Guidance

Explanatory memorandum to The Pensions Regulator's defined benefit funding code of practice 2024

Published 29 July 2024

1. Introduction

1.1. This explanatory memorandum has been prepared by The Department for Work and Pensions and is laid before Parliament by Command of His Majesty.

1.2. This memorandum contains information for the Joint Committee on Statutory Instruments.

2. Declaration

2.1. Emma Reynolds, Parliamentary Under Secretary of State (Minister for Pensions) at HM Treasury and at the Department for Work and Pensions (DWP), confirms that this Explanatory Memorandum meets the required standard.

2.2. Sam Hainsworth, Deputy Director for Defined Benefit Pensions Policy, at DWP, confirms that this Explanatory Memorandum meets the required standard.

3. Contact

3.1. Nicola Lloyd at the Department for Work and Pensions, [email protected] can be contacted with any queries regarding the instrument.

Part One: Explanation and context of the Instrument

4. Overview of the Instrument

What does the legislation do?

4.1. The Pensions Regulator’s (TPR) Defined Benefit Funding Code of Practice (the draft Code) provides practical guidance for trustees on how to comply with all defined benefit (DB) scheme funding requirements. The Pensions Regulator regulates around 5,000 private sector occupational DB pension schemes in the UK. The Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2024 (the Regulations) delegates certain matters to the draft Code. The draft Code will support trustees, sponsoring employers and their advisers in planning and managing their DB scheme funding over the long term and will assist them in complying with the legal requirements. It will replace the current Code of Practice No 3: Funding defined benefits: Second issue published in 2014.

Where does the legislation extend to and apply?

4.2. The extent of this instrument (that is, the jurisdiction(s) which the instrument forms part of the law of) is the United Kingdom.

4.3. The territorial application of this instrument (that is, where the instrument produces a practical effect) is the United Kingdom.

4.4. The draft Code will also be laid in the Northern Ireland Assembly in accordance with Article 85 and Article 86 of the Pensions (Northern Ireland) Order 2005.

5. Policy Context

What is being done and why?

5.1. Following a series of high-profile scheme collapses and against a backdrop of DB scheme closures to new entrants and /or to future accrual, maturing schemes and increased scheme funding deficits, the 2017 Green Paper considered whether changes needed to be made to the funding system.

5.2. The 2018 White Paper concluded that while the regulatory regime was working largely as intended with most members likely to get their benefits in full, scheme funding outcomes could be impacted by short-term thinking, and a lack of accountability over how risks were managed.

5.3. Whilst aggregate DB funding levels have improved in recent years, financial markets and economic conditions are changeable and funding positions can quickly deteriorate.

5.4. New legislative measures in the Pension Schemes Act 2021 were introduced to build on and strengthen the pre-existing scheme funding regime. Further detail is set out in the Regulations which are complemented by a new funding code of practice. The draft Code sets out practical guidance on how trustees can comply with the legislation in relation to scheme funding.

5.5. The draft Code was developed with extensive discussion and consultation by the Department for Work and Pensions and TPR with the aim to:

• encourage greater long-term planning and risk management
• drive more trustee accountability and transparency
• support more effective and efficient regulation of DB funding

5.6. Certain matters are delegated to the draft Code, which provides greater detail on how schemes can comply with the legislative requirements and how TPR will regulate the arrangements. The power to specify the duration of liabilities in years, or different dates, at which different types of schemes reach significant maturity is delegated to the draft Code. This includes setting a low dependency funding target for significantly mature schemes and ensuring risk taking on the journey plan to that point is supportable, based on the trustees’ assessment of the employer covenant and scheme maturity. The draft Code also sets out clear principles and expectations for setting prudent technical provisions and appropriate recovery plans based on the employer’s reasonable affordability.

5.7. The Regulations give TPR discretion to ask for different levels of detail from pension schemes in a statement of strategy, depending on their circumstances, as a key risk management and reporting tool for delivering benefits over the long-term. Having clearer funding standards set out in the Regulations and the draft Code and having more information upfront through the statement of strategy will improve TPR’s regulatory oversight and allow it to be more proactive in identifying and mitigating emerging risks in a targeted way. This approach is part of TPR’s current evolution into a more data-led regulator.

