What's the latest on revised DB funding code transcript

Speaker	Transcript
Chris Brown, Director, Burges Salmon	Hello and welcome to episode 2 of season three of the Burges Salmon Pensions Pod, our fortnightly podcast on pensions news, insights from practice and tips and tricks for trustees and employers and today we are talking about the draft DB funding code of practice and regulatory approach consultation that came out just before Christmas, and I'm delighted to introduce Paul Houghton partner and actuary at Barnett Waddingham and Paul you spoke with David Affairs actually on a webinar about the second consultation just before it went live in the middle of December.
Paul Houghton, Partner and Actuary, Barnett Waddingham	Yes, that's right Chris and and yes thanks for inviting me here today it's lovely to be here.
Chris	Pleasure to have you with us, and I'm also joined, as usual, with Helen. Hi Helen.
Helen Cracknell, Senior Assoicate, Burges Salmon	Hi everyone.
Chris	Okay so I think our first question is to you then Helen, can you just recap for our listeners please the history of the way the revised funding code has developed and where we are and how we've got here?
Helen	Yes of course Chris, so the first consultation on the draft DB funding code was published way back in March 2020 and that aimed to scope out what the revised DB funding code of practice may look like under new developing legislation, so partly that legislation was the Pension Schemes Act 2021 which introduced new requirements for DB pension schemes to have a funding and investment strategy and also submit a statement of strategy to the regulator. So, then the DWP published their draft regulations in July of last year and consult on these last year and then now up to date there's a second larger regulatory consultation on the revised draft DB funding code of practice and this also includes the code of practice, DB funding code consultation document and a fast track and regulatory approach consultation document, so this consultation was published in December of last year and is ongoing at the moment. Paul, is there anything you'd add to that background?
Paul	Yes, I mean that's right, it's quite interesting I think in some ways you can trace the the origins I guess back to 2016 I think 2016-ish when there was a sort of raft of high-profile companies with high profile individuals going insolvent and leaving pension schemes underfunded and that prompted the reviews of the pension funding law. And then you track that forward, and we'll perhaps come on to this but, the intention that these new regulations and new code of practice will be in place from October 2023, and bearing in mind schemes only take evaluation once every three years, that's 2026 by the time some schemes did an evaluation and valuations as you'll know can take a year or more to do, so perhaps it's 2028 by the time schemes are actually complying with these new requirements from something that had origins back in 2016. So, it's a long time coming.
Chris	Yes that's right and there's been I suppose interesting points some of which will come onto the podcast now about how things have developed, but I suppose the overall objective has been to require trustees to reduce reliance on their sponsoring employer as their scheme matures and this is about providing a workable framework under which the Regulator can tackle those schemes that are perhaps not doing what it sees is the right thing, but Paul what's the headline what's the Regulator's overall approach? Thinking to this second consultation from the regulator particularly.
Paul	Yes I think the overall principle is as large as you've described I think Chris which is that all schemes should be well funded on a suitably low-risk funding and investment strategy but at the point that they're mature, but they should know what that target is now and be working towards that now even if they're not at that point of maturity and for what it's worth I think it's a perfectly sound principle and perhaps sort of taking that step back, again you sort of referred to the earlier sort of process and and quite early on in the DWP's thinking they made a comment on the lines of they thought the system was working well for the majority of DB schemes but they wanted a tougher approach to help pick up some those irresponsible decision makers and again I think that's the framework here, that it's trying to sort of provide hopefully a straightforward way through for the majority of schemes but enable the Regulator to focus in where there is most risk in the system.
Helen	And obviously there's still a lot of movement going on at the moment and the draft regulations are yet to be finalised, or do you think anything's going to change in the code? Maybe as a result of consultation?
