Decoding the new DB pensions funding regime

In 2017, the UK government issued a pensions funding green paper entitled “Security and Sustainability in Defined Benefit Pension Schemes”. Now, seven and a half years later, the new funding code has finally come into force.  All new valuations will have to be carried out under this new regime.  

Given the length of time the new funding regime has been talked about, it isn’t surprising that lots of trustees and sponsors of defined benefit schemes have adopted a “wait and see” approach to thinking about the detailed requirements and potential implications. But now the waiting is over and many of those schemes will find themselves in very different funding positions to when the green paper was published, with large deficits being reduced or replaced by a surplus. 

So what should trustees and sponsors be doing now.

• Putting a plan together – The current regime requires trustees to ensure that they have set an appropriately prudent level of technical provisions, reflecting their investment strategy and sponsor covenant, with any shortfall being recovered as soon as reasonably affordable.  The new code builds on this by requiring trustees and sponsors to have a long-term plan to be at least fully funded on a basis that reflects a low-dependency investment strategy by the time their scheme is significantly mature and make sure their technical provisions reflect the journey plan to get there. All of this will need to be documented in a new Statement of Strategy.
• Thinking about the destination – trustees and sponsons will need to think about which of the three long-term objectives they expect to target, between running off (aligned with ‘low-dependency’ requirements), insuring or transferring to a superfund. This may be a relatively straight forward discussion for those trustees and sponsors that have an existing journey plan in place, but will be a more involved process for those considering it seriously for the first time. This also applies to schemes that are currently open to new members, who will have to consider what they would do if they were to close.
• Confirming your relevant date – TPR has confirmed that a scheme reaches significant maturity when its duration (a measure of the average time to the payment of discounted future cashflows) reduces to 10 years.  This calculation should use your low-dependency assumptions but be based on financial conditions as at 31 March 2023. Your relevant date, which is the point at which you expect to reach at least full funding on your low-dependency basis, has to be no later than the end of the scheme year when you reach significant maturity.  You should be able to get a good feel for this date now – it will be important to understand how long a timescale you have to work with.
• Start looking at sponsor cashflows – Although TPR is going to provide more detailed covenant guidance, the new regime sees the old 4 grades of covenant assessment being replaced by a focus on the financial ability of a sponsor to support the scheme (plus allowance for legally binding contingent support). Understanding the level of free cashflows generated by the sponsor and how these are expected to change over time will form the basis of future covenant assessments.  In addition, trustees will need to consider the reliability period (where there is reasonable certainty of available cash) and the longevity period (how long the employer can be relied upon to support the scheme) in setting its journey plan.
• To Fast Track or not to Fast Track – TPR is rolling out a twin-track approach to demonstrating compliance with the new code.  Schemes who adopt a funding approach that meets a set of “Fast Track” parameters can expect their valuation to avoid any scrutiny from TPR.  However, for those that want to pursue their own approach or who can’t meet the “Fast Track” requirements, there will be a “Bespoke” approach.  This will provider greater flexibility but come with a higher level of supporting evidence and greater regulatory scrutiny. With the recent improvements in funding levels, TPR is expecting about 4 in 5 schemes to go down a “Fast Track” route.  In the first instance, schemes should be understand whether their current approach would meet the Fast Track tests or, if not, how material any changes would be to make this option available.    
• Understand the notional nature of the journey plan to low-dependency – While schemes will need to set out their plan to get to a low-dependency funding and investment strategy, this is technically only a notional exercise. TPR does expect the majority of schemes to follow this plan, but there are plenty of reasons why schemes could justify doing something different, for example if the scheme has a material surplus.  
• Mind the expense gap – It used to be relatively rare for trustees to include an expense allowance within their technical provisions.  However, under the new regime, unless sponsors are legally required to meet expenses under the scheme, then the low-dependency basis will need to include an allowance for all future expenses. While this may have a relatively small impact for schemes that are very immature, it could result in situations where schemes that are close to significant maturity may be pushed into deficit when all future expenses are reflected in liabilities.

The new funding code is going to require additional work by both trustees and sponsors, particularly the first valuation that is carried out.  Those schemes with late 2024 and early 2025 valuation dates will end up acting as guinea pigs for the rest of the industry as it gets to grips with how the new requirements are applied in practice for the first time.