TPR draft defined benefit funding code

On 16 December 2022, the Pensions Regulator (TPR) released its draft defined benefit funding code, which sets out its regulatory approach to defined benefit pension schemes going forwards. Whilst the code remains in draft form and subject to consultation, the direction of travel is clear, and there are several changes from the approach outlined in TPR’s March 2020 initial consultation.

Low-Dependency Funding Targets

The central pillar to TPR's new approach is the focus on a long-term funding target of achieving low dependency upon the employer covenant by the time a scheme reaches "significant maturity". TPR has settled on a definition of "significant maturity" based upon the average duration of a scheme's liabilities of 12 years, although schemes will remain free to target an earlier date.

Technical provisions will remain for the purposes of determining ongoing deficits and recovery plans.However, for compliance with TPR's fast-track regime, technical provisions will be expected to represent at least a certain percentage of the scheme's low-dependency liabilities, varying dependent upon the maturity of the scheme.

Ongoing deficits and recovery plans

We would expect the proposed changes to result in maturity becoming a more prominent factor in determination of ongoing deficits alongside covenant strength.

In terms of recovery plans, TPR has moved away from the suggestion that expected recovery plan lengths should vary dependent on covenant strength (in the March 2020 consultation, TPR had proposed that recovery plans would ideally range from three to 12 years dependent upon covenant strength). Instead, under its fast-track guidelines, TPR has set a benchmark of six years regardless of covenant strength if the scheme is not yet "significantly mature" and three years for "significantly mature" schemes.

Recovery plans of this length may prove challenging for schemes and employers with weaker covenants, although longer recovery plans may be permissible if they can be adequately justified based upon employer affordability. This would lead these schemes down the bespoke track, with TPR expecting that bespoke track schemes are more likely to be scrutinised.

We believe that independent covenant advice is likely to be particularly important for schemes which go down the bespoke path, with the affordability reviews which are already central to covenant assessment being essential in order to justify longer recovery plans.

Covenant Assessment

As under previous guidance, the strength of employer covenant is assessed as the financial ability of the employer to fund the scheme and support scheme risks in conjunction with any legally enforceable contingent assets in place. Covenant assessment will remain an exercise in relativity between the employer's financial resources and the scheme's deficits.

However, the focus will move away from a comparison to ongoing deficits, and instead be primarily determined in relation to a scheme's low dependency and solvency deficits.

There is an explicit focus on cash resources and cash flow, along with employer prospects - we welcome this focus as it is in line with the approach we at PCS have taken to covenant for some time.

TPR has additionally set out three areas of focus when assessing an employer's prospects: visibility, reliability and longevity.

Visibility refers to the short term prospects of the employer and will be determined by the availability of forecasts (typically over the next one to three years) as well as the reasonableness of these forecasts. Determination of covenant visibility will also include reference to the employer's track record of achieving historical forecasts.

Reliability refers to the medium term resilience of the employer and will represent the period over which trustees will have reasonable certainty over the employer's available cash to fund the scheme. The regulator expects six years, or two valuation cycles to be a useful starting point. We would envisage that in the process of covenant assessment we would use this as a starting point, then adjust upwards or downwards based upon the particular circumstances of the employer, for example the term of borrowing facilities or scale of cash reserves relative to employer expenses.

Trustees are additionally directed to consider scheme cash flows when considering covenant, as these will impact the point at which as scheme is most reliant upon the employer covenant. Trustees may decide to take a more prudent approach if peak cash flow falls outside the timeframe of covenant reliability.

Longevity refers to the maximum period in which trustees can reasonably assume that the employer will remain in existence. In practice we believe that this will prove challenging to accurately quantify.

However, an approach which considers insolvency risk, an employer's track record, the employer's strategic position within its wider group (as applicable), and understanding of the industry in which the employer operates is likely to allow for a reasonable assessment of this measure. The shorter the longevity and thus greater the risk of employer insolvency, the more weight should be placed upon the solvency deficit and the employer's realisable asset base when considering covenant.

These principles are in line with considerations which we at PCS already take into account when assessing employer covenant. However, we believe that best practice would now dictate explicit consideration of these factors when preparing an employer covenant assessment.

Covenant ratings, cash flow and liquidity information, and covenant visibility, reliability, and longevity periods will also be required in submissions to TPR, as this information will form part of the new Statement of Strategy required of all schemes.

Covenant and investment risk

There is renewed emphasis on aligning scheme risks to the level of available employer support. The draft code introduces a minimum standard for downside investment risk assessment, a 1-in-6 VaR (there was previously no guidance on such risk metrics). TPR's intent is to set a minimum standard rather than to prompt schemes to move away from their current approaches (1-in-20 VaR is a measure currently used widely).

In line with its emphasis on journey planning, the draft code notes that trustees should consider how investment risk might be supported both during and after the period of covenant reliability.

The draft code also stresses the importance of resilience in scheme cash flows, ensuring that the scheme's portfolio can reliably match cash outflows for both benefit payments and collateral calls on derivative financial instruments even in stressed scenarios.

The level of risk will be supported by the employer covenant, meaning that covenant assessment and affordability reviews remain key factors in determining the appropriate investment strategy.

Conclusions

Overall, the matters to be considered when assessing employer covenant and the implications of covenant strength noted in the draft defined benefit funding code remain similar to previous guidance.

However, there is more focus on long term journey planning and the requirement to explicitly consider areas such as the visibility, reliability and longevity of covenant and how the covenant and scheme position may change over these periods.

The most substantial change for both trustees and employers is likely to be the shift away from a short term valuation-by-valuation approach towards consideration of low dependency funding, which may see some employers needing to increase contributions to schemes, particularly in cases where schemes are approaching "significant maturity".

As such, whilst current valuations are not directly impacted by these changes (TPR notes that October 2023 valuations are the earliest likely to be subject to the new regime), it would be prudent for trustees and employers to consider the likely impacts of the new funding regime during forthcoming valuations.

At PCS, we have been ahead of the curve in respect of the evolution of thinking in respect of covenant and all of our covenant assessments since the March 2020 defined benefit funding code consultation have been conducted with a view to the forthcoming changes - we will incorporate the draft code into all assessments going forwards.