5.8. These clearer funding standards will support TPR in protecting member benefits and enhance the system through market oversight.  The draft Code will support trustees to appropriately plan and manage risks over the long-term, whilst at the same time maintaining the flexibility for scheme specific funding approaches.

What was the previous policy, how is this different?

5.9. The current Code, Code of Practice No 3: Funding defined benefits: Second issue, was published in 2014 and replaced the version published in 2006. The current Code will be replaced by the draft Code. The draft Code reflects the Regulations and industry feedback to TPR’s consultation on the draft Code.

5.10. The existing regime sets out how schemes should set their liabilities in a prudent way, but was conceived when most schemes were open, and in steady state. The DB landscape has changed, and most schemes are now closed and maturing. The new arrangements for the first time explicitly require schemes to have a Funding and Investment Strategy setting how they will fund members’ benefits over the long term. This is based on the principle that investment risk should be supportable, and that when a scheme is significantly mature, it should not plan to need further support from the sponsoring employer.

5.11. Better information and clearer funding standards will enable TPR to be more effective, efficient and proactive in carrying out its statutory functions, with the necessary regulatory grip based on clear metrics.

5.12. Furthermore, the draft Code has been developed to recognise the unique characteristics of open schemes. Greater flexibility has been provided in the draft Code for trustees to take account of future accrual and new members when determining the future maturity of the scheme. A new open schemes section outlines expectations for open schemes.

6. Legislative and Legal Context

How has the law changed?

6.1. The changes to the DB funding regime are set out in section 123 and Schedule 10 of the Pension Schemes Act 2021, the Regulations and the draft Code. The provisions in the Pensions Act 2004 and the Occupational Pension Schemes (Scheme Funding) Regulations 2005 will continue to apply (although there were amendments to the latter by the Regulations).

6.2. TPR is required under section 90(2)(d) of the Pensions Act 2004 (the Act) to issue one or more such codes of practice relating to matters including, the discharge of duties imposed on trustees or managers of occupational pension schemes by, or by virtue of, Part 3 (scheme funding). Further, section 90(3) or 90A(3) of the Act confers power on TPR to revise the whole or any part of a code of practice issued under section 90(1) or 90A(1) respectively of the Act and issue that revised code. Section 91 of the Act outlines the procedure for bringing a code of practice into force.

6.3. The draft Code is not a statement of the law, and it is not necessary for all the provisions of the draft Code to be followed in every circumstance. Exceptions to this are where the Regulations provide that certain matters are to be specified by the draft Code, such as setting the duration in years (or other date), which defines when a scheme will reach significant maturity. Any alternative approach to that appearing in the draft Code, where the matter is not delegated by the Regulations, will nevertheless need to meet the underlying legal requirements. When determining whether the legal requirements have been met, a court or tribunal must take any relevant provisions of the draft Code into account under section 90(5) of the Act.

Why was this approach taken to change the law?  

6.4. Under section 90(2)(d) of the Act, TPR is required to issue a code of practice on scheme funding. The draft Code interprets the legislation and sets out how schemes can meet the legislative requirements in the context of the way in which TPR will regulate. It emphasises a flexible and scheme specific approach to regulation, taking into account the wide variety of DB schemes. It further supports this diversity by including a separate chapter for schemes which remain open to new members, and may not be maturing like the majority of schemes which are now closed.

7. Consultation

Summary of consultation outcome and methodology

7.1. The draft Code has been finalised to reflect the Regulations, consultation responses and extensive engagement with industry and provides further flexibility for scheme specific approaches to risk-taking and for open schemes.

7.2. TPR first consulted in March 2020 and again published a three-month consultation on the draft Code in December 2022,  along with a consultation on its regulatory approach, including a Fast Track approach for valuation submissions In March 2024 it also consulted on its approach to the statement of strategy and is seeking views from trustees and advisers on the form of the document, and the type and extent of the information that will need to be submitted.

7.3. TPR received 87 responses to their December 2022 draft Code consultation from a broad range of stakeholders, including trustees, employers, and advisers of DB schemes. There was broad support for the proposed approach, with many commentators reassured by the draft Code’s flexible interpretation of the (then) draft version of the Regulations. There were some concerns on elements of the detail, which have helped to drive the development of the draft Code. This includes ensuring that there will be appropriate flexibility for risk taking at low dependency and along the journey plan, and appropriate flexibility for open schemes.

