In December, The Pensions Regulator (TPR) published its draft Code of Practice on DB funding. This is the biggest shake up in DB funding for almost 20 years.

Whilst most of what is in the Code is welcome detail and we are now helpfully starting to see the new regime take shape, in our view there are still a number of areas where the underpinning regulations and/or the Code fall short and may lead to unintended negative consequences for DB schemes and their members.

In this blog, LCP’s Jonathan Camfield and Jon Forsyth set out detail on each. The views expressed in this document are those of the authors and not necessarily those of LCP. There is a lot new in the Code for trustees and sponsors to consider. To help, our News Alert includes an overview and we held a recent webinar walking through the detail and what it may mean in practice.

1. Rigidity of law on de-risking

Under the DWP regulations as drafted, all DB schemes, without exception, will have to reach a state of ‘low-dependency’. Our understanding is that this means that schemes have to plan to reach a funding level where no additional funding is expected to be needed from sponsoring employers, and then to lock-in to that situation by means of a low-risk (and low-return) investment strategy. This goal has to be reached by the time schemes are ‘significantly mature’, which for a typical scheme means their members have mostly retired.

Whilst this may be a sensible target for many schemes, it will not be for all. In fact, for a minority of cases this is expected to lead to sponsors being asked to pay unaffordable levels of contributions, which could lead to significant pressure on businesses and in some cases insolvencies and job losses, and cuts to pension benefits for scheme members. In these cases an alternative approach would make success - for the pension scheme, the sponsor, and importantly the members - considerably more likely. We explored this issue in detail with some cases studies in our LCP on point paper: Missing the target

Helpfully, in its draft Code, TPR does recognise this issue and indeed has set out a pragmatic approach for such schemes in the Code – but critically we do not see this pragmatic approach as being compatible with the law as currently drafted (noting that we are not lawyers).

What do we want to change? At or after schemes reach significant maturity, we want the law to be constructed in such a way that it recognises that in some cases the best outcome for the scheme and its members could be to not invest in a low risk (low return) way, and permits this where appropriate. Otherwise, there is a risk that the law, the courts and legal interpretation will lead to costly suboptimal decisions for some pension schemes, sponsors, members and the PPF.

2. No transition period

There are no transitional provisions for the new Code, with the full force of the new requirements coming into play at each scheme’s first actuarial valuation following the commencement of the regulations.

This is expected to be challenging for a number of schemes, especially those that have already reached or are close to reaching significant maturity. Such schemes may need to collectively de-risk their investment strategies over the next few years, and also swiftly get up to full funding.

What do we want to change? We think some explicit transitional provisions are needed to avoid significant impacts for mature schemes. The regulations should also make it explicit that a scheme does not need to be fully funded at all times once it is significantly mature. If it falls below full funding, there should be a permitted transition period to return to full funding.

3. Requirements on investment strategy at significant maturity

Once they reach significant maturity, our understanding is that schemes must “broadly match” benefit payments with cashflows from investments, and invest such that the value of assets relative to liabilities is “highly resilient” to short-term adverse changes in market conditions. These terms are open to interpretation – but in our view, taken at face value, the regulations are overly restrictive for investment allocations for schemes at or close to significant maturity.

Again TPR has been somewhat pragmatic in its own interpretation of this aspect of the regulations in its draft Code – but ultimately it will be the Courts that decide what these terms mean, and as such legal precedent and advice could end up requiring something considerably more strict than is set out in TPR’s draft Code. There is a significant risk that the clarification of legal interpretation over time could create considerable new systemic risks in the bond markets, as all pension schemes look to comply over a short period with narrowing legal opinion. It is clearly important that this risk is avoided if at all possible, given the events of late 2022.

What do we want to change? More flexibility in the regulations than is implied by the terms “broadly cashflow matched” and “highly resilient”. One simple option would be to change “and” to “or”, so that schemes either need to be “broadly cashflow matched” or “highly resilient”.

4. Clarity on recovery plans

The draft regulations require deficits to be recovered “As soon as employers can reasonably afford”.

