19 January 2023

On 16 December 2022, TPR published its long awaited second consultation of its draft Code of Practice (the ‘draft Code’) on the funding of defined benefit (DB) pension schemes. Once finalised, the draft Code will replace the second version of TPR’s Code of Practice 03: Funding Defined Benefits which came into force on 29 July 2014 (29 July 2015 in Northern Ireland), and its content is markedly different. The draft Code provides practical guidance on how to comply with the scheme funding requirements set out in Part 3 of the Pensions Act 2004, the Occupational Pension Schemes (Scheme Funding) Regulations 2005 (the ‘2005 Scheme Funding Regulations’) and the draft Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023 (the ‘draft Regulations’).

Unusually, the draft Code is based on the draft Regulations consulted on by the DWP last summer (on which see our August 2022 update) - draft regulations are typically finalised before consultation on a Code of Practice begins. Therefore, there is potential for some of the detail to change. TPR has said it “will continue to engage closely with the DWP and industry after this consultation… to take account of changes made by the DWP in response to their consultation”. The overall objective remains the same, requiring trustees to reduce reliance on their sponsoring employer as their scheme matures and providing a more workable framework under which TPR can tackle those schemes which it believes are not doing the right thing.

Given that consultation on the draft Code was launched as the industry headed off for its Christmas break, there is a slightly longer consultation period of 14 weeks, with the deadline for responses closing on 24 March 2023. The draft Code and draft Regulations are currently expected to be laid before Parliament in June and to come into force in October 2023. They will then apply to a scheme’s first valuation with a valuation date on and after the “in force” date. However, TPR is aware that this is an ambitious objective and consequently these timescales may change.

Who should read this update?

This update will be of interest to the trustees and sponsoring employers of defined benefit occupational pension schemes and their advisers.

What was included in the consultation?

Alongside the draft Code, TPR also published:

Summary of the new requirements

By way of reminder, under the new regime, trustees of DB schemes will have to:

  • Determine, review and, if necessary, revise a scheme funding and investment strategy, with the purpose of ensuring that pension and other benefits under the scheme can be paid over the long term; and
  • As soon as reasonably practicable after determining or revising the scheme's funding and investment strategy, prepare a written statement of strategy, reporting progress against their determined targets and send a copy of the statement to TPR.

A scheme’s funding and investment strategy must set out how the funding and investments of the scheme are intended to look by the time the scheme will reach ‘significant maturity’ and how it will get there. By this point the scheme will need to be funded and invested so that, under reasonably foreseeable circumstances, no further employer contributions will be required to fund the benefits accrued by members (known as ‘low dependency’).

Trustees will be required to report on progress against the targets set in their funding and investment strategy in a written statement of strategy. The statement must include a section setting out what action the trustees will take if the main risks faced by the scheme in implementing the funding and investment strategy materialise, along with the current and future level of risk they will take in relation to the investment of the scheme’s assets. All schemes must submit a copy of the actuarial valuation alongside the statement of strategy to TPR. Previously, trustees were only required to submit a copy of the actuarial valuation where a recovery plan was in place.

A deeper dive into the new concepts

  • Significant maturity– Maturity can be described as how far a scheme is along its life cycle. The draft Regulations provide for maturity to be measured in years using a “duration of liabilities” measure and, as expected, the draft Code defines the point at which a scheme reaches “significant maturity” under Regulation 4(1)(b) as the date on which the duration of liabilities reaches 12 years. However, TPR recognises that the recent volatility in the bond market has highlighted the disadvantages of using duration as a fixed metric for significant maturity and David Fairs (current TPR Executive Director for Policy) has said that TPR is “exploring a couple of alternatives”. One route they are considering is ensuring that there is a “degree of predictability and certainty of when significant maturity arises”; whether that be by “[averaging] over a period of time, or [adopting] a definition of duration that uses a fixed rate of interest”. Therefore, this remains one of the main areas of uncertainty in the draft Code and could see further changes depending on the final wording of the draft Regulations. 
  • Low dependency investment allocation– In determining a scheme’s funding and investment strategy, trustees must assume that on and from the relevant date (being a date no later than the end of the scheme year in which the scheme is expected to reach significant maturity) scheme assets will be invested in accordance with two principles:
    • the investments would meet the requirements of a low dependency investment allocation; and
    • the assets would be sufficiently liquid to enable the scheme to meet expected cash flow requirements, with reasonable allowance for unexpected cash flow requirements.

The draft Code is helpful in that it confirms that full cash flow matching is not required. Furthermore, the types of cash flow matching assets are wider than anticipated in that they can include credit and potentially some illiquids such as property and infrastructure related investments and schemes will be allowed to hold a reasonable level of growth assets at significant maturity. The draft Code states that TPR expects trustees to carry out suitable analysis to enable them to assess the resilience of their low dependency investment allocation to short term adverse market changes and confirms that as a minimum, TPR expects schemes to carry out a one-year, 1-in-6 stress test, showing no more than a 4.5% change in funding level.

  • Low dependency funding basis– Again, the draft Code is helpful in that it states “we do not expect trustees to have to stochastically model each assumption or set of assumptions to satisfy themselves that the low dependency test has been met” i.e. the point at which no further employer contributions would be required under reasonably foreseeable circumstances. Instead, assumptions should be chosen prudently, but there is an acknowledgement that trustees may choose to focus prudence in certain areas and will focus on the assumptions that have the greatest impact.
  • Employer covenant – The draft Code confirms the new statutory obligation on trustees to carry out an employer covenant assessment to understand the extent to which the employer can support the scheme now and in the future and to include that assessment in the funding and investment strategy - a key change under the new regime is that in the long-term, employer covenant is intended to have much less significance because once ‘significant maturity’ is reached, covenant reliance is intended to be minimal. TPR has also stated that it will be consulting on updated covenant guidance in the coming months, and notably has stated that it intends to move away from the current system of grading. The draft Code splits employer covenant support into two categories:
    • the employer’s financial ability to support the scheme, including its cash flows and other factors that are likely to affect the performance and development of its business, including the likelihood of an employer insolvency event occurring; and
    • contingent asset support but only where the trustees can evidence that the contingent asset is legally enforceable and will be sufficient to provide the level of support when required.