7.4. Following this consultation, TPR has engaged extensively with external stakeholders – government partners, industry representative bodies and open schemes, to finalise the draft Code and explain the changes being made. The meetings were positive, and the direction of travel was well received. The stakeholders engaged with were largely reassured that the key areas of concern raised in the consultation had been addressed. The draft Code has been revised to strike a balance between setting clear funding standards and maintaining flexibility for scheme specific approaches.

Key changes to the draft code following consultation:

7.5. Low dependency investment allocation (LDIA) – The LDIA ensures that trustees are targeting a low dependency funding basis by the relevant date in the Funding and Investment Strategy. The draft Code makes clear there is no requirement to invest in line with the LDIA, but there is an expectation that, for most schemes, investing in the best interest of members at and after the relevant date will mean investing in line with the trustees’ chosen LDIA. TPR makes clear there is significant flexibility to take investment risk when complying with the low dependency principle, and there are no restrictions in the draft Code on trustees’ ability to invest in line with their fiduciary duties. The draft Code has also been updated to reflect that the Regulations define the LDIA as providing a highly resilient funding level to short-term changes in market conditions.

7.6. Significant maturity – The Regulations set out that significant maturity must be measured using the duration of liabilities approach. They delegate the power to TPR to specify the duration of liabilities in years, or different dates, at which schemes reach significant maturity. TPR consulted on the duration of liabilities for significant maturity at 12 years. This metric has now been reduced to a duration of 10 years for schemes with DB benefits and 8 years for schemes with cash balance benefits. This move reflects a revision to the Regulations in the calculation of duration, and a significant shift in market conditions with the aim of keeping the date of reaching significant maturity broadly consistent to the date consultation responses previously agreed with.

7.7. Open schemes – TPR has engaged closely with open schemes individually and held a roundtable as it finalised the draft Code to ensure it reflects open schemes’ unique characteristics.  The Regulations explicitly allow these schemes to consider new members and future accrual of benefits when determining the future maturity of the scheme, based on the covenant of the employer. Reflecting consultation responses and engagement with open schemes on the draft Code, TPR has built-in more flexibility on the length of future accrual and new members that trustees can take account of when determining future maturity. Schemes which have a good flow of new members, will not need to take steps to de-risk their investments in their investment strategy, provided the risks are supportable. The draft Code has a new specific section outlining expectations for open schemes.

7.8. Employer covenant assessment – The draft Code has been updated to align with the Regulations and to provide greater clarity on how to assess the employer covenant reliability and longevity periods. Within the draft Code, TPR sets out its expectations on how long these periods should be for a typical scheme and acknowledges that some employers may be able to demonstrate a longer period is appropriate for them.

7.9. Assessing maximum risk over the journey plan – TPR consulted on a formulaic test to determine the maximum level of risk that can be supported by the employer covenant. TPR has considered concerns raised in the consultation responses when finalising the draft Code. Considering the concerns raised, the draft Code has replaced this formula with a principle-based approach to assess that the level of risk being run in the journey plan is supportable. This provides trustees with flexibility to recognise the different ways in which schemes can assess risk as well as the different types of support that can be available.

7.10. Recovery plans and reasonable affordability – The draft Code makes clear that trustees must follow the overriding principle that steps must be taken to recover deficits as soon as the employer can reasonably afford. The draft Code also reflects that, in preparing or revising the recovery plan, trustees must take account of certain matters including the impact of the recovery plan on the sustainable growth of the employer. The draft Code sets out that trustees should assess affordability on a year-by-year basis, with steps taken to reduce the deficit set in line with this assessment.

8. Applicable guidance

8.1. Alongside the draft Code, TPR will also be publishing their response to their December 2022 consultation on both the draft Code, its regulatory approach, including Fast Track and its potential impacts. Fast Track is TPR’s view of tolerated risk for a scheme where it is unlikely to engage with a scheme regarding its valuation. TPR plans to publish further analysis, in due course, illustrating how some of these figures may look as of 31 March 2023, considering its updated Fast Track parameters and estimated funding positions at that date, but no further formal Impact Assessment.

