On publication of the Department for Work and Pensions' (DWP's) draft regulations in July 2022, many in the industry were alarmed by the prospect of a significant loss of flexibility regarding their funding and investment strategies.
While concerns remain, the draft New Funding Code (the "draft code") helpfully interprets the most contentious parts of the draft regulations in a pragmatic way. This is particularly important for large schemes, as they are much more likely to need a bespoke approach to their journeys.
Below, we examine the differing circumstances for large schemes, and where everyone should be focussing their attention.
Longer time horizon
"Large schemes" is a very blunt generalisation - typically larger schemes tend to be individually quite distinct. Some large schemes (albeit a minority) remain open to substantial numbers of new entrants. Others were in the first tranche of schemes to close to DB accrual. So each scheme's closeness to "significant maturity" - the point by which all schemes must achieve low dependency on their sponsors under the proposals - will vary considerably.
However, large schemes also possess a couple of common features which may mean that they typically, compared to smaller schemes, have a relatively longer time horizon to ultimately buy-out:
- They can adopt more sophisticated investment strategies to better mitigate on-going risks (including longevity risk), thereby choosing to have a more reliable, albeit potentially longer, journey.
- Given their size, large schemes may have a lower likelihood of receiving a cash injection to bridge the buy-out gap from a low-dependency funding position.
These features mean that a large scheme may have a relatively longer lifetime under the draft Code.
Fast Track
Under the draft Code there is also an enormous range between what might be acceptable within the broad high-level principles, and the parameters associated with Fast Track.
For example, the Fast Track parameters were derived assuming a 15% allocation to growth assets at significant maturity, whereas TPR's guidance states that a long-term allocation of up to 30% in growth assets may be appropriate in some circumstances. This could represent a meaningful difference in terms of future expected returns - around 0.5% pa - corresponding to a potentially material difference in the calculation of any funding deficit (even on a prudent basis) and, in turn, leading to lower ongoing contribution requirements both in terms of future benefit accrual if the scheme is open, and any deficit repair.
All of this means that it is typically going to be inefficient at best for large schemes to put any significant weight on the Fast Track parameters. Instead, the answer will more feasibly be a bespoke approach, building on what is likely to be a well-advanced existing funding strategy.
Nevertheless, these schemes will have to demonstrate compliance on a regular basis. It will be important therefore to build in resilience to meet the requirements of the draft Code, whilst at the same time delivering on the trustees' and sponsoring employers' practical objectives.
So where should the attention be?
Where schemes are expecting to run-on for some time, sponsoring employers are more likely to be concerned about the possibility of over-funding and "trapped" surplus, and therefore a more reliable assessment is needed of whether or not an emerging deficit actually justifies additional contributions. Alignment of the discount rate with the investment strategy will become particularly important. A ‘Gilts plus' approach may result in more volatility than an approach based on actual investment yields (less a margin) and I therefore expect more of a movement in the direction of the latter in the years ahead.
Large schemes may already have a longevity hedge in place or may be more likely to consider this in future, especially if reduced levels of leverage on LDI strategies reduce the attractiveness of partial buy-ins. The Code does not explicitly recognise the risk reduction benefits of a longevity hedge and therefore thought should be given to how a case can be made to get due credit for that as part of the overall compliance with the "low dependency" objective. Similarly if trustees feel they are taking a much more progressive approach to managing climate risk then how might they get due recognition for that?
Schemes that are expecting to run-on for the foreseeable future on a prudent low-dependency basis will, all else being equal, expect to gradually build up a surplus. How will that surplus be used? Further reduce risk? Justify increased risk? Provide benefit improvements? Fund new benefit accrual? A nice problem to have perhaps, but schemes will want to retain sufficient flexibility in their approach to navigate the "real-life" strategy for the trustees and the employer whilst avoiding any unintended consequences under the New Funding Code.
Large schemes are more likely to have a more "sophisticated" relationship with the employer covenant - for example via the use of contingent funding arrangements, asset backed contributions or parent company guarantees. These might not naturally fit in to the new definitions of periods of covenant "reliability" and "visibility" under the draft Code and extra work may be required to ensure that full value of the benefits of these arrangements is properly recognised.
Overall, I do not expect that large schemes should see the New Funding Code as a great imposition on their intended funding and investment strategies going forward. Nevertheless, it is interesting that the Code will be arriving at a time when many schemes are embarking on a different stage of their journey - one that is perhaps less about reducing risk and more about maintaining a low-dependency position.
This is therefore an important opportunity to take a step back, take a fresh and perhaps independent perspective, and build a resilient and enduring approach for the future.