It goes on to state that an assessment of the employer’s financial ability to support the scheme is primarily forward-looking and should consider the following:

  • Visibility over employer’s forecasts, typically over one to three years (this should include not only forecast cash flows but also profit and loss account and balance sheet forecasts);
  • Reliability over available cash. When assessing reliability, trustees should consider the employer’s forecasts (to the extent that these are available and deemed reasonable), and the employer’s prospects (including its capital structure and overall resilience, and the market in which it operates);
  • Longevity of the covenant. This represents the maximum period in which trustees can reasonably assume that the employer will remain in existence to support the scheme.

How does this affect the triennial valuation?

  • Setting assumptions for technical provisions - The draft Code states that the economic and actuarial assumptions used to calculate the technical provisions must be chosen prudently, allowing a margin for adverse experience. Furthermore, the technical provisions must be calculated in a way that is actuarially consistent with the funding and investment strategy i.e. moving towards a low funding dependency basis by the relevant date. Past service in schemes that remain open to accrual of benefits should have the same level of security as a comparable closed scheme. However, helpfully, TPR has confirmed that for open DB schemes, it is reasonable to assume “a reasonable allowance for future accrual and new entrants which will delay the time the scheme is assumed to reach significant maturity”. This means that an assumption can be made that risk will be taken for longer, resulting in lower technical provisions.
  • Recovery Plan - In its drive for low-dependency, TPR and DWP require that any deficit “must be recovered as soon as the employer can reasonably afford”. The draft Code gives guidance as to how affordability should be considered and assessed by trustees in this context and seeks to deal with some of the concerns that have been raised by the introduction of this new requirement in the draft Regulations. Trustees should:
    • Assess the employer’s available cash;
    • Assess the reliability of that available cash;
    • Determine whether any of the available cash could reasonably be used by the employer other than to make contributions to the scheme – a new concept of ‘reasonable alternative uses’. It remains to be seen where the final regulations adopt this concept too.

Allowance for post valuation experience is permitted provided that account is taken of both favourable and unfavourable changes, all changes to scheme assets, liabilities and covenant should be considered, changes should be assessed over the bulk of the period since the effective date of the valuation and trustees should be prudent in deciding how much of any post valuation experience should be taken into account.

In a change from the first consultation, allowance for assumed future investment outperformance will be permitted, but only to the extent supported by the employer covenant or a legally binding contingent funding arrangement.

  • Twin track approach - Neither the draft Regulations or draft Code make any mention of the twin track funding approach (‘bespoke’ and ‘fast track’) proposed by TPR in the first draft Code of Practice. Instead, TPR has produced a separate consultation document which clarifies its proposed regulatory approach for fast track. In that consultation document, TPR clarifies its twin-track regulatory approach as follows:
    • Schemes can continue to adopt a scheme-specific funding approach provided it meets the new legislative requirements and the key principles set out in the draft Code;
    • Fast Track will not operate as a benchmark but instead be used as a filter for TPR’s assessment of actuarial valuations, so that if all the Fast Track parameters are met, TPR is unlikely to raise concerns with the trustees.

Key parameters for assessing the Fast Track include setting the technical provisions test as a percentage of the low dependency funding basis liabilities based on duration, setting the discount rate for the low dependency funding basis as the gilt yield curve + 0.5% pa and agreeing a maximum recovery plan length of six years before a scheme reaches the relevant date and 3 years once it has. The use of Fast Track is intended to reduce cost for schemes (as it reduces regulatory involvement and the need for trustees to obtain additional covenant advice to support the valuation) and TPR estimated that as at March 2021, half of schemes may fit within these designated parameters.

Takeaways for trustees and sponsoring employers

  • Ask your actuarial and investment advisers for advice as to what extent the new requirements will affect future triennial valuations, including whether your scheme will be able to meet the Fast Track parameters or if a bespoke approach is more appropriate. Whilst these new requirements are not yet in force, it would be sensible to have an eye on the expected future requirements when agreeing current valuations;
  • Keep abreast of any changes made to the draft Regulations and consider whether to send a response to TPR’s consultation on the draft Code and Fast Track and regulatory approach;
  • Arrange training for the trustees and the sponsoring employer on the new requirements and the decisions that will need to be made;
  • Consider whether a change in approach is required in relation to covenant advice, particularly where the bespoke approach is to be adopted;
  • Consider how the draft Regulations will alter the process for agreeing the valuation and required documentation and agree a process for this with the sponsoring employer/trustees. Where the employer’s agreement is currently required under Part 3 of the Pensions Act 2004, their agreement will also now be required to the scheme's funding and investment strategy. Trustees will also have to consult the employer in relation to the preparation or revision of Part 2 of the statement of strategy and include written confirmation in the statement that such consultation has taken place;
  • Appoint a Chair of Trustees if you do not have one – they will have to sign the statement of strategy.

We are well placed to advise sponsoring employer and trustees of DB pension schemes of all sizes on the new funding requirements. If you would like to explore this topic further, please contact Clive Pugh or your usual contact in our Pensions team.

Key contact

Clive Pugh

Clive Pugh Partner

  • Pensions Regulatory
  • Pensions Services
  • Pensions Legal Advice 

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