8.2. TPR will be consulting on updated covenant guidance to further support trustees in due course.

Part Two: Impact and the Better Regulation Framework

9. Impact Assessment

9.1. An Impact Assessment has not been prepared for the draft Code because an Impact Assessment was prepared with support from TPR for the Regulations, which considered the impact of both the Regulations and the draft Code together.

9.2. That Impact Assessment accounted for potential extra costs that may arise, including implementation and familiarisation costs and the impact on deficit repair contributions. It was a best estimate of the impacts of all elements of the new funding regime, including the Regulations and the draft Code. The regime embeds existing good practice into a clear funding standard and many schemes would already meet these requirements and are therefore not expected to face extra deficit repair contribution costs.

9.3. In the Impact Assessment, we estimated there may be an implementation /familiarisation cost for all schemes. Initial implementation costs, including familiarisation could total around £36.8 million in the first year, or around £7,000 per scheme on average. Schemes may then face ongoing administration costs of £5.4 million per annum, or around £1,100 per scheme on average, excluding costs associated with changes in deficit repair contribution (DRC) payments.

9.4. Scheme sponsors may also face further costs as a result of the Regulations as they may face an increase in DRC payments as a result of changes to funding targets and recovery plans, with an estimated increase of around £7.1 billion to around 1200 schemes over the 10-year period. However, there will also be some schemes who after moving their assumptions in line with the Regulations see their deficits decrease – meaning some scheme sponsors will have the opportunity to decrease or cease making DRC payments, this will save sponsoring employers an estimated £7.4 billion over the 10-year period for around 1400 schemes. This results in a net saving to businesses in total employer DRCs of around £0.3bn over the 10-year period. Whether individual businesses will face an increase or decrease in costs is dependent on how different their funding target and recovery plans are, relative to the new framework at the time they undertake their next valuation.

9.5. Since 31 March 2021, the aggregate funding levels for DB schemes have increased substantially. For those schemes we have modelled as increasing contributions, we would expect the nominal figures to be significantly lower if recalculated at a current date.

Impact on businesses, charities and voluntary bodies

9.6. The impact on business, charities or voluntary bodies is that all those with DB pension schemes could be impacted, as all schemes and trustees will need to familiarise and implement the draft Code. The cost of this is discussed in paragraph 9.3 on the Impact Assessment which considers all aspects of both the draft Code and the Regulations. The Department for Work and Pensions estimates that the implementation of the draft Code and the Regulations may lead to a net decrease in costs to businesses with schemes of around £20.6 million per year.

9.7. The draft Code and the Regulations do impact small or micro businesses. This is outlined in the Impact Assessment.

10. Monitoring and review

What is the approach to monitoring and reviewing this legislation?

10.1. The approach to monitoring this legislation is that there is no requirement to carry out a statutory review of the draft Code.

10.2. However, TPR regularly reviews its guidance and codes of practice to ensure they meet stakeholders’ needs, and to assist TPR in meeting its statutory objectives.

Part Three: Statements and Matters of Particular Interest to Parliament

11. Matters of special interest to Parliament

11.1. The Regulations came into force in April 2024 and provide that the Funding and Investment Strategy requirements for DB schemes come into effect in relation to actuarial valuations with an effective date on or after 22nd September 2024. The laying of the draft Code, formerly scheduled in June, was delayed due to the dissolution of Parliament. It is a statutory requirement that the draft Code must be laid before Parliament for 40 days ignoring any period during which Parliament is dissolved or prorogued or during which both Houses are adjourned for more than four days, to allow for scrutiny. It is not possible for this period to have completed before 22 September 2024, so for a short period of time there will be no legal foundation for part of the Regulations which delegate key metrics to the draft Code. TPR will provide advice and assurance to trustees, employers and advisers affected by the regulatory gap before the draft Code is brought into effect and it will produce guidance on how it will regulate and mitigate potential impacts for schemes with valuations which fall in this period.

12. European Convention on Human Rights

12.1. No statement is required.

13. The Relevant European Union Acts

13.1. This instrument is not made under the European Union (Withdrawal) Act 2018, the European Union (Future Relationship) Act 2020 or the Retained EU Law (Revocation and Reform) Act 2023.