risking pathway into this low dependency investment allocation over time, which could be through some combination of funding level and time-based de-risking triggers.

We therefore believe it’s important that trustees put in place a governance structure that enables accurate and real-time monitoring of the funding level and an execution plan for de-risking triggers, ensuring that risk is reduced as efficiently as possible.

These new regulations clearly give trustees a lot to work through, adding to the increasing list of regulatory requirements – and cost – faced by DB pension schemes. We believe that trustees may find themselves better insulated from the financial impact of complying with both this new legislation, and any other requirements that might be around the corner, by adopting an ‘all-in’ approach to both fees and investment services.

If you’d like to know more about the implications of the Code and how it affects you, then please get in touch with your usual LGIM representative.

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[1] Although the Funding and Investment Strategy Regulations 2024 underlying TPR’s new Code will apply to pension schemes with valuations from 22 September 2024, we note that the final Code is unlikely to come into force until November 2024. This is due to the requirement for the Code to lay in parliament for 40 days (excluding any breaks for parliamentary recess). TPR recognise this means there will be a ‘regulatory gap’ for a small number of schemes with valuations dates between 22 September and November when the final Code is published. They do however emphasise that the latest response announced last week provides a clear indication for what the final Code will look like, with any major changes ‘taken into account when assessing valuations.