Paul	Yeah I mean no inside track here I'm afraid to share but I think particularly for the interaction of the code and the regulations is obviously quite interesting and and in particular there's been pushback from quite a consensus view from the industry on some of the hard edges in in the underlying regulations so things like is it totally prescriptive on on investment strategy for schemes, particularly that sort of point of maturity, does that hard or prescriptive nature of the regulations mean that or prevent some viable recovery plans for schemes where they're not quite fully funded but affordability of contributions is a genuine issue and at the other end of the spectrum I think there's a view that or it is true that these regulations have been initially drafted from a mindset of a closed pension scheme so does that really make sense or will it cost more for compliance for an open scheme that they're still open to accrual. And so I think they're some of the parts that that we're hoping or well we're certainly know if it's going to be reviewed as part of the consultation and may well be softened but we shall see and then yeah I mentioned that sort of interaction with the code of practice and I think I think one thing that was to me definitely interesting reading the the second consultation on the code of practice was I think the Regulator has taken quite an open interpretation to some of the regulations, so for example they're saying that in their eyes schemes can still retain some investments there isn't where they're significantly mature so that's I think that's definitely welcome but I think it does leave a little bit of a question around whether the code and the regulations are completely aligned which we'll be interested to see how it plays out and if it stays as it is will leave some open questions for schemes and advisors.
Chris	There's also some tech-y legal points around what ought to be in the code versus what ought to be in the regs, and things which I guess are a legal point that's yet to be clarified, but the overall principle of having low dependency with an objective approach to covenant will remain consistent though, that's fair to say I think. So I guess the key principles is wording from the regulations is the requirement for schemes to be in at least a state of low dependency on their sponsoring employer by the time they are significantly mature, so Paul, Helen let's unpack some of those concepts. Paul what does it mean to be significantly mature?
Paul	Okay so this is the gets us actuaries all excited certainly with changes over the last few months so yes feel free to interrupt if I drift off on this one. So significant maturity, it's a definition of time so it's that point in the future when when a scheme is so mature that the regulations require the scheme to be well funded and taking little investment risk. The regulations then refer to significant maturity being measured by reference to a mathematical definition called duration, and the principle of this term duration is that it's meant to represent the average time to payment of the benefits that are due from the scheme. This is all a bit exercise at a moment is the fact that the calculation of duration itself is dependent upon the assumptions you use in your valuation, so the way it's written out is that the regulations require the pensions Regulator to set what the duration should be and in its consultation the pensions Regulator has provisionally set this as a 12 years, but actually as I mentioned it is influenced by or does vary with the assumptions you use and during the course of 2022 when there's been lots of changes in financial markets and so assumptions that the pension schemes use, most schemes would have seen their duration reduce for example by around three years and so if that 12 years remains fixed then what we're seeing is a sort of step change yeah how close schemes are to bring mature.
Chris	And the Regulator has recognised the recent volatility in the bond market.
Paul	Yes that's right yes, so in their consultation practice they have absolutely recognised that, I mean Helen mentioned earlier the concept the first consultation went a lot of things around this was March 2020 so it's been in place for some time obviously, understandably other events have sort of got in the way a bit but things have moved on and the consultation does ask questions around the definition whether it's writer setting in the current way whether the number should change, whether the formula sitting behind it should change, so that is open to change as we're currently speaking.
Chris	Yes absolutely.
Helen	There's a lot of questions about whether it is a good measure to be used but we'll see how people respond to the consultation on that.
Paul	Yes, it's interesting because the easy answer is get into a drift, I think there are different ways of doing it so there's no absolutely perfect measure that doesn't come with other consequences at how things change over time but I think there probably are improvements that could be made, such as fixing the assumptions that are used rather than having them so variable changes in market conditions.
Chris	And I think the Regulator has said it's exploring a couple of alternatives. Okay, so that's significant maturity. What about the concept of low dependency and the different parts to this, do you want to talk about the low dependency funding basis, Paul, please?
Paul	Yes, well so the concept of low dependence seen in the regulations is that it's a pension scheme has reached a funding position whereby it has enough money or enough assets to pay the benefits due, but it's also taking so little risk that in all likelihood it's going to remain in that strong funding position, and so therefore it has a low dependency on the sponsor or the company that sits behind the pension scheme from the point of view that it's highly unlikely to be asking for future cash from them. And that's why it's sort of been brought into these new regulations as they stand, it's not really a new concept in pension scheme world and it's been perhaps interchangeable jargon such as self-sufficiency that's been around for a little while so not a new concept as such, but obviously being hard code get into the to the regulations.
Helen	Do you think a big change though was the link between journey planning for low dependency and linking with a covenant?