This has been a broad TPR principle for some time, and at first may sound reasonable, but we are concerned about the impact of putting this into law, rather than having it as a regulatory principle. Again, taken at face value, this leaves a number of unanswered questions including:

• Where a sponsor is making sizeable pension contributions but paying dividends, does this mean that dividends need to cease until the pension deficit is cleared?
• Will some sponsors be forced into paying off the DB pensions deficit immediately (or within a very short period) at the expense of investment in their business?
• And how does this interact with TPR’s statutory objective to minimise any adverse impact on the sustainable growth of an employer?

Once again this is an area where TPR has provided its interpretation in the draft Code, but it will ultimately be for the Courts to decide what this law means. There is a risk that, following a major business/pension scheme failure (eg the next Carillion), a future Court could decide that pension contributions should have been prioritised above discretionary spend (eg dividends). Such legal precedent would have a major impact on UK plc, significantly shifting the delicate balance that directors currently take in balancing their responsibilities to all stakeholders.

What do we want to change? Vague terms within law that are subject to interpretation (eg “reasonably”) can create new risks for all stakeholders and in this case we think this aspect of the regulations should either be scrubbed (and left to TPR to police, as per currently), or clarified, eg by explicit reference and recognition to the need for sponsors to balance competing demands.

5. The weaknesses of duration as a measure of maturity

The regulations and draft Code require a low-risk approach to be adopted by the time a scheme reaches a 12-year “duration” (a technical measure of the maturity of a scheme). However, in the draft Code it is clear that various other options are also being considered by TPR and DWP as to how to best measure the maturity of a scheme.

Duration does have drawbacks – notably it is highly sensitive to market conditions, meaning schemes targeting a certain date for their low-risk strategy can easily find that date having to be suddenly brought forward (or pushed back) by many years if long term yields in bond markets change.

For example, for two schemes we have looked at, one relatively immature and one relatively mature, as of late 2022 they were expected to reach significant maturity a full nine years earlier than if the same calculation was done at the start of 2022 – primarily due to gilts yields rising over the period. For the relatively mature scheme, this has meant a journey plan to significant maturity of (originally) 10 years now shortening to a matter of months.

Whilst the movement in yields over 2022 might be said to be unprecedented, this illustrates the challenges that can be expected to arise from using this measure of maturity.

What is more, there is potential to “game the system” here – durations can be changed by (for example) assuming members live longer, or take different options at retirement.

What do we want to change? A change away from a market-based duration as a measure of significant maturity. This may mean adopting fixed (rather than market related) discount rates to measure a duration, or using a different measure altogether (eg percentage of vested pensioner liabilities). If this is not changed, it will make it very difficult for schemes to plan their investment de-risking journey – knowing that the date they need to be “low risk” can change materially between valuations. If the figure of 12 years is retained, it also means many schemes will need to de-risk much more quickly than they had previously anticipated, given current higher gilt yields and consequent shorter durations. In turn, this is likely to exacerbate systemic risks in the bond markets.

6. No mention of climate change risk

One significant risk conspicuous by its absence from the draft Code is climate risk. There is plenty within the Code on the importance of understanding risks in general, and on integrated risk management, so the fact that a search for the word “climate” returns zero hits is both surprising and disappointing.

TPR has previously indicated it cares about this issue and wants schemes to be undertaking necessary analysis and risk management – so some discussion within the Code would have been very welcome. There are many schemes that have made great progress in this area, but perhaps many more who are still not considering it in any detail and are unsure where to start. Some direction here from TPR would have been welcome – though perhaps we can expect more in separate guidance in due course (some of which has already been published). But especially for a new regime that is focussed on the longer term journey, and integrated risk management, climate risk feels worthy of some more consideration in the Code.

What do we want to change? TPR should highlight its key expectations on integrating climate risks into covenant, funding and investment risks in the Code – lending more weight to its already published guidance in this area, and giving schemes clarity on what is required. If not it seems likely that the many schemes who have not already started integrating climate risk into their risk management decisions will continue to not do so for the time being – potentially leading to perpetuating additional systemic risk in the DB universe.