The Pensions Regulator yesterday launched its long awaited consultation on a revised DB funding code with a comprehensive 175 page document.

The first part of the consultation, which focuses on the proposed regulatory approach and principles underpinning the new framework, will run for 3 months until 2 June 2020. A second consultation, which will focus on the actual draft code and guidelines, is planned for later in 2020 with the new code anticipated to come into force in late 2021.

A new regulatory approach to valuations: fast track and bespoke

The government's white paper on protecting DB pension schemes stressed the need for greater clarity around what is expected of trustees, greater accountability for their decision-making and clearer parameters around the use of the inherent flexibilities in the scheme specific funding regime.

TPR's response has been to propose a twin-track approach to demonstrating funding compliance, in theory offering trustees and sponsoring employers a choice between a "fast track" route and a "bespoke" route when carrying out the valuation process.

Under the fast track route tPR will set a series of quantitative compliance guidelines (covering key aspects of the valuation such as the funding target, technical provisions, recovery plan length and investment risk) and some scheme specific factors (such as maturity of the scheme and employer covenant strength). This framework would represent what tPR describes as a baseline of "tolerated risk" for schemes in different circumstances. If all aspects are satisfied, the valuation would be eligible for the fast track route and the trustees can expect minimum regulatory involvement.

The alternative bespoke route allows a greater degree of flexibility (which may be favoured by sponsoring employers), but will require the trustees to demonstrate with appropriate supporting evidence how and why they have differed from the fast track position and how any additional risk is being managed. Valuations under the bespoke route are likely to attract greater regulatory scrutiny when compared to those under the fast track route.

Key principles underpinning the new framework

TPR has also identified a number of overarching principles which it proposes should underpin all scheme valuations (regardless of which route is followed in practice).

1. Compliance and evidence

Trustees and employers will need to demonstrate that they have understood the funding and investment risks associated with the scheme and provide evidence as to how the risks have been properly managed with appropriate support or mitigation.

2. The long term objective (LTO), journey plans and technical provisions (TP)

The much talked about LTO makes its appearance, with a focus on ensuring that schemes progressively reduce their dependency on the employer's covenant over time and are invested with high resilience to risk by the time they are "significantly mature". TPR will expect trustees to develop a journey plan to achieve their LTO. Interestingly the bespoke valuation route appears to allow potential flexibility in setting the level of the LTO, provided there is an appropriate and robust investment strategy and additional support is provided to the scheme.

3. Scheme investments

TPR makes it clear that actual investment strategy and asset allocation over time should be broadly aligned with the scheme's funding strategy and that they expect asset allocation at significant maturity to have high resilience to risk, a high level of liquidity and a high average credit quality.

4. Reliance on employer covenant and additional support

In tPR's view schemes with stronger employers can take more risk and assume higher returns (but trustees should place less reliance on the covenant over time, depending on its visibility). Schemes can also account for additional support when carrying out their valuations provided it offers sufficient support for the risks being run, is appropriately valued and is legally enforceable.

Here the consultation focusses upon the use of contingent assets (appropriate for supporting longer term risks) and guarantees (appropriate for supporting higher investment risk in the short term). TPR will expect trustees to follow a framework to assess the quantum and quality offered by the additional support (including the legal enforceability if called upon).

5. Appropriate recovery plans

Deficits on a TP basis should be recovered as soon as employer affordability allows, while minimising any adverse impact on the sustainable growth of the employer.

6. Open schemes

Members' accrued benefits in open schemes should have the same level of security as members' accrued benefits in closed schemes, with tPR keen to stress that it does not intend the new code to put further pressure on open schemes to close to the future accrual of benefits.

Our comment

Although the consultation will be subject to extensive scrutiny and comment, tPR's opening position represents a comprehensive blueprint for the future funding of DB schemes as they become increasingly mature.

The codifying of the LTO will focus trustees' and employers' minds on working towards a position of self-sufficiency (where less reliance will need to be placed on further direct support from the employer).

In the meantime we anticipate that the proposed changes to the DB funding code are likely to result in trustees and employers engaging with further de-risking initiatives, implementing alternative funding solutions (such as asset backed funding arrangements), putting in place contingent support for the scheme and undertaking exercises designed to improve the covenant supporting the scheme.