Whilst many defined benefit (“DB”) pension schemes in the UK are experiencing positive funding positions, it is still essential to understand how the new DB Funding Code (“the Code”), effective for valuations on or after 22 September 2024, impacts both trustees and sponsoring employers. The Code, published by The Pensions Regulator (“TPR”), sets out TPR’s expectations and guidance for meeting the requirements of the statutory funding regime, particularly the new Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2024 (“FIS regulations”). Aimed at strengthening the security and sustainability of DB schemes, the Code has natural points of tension that require careful consideration. This article highlights some of the key tensions and what they mean for those managing DB schemes.
Fast Track vs. Bespoke routes: finding the right fit
One of the Code’s central features is TPR’s dual approach to compliance with the FIS regulations, being the Fast Track and Bespoke assessment streams.
Fast Track is intended as a simple, standardised route, providing trustees with clear guidelines on funding assumptions, investment risks, and contributions. TPR published tolerated risk parameters for Fast Track in July – along with publishing the Code – against which trustees can test themselves. However, there are a number of schemes with specific characteristics that will not comfortably fit within this standardised model.
For example, schemes with significant funding deficits or weak employer covenants, or schemes with lengthy recovery plans (beyond TPR’s guideline 6 years) are likely to feel they have to use the Bespoke route rather than Fast Track. There will also be more nuanced situations to consider, such as schemes whose trustees look to take advantage of more high-risk or volatile assets, such as equities or illiquid assets, as part of their investment strategy; and any scheme undergoing material changes, such as restructuring, winding up or merging.
For schemes that have unique characteristics or face specific challenges, the Bespoke route allows greater flexibility but at the expense of TPR’s regulatory assurances in relation to Fast Track. Use of the Bespoke track will involve more work than merely stress testing against the Fast Track risk parameters.
Whilst Fast Track offers regulatory certainty with reduced scrutiny, trustees and employers of schemes having (or choosing) to use the Bespoke route face increased regulatory oversight and a greater burden of proof to demonstrate compliance. Trustees and employers must weigh the benefits of regulatory simplicity against the need for tailored solutions to manage scheme-specific risks effectively.
Balancing employer covenant and investment risk
The FIS regulations provide a new statutory requirement for assessing the employer covenant— essentially, the financial strength of the sponsoring employer. This looks at two key factors:
- the ‘reliability period’: the timeframe during which an employer is expected to have sufficient cash flow to support the scheme. It involves assessing the employer’s financial stability and ability to meet its obligations to the scheme in the short to medium term; and
- the ‘longevity period’: the long-term ability of an employer to support the scheme, considering the scheme’s duration and the expected lifespan of its obligations. It involves evaluating the employer’s capacity to sustain contributions over an extended period, accounting for factors such as demographic changes, economic conditions, and the employer’s business prospects.
These are used to assess the level of risk an employer can support, and consequently how much reliance can be placed on the employer’s ability to support the scheme, particularly during adverse conditions. Trustees are also encouraged to align their investment strategy with the strength of the covenant. A weaker covenant may necessitate a lower-risk investment approach to protect the scheme’s funding position.
Higher-risk investments can yield greater returns, which may be crucial for improving a scheme’s funding level, but if the employer covenant is weak, taking on additional investment risk could expose the scheme to losses. The Code does include a section focusing on poorly funded schemes. TPR expects such schemes to set assumptions based on a weak employer covenant and to potentially take more risk in their investment strategy to ensure the payment of members’ benefits. Given that the Code’s principles are yet to be put into practical effect by schemes, this will need to be closely considered by trustees and employers when agreeing the strategy.
Regulatory expectations and economic uncertainty
TPR’s expectations in the Code push schemes to maintain high levels of security and resilience. In economically turbulent times (characterised by inflation, low interest rates and/or market volatility) meeting these expectations becomes challenging. Market uncertainties may reduce investment returns and employers may face financial constraints, further complicating efforts to comply with legislative requirements.
Trustees are expected to demonstrate robust risk management, even when economic conditions are unpredictable. Successfully balancing regulatory demands with economic reality requires careful planning and the ability to adapt strategies as conditions shift. This aspect of the Code emphasises the need for resilience in managing both scheme funding and economic fluctuations.
Shorter recovery plans and the need for employer flexibility
The Code emphasises the need for shorter recovery plans to address scheme deficits, which is intended to enhance scheme security and mitigate long-term funding risks. However, shorter recovery periods can increase pressure on employers, who may need to make larger, more immediate contributions to meet these tighter timelines in difficult economic climates. This can strain employer finances, especially where cash flow is already tight.
Trustees must consider the employer’s financial position while adhering to regulatory requirements, as failure to strike this balance could jeopardise either or both the trustee’s and the employer’s abilities to fulfil their obligations. The key here is open communication and negotiation between trustees and employers to find a workable solution.
Moving forward: a collaborative approach
While the Code introduces important reforms to strengthen DB schemes, it also requires trustees and employers to navigate significant tensions collaboratively. Achieving a balance between long-term funding goals, regulatory requirements, and the flexibility needed to handle unique scheme characteristics is critical. Trustees and employers who embrace open communication and proactively assess their options will be better equipped to meet the challenges ahead.
