Long-term funding and investment: TPR speaks

The Pensions Regulator (TPR) has finally launched its consultation on a new DB Funding Code of Practice. The Code, which follows TPR’s initial 2020 consultation on funding principles, will play a major part in determining how schemes set their long term goals and manage their investment and funding as they journey to those goals. Trustees and employers should analyse the detail and consider whether to respond.

The background

The Pension Schemes Act 2021 provides that trustees of DB pension schemes must determine a “funding and investment strategy” for providing benefits over the long term, and set this out in a new statement to be submitted to TPR. The relevant provisions are not yet in force, but this summer the Government consulted on associated Regulations.

Under the Act, trustees must specify the funding level and investments they intend to have at the date the scheme reaches significant maturity; and calculate liabilities for the scheme’s funding and investment strategy on the principle that by no later than that date, the scheme is fully funded on a low dependency funding basis and invested in a low dependency investment allocation.

The draft Code is designed to support schemes in setting the journey plan towards their long-term objective, reducing reliance on their sponsoring employer as the scheme reaches maturity. The technical provisions set at each triennial scheme valuation effectively become steps along that journey.

What does the Code cover?

As expected, the Code refers to a scheme achieving significant maturity by no later than the end of the scheme year in which it reaches a duration of liabilities of 12 years. TPR estimates that 11% of DB schemes currently have a duration of less than 12 years and so will already have arrived at that benchmark.

The draft Code proposes that trustee should test the resilience of their low dependency investment allocation through a 1 in 6 stress test - with resulting variations in funding levels due to market movements expected to be limited to 4.5%. The consultation suggests that even at significant maturity, holding 20% to 30% of growth assets in a scheme’s low dependency investment allocation could be consistent with the draft legislation but notes the resulting need to use leverage to achieve the expected 90% inflation and interest hedging.

A key point for industry is striking the right balance between member security and employer affordability. The draft Regulations would amend the existing scheme funding rules to entrench the principle that “funding deficits must be recovered as soon as the employer can reasonably afford”. TPR’s view is that trustees should agree a recovery plan as short as employer affordability allows, subject to not impeding the employer’s sustainable growth.

The draft Code contains a lot of detail on employer covenant monitoring. TPR expects that, when considering employer covenant, trustees should examine the covenant visibility, reliability and longevity as distinct elements, monitored over different time periods. TPR will also update its covenant guidance to supplement the principles set out in the Code.

During the passage of the Act, there were concerns about how the new funding and investment proposals would affect open schemes. TPR says that for the purposes of journey planning, open schemes may assume a reasonable allowance for future accrual and new entrants, delaying the time the scheme reaches significant maturity and permitting trustees to budget investment risk over a longer period.

TPR acknowledges the impact of more recent events (the LDI crisis) and the current economic backdrop, but insists that long-term planning and risk management are key tenets of good scheme management across all market conditions. Indeed, it comments that schemes which use liability-driven investment may be in a better position to evidence that they can meet TPR’s expectations.

Fast Track vs Bespoke

In addition, TPR is consulting on a proposed twin track regulatory approach under which it can filter out schemes that require minimal engagement, via a “fast track” procedure. Trustees following Fast Track will have to demonstrate how their scheme meets specified criteria on technical provisions, investment stress and length of recovery plan (which should be no longer than six years - or three years where the scheme has already attained significant maturity).

Where a valuation submitted to TPR meets the Fast Track parameters, TPR is unlikely to scrutinise it further. However, TPR is at pains to say that it is equally valid for schemes to adopt a Bespoke approach instead, allowing trustees flexibility to select their own scheme-specific funding solutions.

What happens now?

The unusual decision for TPR to consult on its regulatory approach in advance of final Regulations reflects the clear desire of policymakers to get the long-delayed funding & investment framework up and running. TPR hopes the final regulations and Code will come into force next October. Whilst the regulations and Code will only apply to schemes with ‘as at’ valuation dates on or after the new regime comes into force, we expect many schemes will look to move towards compliance even for earlier valuations.

TPR is adamant that it is not looking to fundamentally change the shape of the existing pensions landscape, but to embed good practice. However, the level of detail in the draft Regulations and the Code means that significant work will be required for trustees to show they meet TPR expectations.

Both consultations close on 24 March 2023 and we recommend you review them with your advisers. This may be the last chance to influence the shape of a funding and investment regime that, by definition, will affect schemes for many years to come.