Paul	Yes absolutely, so I see a lot of this as as perhaps formalising what is currently good practice for a lot of pension schemes, yes it's absolutely a change that the nature of having introduced into regulations the idea of having this long-term focus rather than the three yearly tri-annual valuation cycle. The position with covenant is interesting and certainly the content on the second consultation of the code of practice or the second conversation was interesting in a couple of ways from my perspective, one is that on one hand while it's been quite well trailed that the amount of risk a pension scheme could take would vary or should vary with the covenant supporting the scheme, actually when it came to sort of finally defining fast track that disappeared from what's come out in the second consultation but on the other hand there's definitely a lot more content that's prescribed in how trustees should assess covenant and view covenant and and being really quite prescriptive around some of the language it uses and some of the things that trustees ought to be thinking about, such as visibility of business forecast, liability of cash and having this idea of longevity of governance, how long can trustees realistically view the governance strength if into the future.
Chris	And that is a move away from the grading system that the Regulator favourite before.
Paul	Indeed yes.
Chris	And I suppose the other element of thinking about low dependency is on the investment side and that's set out in the code as having an investment strategy under which the cash flows from the investments are broadly matched with payments and benefits under the scheme and that the value of the assets relative to the value of the schemes liabilities is highly resilient to short-term adverse changes in market conditions.
Paul	Yes that's obviously new for pension schemes to have this sort of quite prescriptive approach written into the into the regulations and I think that was probably the area and I referred to before there being some sort of industry pushback on on whether the regulations were too prescriptive and I'd say this was probably the single area that had the most pushback that general consensus view was that was arguably overly prescriptive, do you need both the cash flow elements and being resilient to fluctuations in funding level hard-coded into the regulations, or should there be more scope. Particularly for schemes that have a strong covenant or say sit in surplus at that point in time and around their investment strategy so yes it would be interesting to see how that flows through in the final regulations.
Chris	Yes absolutely. There is still lots to be unpacked and to be clarified as final regs come out and as the code itself is finalised. One point we just wanted to draw out from a sort of legal perspective on the approach to investment strategy is that there was uncertainty from the first consultation and the draft regs around who decides on investment matters and we'll come on to this but given that trustees need to agree the long-term funding and investment strategy with the employer, but that the code has clarified that whilst that long-term strategy needs to be agreed with employment the actual investment strategy itself perhaps the actual choice of investments is for the trustee and there's no fettering on the trustee's discretion over investment decisions.
Paul	Yes we're certainly happy for you to talk about that one, but that definitely does stick out as a general point of of potential issue that trustees and companies will need to work through, how much does long-term strategy dictate.
Helen	Well to be consulting on the code when the regs aren't fully finalised as well, so it'll be interesting to see how they change each other.
Chris	Yes if the regs will be clarified, yes absolutely.
Paul	Yes definitely.
Chris	Okay so we are whizzing through this podcast episode but I think time to move on to the the twin track routes for compliance and I suppose in the first consultation the fast track was sort of almost presented as a default or as a preference that trustees might need to explain away from if they used a bespoke approach on their valuation, but it's now clearer and the Regulator has said I think that the fast track is a filtering mechanism, so Paul could you just give our listeners a little bit please about about the fast track and The Regulator's latest detail on that?
Paul	Yes of course and I agree I think that subtle shift in emphasis or the position of fast track has been interesting to see over the three consultations. I think the code still refers to fast track being a method of demonstrating compliance but I think it is now absolutely more as a filtering mechanism for the Regulator to where it needs to focus its energies and the fact that it now sits outside the code which among other things means it can be changed more readily, more easily in the future. Yes as it stands the the fast track itself there's a few different aspects to it, there's the actual evaluation side and and Fast Track itself is sort of a mixture of defined limits on financial assumptions that are low dependency, such as discount rate and inflation and I think again they've been trailed for quite a long time by the pensions Regulators at a discount rate of half a percent above guilt so at the point of significant maturity and then there's some sort of more broad principles around how the non-financial assumptions should be set to not prescribing them, reflecting the fact that schemes ought to have different demographic assumptions but there's some sort of principles around that, so there's the sort of valuation assumption side to fast track there's then a second test around recovery plan length which is perhaps more straightforward that it sort of guarantees standard at six years or three years when you get to significant maturity and those are probably the two aspects that have been well known for a while and in my experience I think most schemes have an intuitive feel for where they sit compared to those yeah these fast track parameters or tests but the third strand to it is, as everybody talks about, it's introducing investment risk and there'll be some tests around the measurement of investment risk and I suspect that that's perhaps the area where most schemes don't currently have an intuitive feel for how compliant, maybe compliant's not quite the right word now given it's more of a filtering mechanism, but how they're measuring up against the fast track test I suspect a number of schemes will be looking at over over the coming weeks and months.
