On 29 January 2024, the government finally published the Funding and Investment Regulations that pave the way for a new Funding Code for DB pension schemes, and a new funding regime that will apply to valuations from 22 September 2024.  

They’ve been a long time coming …. but they are certainly improved from the original draft, albeit with some detail still to come in the Code. Starting at The Pensions Regulator in July 2018, I recall being set the task to create a new funding code that for generally larger schemes provided a good deal of flexibility but for smaller schemes with limited advisory budget provided greater direction. No easy task. The backdrop for DB schemes was changing. Most had closed to new entrants and many also closed to future accrual.

By definition this meant that most DB schemes had a finite end point but back in 2018, the majority had deficits. Once a DB scheme hits a certain maturity and starts to pay out significant benefits, any deficit can become a real problem. As you pay out full benefits to retired members the shortfall for remaining members tends to grow exponentially, leading to an equally exponential increase in employer contribution rates.

Putting DB schemes on a travelator that got them to a good end point became a priority for DWP and TPR. There were some other challenges. Some schemes abused the flexibility in the existing Funding Code and the levers that TPR could use to prevent that abuse were cumbersome, resource intensive and expensive.

A long and winding road

Development of the Code has had to overcome some challenging obstacles. The first consultation from TPR was timed perfectly just before the pandemic. An initial warm welcome, cooled with the economic uncertainty that the pandemic brought. The code had already weathered a General election and Brexit but whilst those seemed challenging at the time, they were dwarfed by the impact of the pandemic and lock down. The analysis actually held up remarkably well through the economic challenges we have had since. The passage of the Pension Schemes Bill and consultation on the Regulations did meet with challenge, particularly from some open schemes.

TPR analysis showed that the majority of open schemes would easily meet the requirements of the Code and many would meet the parameters for Fast Track. For those that didn’t, maybe TPR wanted them to improve their funding position or better understand their risks and that was partly the point of the new code. Could there be a separate regime for open schemes? Well, when the possibility was aired some immediately started to plan how they could “game” the system.

Equally, TPR didn’t want to cause viable open schemes to close with the adverse impact on member retirement provision. So how do you create an easement that provides more flexibility to open schemes, isn’t easy to game, and if an open scheme sponsor were to fail, doesn’t leave members of that scheme worse off compared to a closed scheme? And what is the impact on the rest of the ecosystem? If you set lower levels of funding for open schemes, does that result in a higher PPF levy? Logically, that would be the case but the PPF would no doubt have met with some headwinds if it had tried to do that.

Working through the challenges

By linking required funding levels to maturity, TPR thought it had developed an elegant, if somewhat actuarial, solution. It avoided the risk of being gamed and allowed open schemes greater freedom in terms of both funding and investment. Unfortunately, elegant actuarial solutions are not always fully understood with some continuing to say the code didn’t adequately take account of open schemes’ circumstances.

The Regulations now published, make this clearer – the policy position isn’t changed, the Regulations just make the actuarial eloquence more explicit. And that is true more widely across different aspects of the Regulations. The original draft regulations published in 2022, were less clear in some areas than perhaps they should have been or were open to a range of interpretations. In general, the intent of the regulations has not changed.

They have just been made clearer. Change was certainly needed in the definition of Significant Maturity. Rising interest rates in 2022 and in particular the September 2022 “Fiscal Event” that led to near gilt market meltdown meant that the previous definition was not fit for purpose. And so the parameters have been fixed relative to March 2023 – a good solution in my view. Overall, the new regulations have been brought much closer to the draft funding code consulted on in December 2022, removing a number of apparent discrepancies between the two.

An opportunity missed  

Perhaps my biggest remaining disappointment with the new regulations is the lack of flexibility post Significant Maturity. If you establish a prudent funding level at that point, that has a high probability of delivering full member benefits, then it is fairly obvious that, it is more likely than not to generate a surplus in time.

This will create some strategic challenges for sponsors and trustees. In effect, sponsors and trustees will broadly have two choices under the new funding regime. Either they try and exploit the difference between their scheme’s actual long term objective and the requirements of the Code (to try and run on whilst managing the growth of surplus) or they should probably try to buy out as soon as possible. 

Under the former approach, sponsors might seek to agree with trustees that they will fund to say gilts +0.75% in the scheme (pushing the Code towards its limit) and put the difference between that and the liabilities determined on gilts +0.25% in an escrow account. In contrast, if schemes choose to buy-out as soon as they can, that will protect pensioners, but it will cost capital and also it is effectively at odds with Government policy on Productive Finance – which is looking for schemes to run on, and invest in assets that will support the economy and generate surplus.  

If the Government is really serious on this, then it needs to address surplus extraction rules quickly to encourage schemes not to buy out, and support the Regulator in developing a Code that is as flexible as possible.

Will the new Funding Code make a significant difference?   

The impact analysis suggests that around 1,200 schemes will pay £7.1bn more over the next 10 years. That is, on average, an extra £600,000 per scheme, per year.  In the general scheme of things, that is not a lot.

Following the significant improvement in Funding Levels post the 2022 Fiscal Event, many might be asking is it still necessary? And given the recent development of both Conservative and Labour policies on Productive Finance, others might be asking is it in line with policy direction?