The new Defined Benefit funding code and scheme investments – Reasons to be cheerful

4 November 2024

The first thing to say about the overall Defined Benefit funding code of practice is that the investment elements are integral to it. By covering both funding and the interlinked topic of investment, the final code (like the draft) brings together the respective roles of the Scheme Actuary and the investment consultant into a coherent whole.

Low-dependency funding

Firstly, schemes need to agree their long-term objective – essentially whether they plan to buy-out with an insurance company or to run-on.

Secondly, the funding code says that schemes need a plan in place to reach their low-dependency funding target. And once they achieve that, they are expected to have a low-dependency investment strategy.

Again, we already knew this – there’s no real change from the draft code. Most trustee boards should already have plans in place to move towards a low-dependency basis. It’s good that this funding code hasn’t disrupted that. Any plan already agreed to meet the draft code is likely to meet the requirements of the final version.

The Pensions Regulator’s (TPR) expectations for the structure of the low-dependency investment strategy seem reasonable to us, by which I mean that they’re not excessively prudent. Again, this is consistent with the draft code.

Flexibility to diverge from low dependency asset allocation

We welcome the flexibility trustees now have to diverge from a low-dependency, low-risk asset allocation, where appropriate. Even with the long-term objective underpinned by low-dependency actuarial assumptions, trustees now have some latitude to invest in a slightly riskier way.

A particularly welcome aspect of the new funding code is the clarity that surplus assets don’t need to be invested on a low-dependency basis. Where a scheme holds an excess of assets over and above the value of its liabilities, trustees can now invest that surplus more freely.

That’s a key change from the draft, and a really positive development. In fact, from an investment perspective, it’s the best part of the new funding code. It offers the potential for a scheme to aim for a funding level above 100% on a low dependency basis, and to invest the surplus in assets that offer long-term growth potential.

This flexibility to invest surplus assets more effectively creates a strong argument not to be too cautious when setting the low-dependency level.

For low-dependency funding on a fast-track basis, TPR says that the discount rate should be no higher than gilts + 0.5% pa. Let’s look at a couple of example approaches open to a fictional scheme with £10m of liabilities (valued at a discount rate of gilts + 0.5% pa) and £12m of assets:

• Example 1 – The scheme sets a discount rate of gilt + 0.5% pa. It’s now 120% funded, with £2m that can be invested flexibly.
• Example 2 – Because the scheme is well-funded, the scheme sets a discount rate of gilt + 0.25% pa. It’s now 100% funded, with a liability value of £12m, which is equal to the assets.

Example 2 shows that with a cautious liability value, the scheme potentially misses out on the investment flexibility that a surplus would have brought. Example 1 still satisfies TPR’s guidance, and the surplus assets can now be invested in assets with potentially higher returns. This offers the additional benefit of building up a funding buffer to protect against adversity.

It’s a powerful argument for avoiding an excessively prudent long-term funding target, and could become a key discussion point at future funding valuations.

Prior to the new funding code, there was a tendency to take a more prudent approach at each valuation – reducing the discount rate and becoming 100% funded on an increasingly prudent basis. Whereas now, schemes can work at an acceptable level of prudence to build up a surplus, which can be invested in a more effective way.

More flexibility for open schemes and run-on

This makes it easier for investments to support scheme run-on, at a time when the prospect of run-on is turning many trustees’ heads. As Vicky Greenwood argues in Pension scheme run-on – Gimmick or game changer? run-on should be considered by every scheme, even though it may only prove suitable for a minority of schemes.

In a similar vein, we also welcome the additional flexibility for schemes that are open to accrual, another significant change from the draft code. Trustees can now allow for longer-term future accrual and new members when considering significant maturity. Our recent First Briefing provides further commentary on this.

Guidance on matching assets

The final version of the code clarifies that matching assets do not have to generate income directly. This is helpful guidance.

Many schemes continue to successfully use leveraged liability-driven investments (LDI). The structure of this asset class makes it very effective at liability matching, but LDIs do not typically generate income. We welcome the fact that schemes can keep such arrangements in place as they reach a strong funding position.

It’s always important to ensure that accurate liability hedging takes account of yield curves, and it’s good to see that TPR has recognised this in the code. When investing in bonds, schemes should consider when they’re due to mature and pay out, in relation to cashflow planning, and protecting against interest-rate and inflation risks.

The importance of proportionality

The code includes a section on proportionality. The final code sensibly offers some flexibility for trustees of smaller schemes. As Steve Deverell-Smith points out in a recent blog post – DB funding code – What does it mean for employers – the average cost of implementing the code could run to nearly £10,000 per scheme over three years. Allowing for some degree of proportionality is a key concession for smaller schemes.

Clarification on sponsor consultation

There is no change to the requirement to consult sponsors on investment matters.

Historically, investment decisions have always been made by trustees. Although trustees were required to consult with the sponsor, in theory, they could ignore any disagreement (if there were good reasons to do so). The draft funding code stipulated that the agreement of the employer was in fact needed, which seemed at odds with trustees’ ultimate prerogative to determine the investment strategy.

However, in the final code, TPR has restored the status quo, giving trustees the same investment autonomy as before.

Why my glass is half full

The funding code will require trustees to consider their investment arrangements in more detail and many trustees – especially in smaller schemes – may perceive the new obligations to be excessively onerous. However, from an investment perspective, much of the final code is as expected. The changes made to the earlier draft strike me as favourable, and the increased flexibility regarding the investment of surplus assets is welcome.