Helen	Do you still think that most trustees will be looking to choose the fast track though going forwards?
Paul	I think it will definitely become the benchmark and actually the way the code of practice is currently worded, even if you're not adopting fast track yet, you've got actuaries going to be calculating the fast track valuation position the submission around the investment stress for example is all by reference to the fast track basis so it will be calculated, it will be apparent to trustees, so it's definitely going to become a benchmark. I think there is also a question around how onerous the new code and the underlying legislation is, particularly for smaller schemes and the way to make it as straightforward as possible is to just adopt fast track in reality, which then obviously leads it to an interesting question for schemes who currently have a valuation targets or basis that's more prudent to the fast track and and will there be a a trend or pressure to sort of level down if you like to the fast track basis, but we'll see how that plays out but I think it will become the standard benchmark for for most schemes.
Chris	Yes it's interesting isn't it because I suppose there'll also be some schemes that have weaker covenants that won't be able to support the fast track assumptions, and on the other hand you'll have as you say Paul some schemes that could meet the fast track approach but want the flexibility of a bespoke group, so it will be interesting to see to see how it plays out I guess.
Helen	I'll say it's interesting as well that The Regulators themselves have said that they expect 50% of schemes will pass the requirements for fast track.
Paul	Yes and extended on from that, so I think bespoke itself is going to vary quite significantly depending on how far away from fast track you are, so again I think there's there's another grouping of schemes who who will meet fast track as best they can, but as you said Chris, can't afford the contributions to have the recovery plan but in the way it's shaping up is that that bespoke route will be much lighter touch, for the want of a better expression, than a scheme that is operated to different assumptions or more investment risk.
Chris	You mean like a bit like a funnel of the filtering mechanism, so if you're slightly outside fast track for whatever reason then you're less likely to be investigated than one that is a long way away from fast track?
Paul	Yes, whether they'll be great sort of bespoke light if it's just the contribution elements you're missing on or the investment strategy obviously getting a little bit into the detail but schemes that have asset back contributions are likely to fail the investment stress because it gets taken outside of that calculation, but you would envisage it that's quite easy to demonstrate, it's all reasonable because you just add it back in and show the risk that's there as opposed to some a scheme that is more intentionally running a different risk profile, no doubt for good reason, but we'll have to sort of go through a process of demonstrating why collectively that makes sense for them.
Chris	Yes, okay, Paul you mentioned recovery plans a minute ago and the Regulator has been a bit more flexible than we had anticipated in terms of trustees' approach to these and in terms of trustees' approach to how fast they can recover deficits, I don't know whether you might be able to tell us just a little bit about that?
Paul	Yes so I think the code of practice introduced flexibility into recovery plans in a couple of ways so first it was quite clear it's allowable to allow for known improvements in the funding position after the valuation date within a recovery plan and before determining the cash contribution.
Chris	You might be about to go on to it but stealing your thunder, there was a point around when the regs talked about recovering deficits as soon as reasonably affordable from the employers, is this where you're going Paul, sorry? I think there's more, I said the code talks about trustees being able to take into account reasonable alternative uses of employer-free cash flow, so balancing those two will be something that you know trustees will need to weigh up and that concept of reasonable alternative uses of employer cash flow and then the regulator gives a bit of detail about what that might be, that's not in the draft regs currently, so there's a question about the primacy of the code and the regs again, it's that same point.
Paul	Yes exactly right Chris, so it was presented as a sort of question in the regulations about whether this affordability should have primacy over other considerations when it comes to recovery plan contributions, whereas the code is very much it feels like more on the current position of that's one consideration to be balanced alongside others, if the regulation do flow through with affordability you should take precedent over the other considerations that is going to be a material change to the current position for a number of schemes and particularly for a number of sponsors, but again the code whilst the way it's worded is more familiar with the current position, some of these concepts while they sound good and reasonable they are difficult in practice if trustees and companies are going how should a trustee weigh up reasonable alternative use, so again we'll see if schemes go down a fast track for each of them perhaps having a six-year recovery plan in effect just yeah solves that equation, but there may well be some interesting conversations I think coming out of the new code of practice.
Chris	Yes interesting and it feels like we could have a podcast on each of these concepts and whole series on funding, but okay so Paul we just wanted to ask I think you mentioned this at the top, just how this all applies to open schemes?
Paul	Yes so again from a personal perspective I did find the changes in the code quite welcome for open schemes but I think there is an underlying issue that it feels a bit like open schemes are trying to be shoehorned into underlying legislation that's written from the mindset of a closed scheme, so an open scheme still has to set a strategy for funding an investment to the point they're significantly mature and obviously there's a whole array of open schemes, there's some that just have a few members earning accrural through to some that are still having new entrants but for a genuinely open scheme, a new entrance that's that's a slightly odd concept about the long term significantly mature strategy but the code did make a couple of welcome changes I think such as removing the future service test from the fast track requirements, albeit I guess by the time you get to the next evaluation what was future service has now become fast past, this is perhaps a little bit of a temporary reprieve rather than coming from the outside, but also the allowance for a reasonable amount of future service to be included in in the calculation of duration again was a welcome change but I do suspect that the reality is that a number of open schemes are going to be going down the bespoke route and so having valuation discussions with the regulator.
Helen	So we've talked about having a journey plan based on covenant assessment to hit a long-term funding target by the time the scheme is significantly mature, there's also a new requirement to document this in a funding and investment strategy. Paul where are we with the documentation?
Paul	I think you made the point earlier Helen that we've got this sort of slightly odd situation that we've got the code of practice being built on regulations that are yet to be finalised, that comes in here with regulations require the strategy and that the regulator will set out the detail or the format of what that should look like, and again some of the core principles that sit behind the principle of this, it's a mechanism by which the regulator can collect information from pension schemes for example, which feels reasonable. However I am concerned, and this may be an invalid because we are awaiting some of the detail on what it will look like, I am concerned that it does currently look quite onerous again particularly for smaller schemes with requirements to describe long-term strategy, the journey plan, risk management and other definitions and pieces of information. So the Regulator, I think is the position is required to design the format of the statement but is yet to sort of provide a template for that and I think really the position is we would welcome an example sooner rather than later so we can get a feel for what the requirement is.
Chris	Yes absolutely and the interesting thing is that, following on from your point Paul I suppose, is that not only will some schemes, smaller schemes, have to make sure they comply but all schemes will, and it used to be that you only had to submit the actual evaluation if you had a recovery plan because you're in deficit, whereas now everyone will need to submit this strategy and statement, whatever the scheme is position, so it'll be relevant to a lot of schemes where they're TP Surplus, Technical Provision Surplus. Yes that's a shift.
Paul	Yes, a number of schemes that have not had to engage with the Regulator for previous valuations will now be meeting this.
Chris	Yes okay, so it's been it's been a great discussion, I think we'll finish with Paul what's next, what can we expect next in the way this plays out?
Paul	I think where we are is we've got this consultation on the second code of practice and that closes in March, but as I said earlier the idea is that this is then all coming into effect alongside the the regulations which have also to be finalised from October, I'm sure you understand this better than I do, but I understand that would effectively need to go to Parliament by sort of around June time to meet that time scale.
Chris	It has a 40-day time period in Parliament that's right.
Paul	Yes that that to me feels like quite a lot still to do to meet that timeline, so we shall see I guess whether October is met. I think from our day-to-day practical perspective, if this is applying to evaluations from October 2023, we don't wait until October to start discussing valuations with trustees, ideally we'd be doing that sort of several months in advance so obviously we know a lot of what's coming but we don't know all the detail yet and really would like to see some clarity around some of these points by late Spring/ early Summer, but we shall see.
Helen	Thanks so much for coming on the podcast and sharing all your valuable insights with us.
Paul	It's an absolute pleasure and thank you for inviting me on.
Chris	It's been great to have you, thanks Paul.
Helen	Thanks for listening to the Burges Salmon Pensions Pod. If you'd like to know more about our pensions team and how our experts can work with you, you can contact myself, Chris or any of our team via our website. Our next episode will look at diversity and inclusion in pensions. All of our episodes are available on Apple, Spotify or wherever you listen to your podcasts. Don't forget to subscribe and thanks for listening.