David Fairs: Is this the end of the line for the funding code?

When I joined The Pensions Regulator (TPR) in July 2018, a major item in my in tray was to produce a new funding code. The groundwork for a new funding code was set out in the Department for Work and Pensions' (DWP's) white paper - Protecting Defined Benefit Pension Schemes - published earlier that year.

The white paper set out that the funding regime was largely working as intended but some were inappropriately taking advantage of the flexibility in the existing code.

There was also a recognition that the landscape was changing. A greater number of schemes were closed to new entrants and often also to future accrual. As schemes mature and get closer to their end point, any underfunding becomes challenging - as members retire and benefits are paid out in full, the level of under funding for those yet to reach retirement increases and the level of contributions can rise exponentially.  Of course, as benefits are paid out, the absolute size of the pension scheme relative to the sponsor should decrease and so that exponential increase in contributions might not be an issue. But that is hard to foretell 15-20 years into the future.

A new funding code therefore has a number of objectives:

• Prevent abuse of those inappropriately taking advantage of the flexibility in the system - including introducing guidance on the level of investment risk
• Provide an efficient means of the regulator intervening and taking action against those abusing the flexibility
• Ensure that schemes are on a glide path to an appropriate level of funding and with an appropriate investment strategy by the time they reach significant maturity
• The funding code has to also fit with the regulator's objectives to ensure that members receive their entitlements and also that the Pension Protection Fund (PPF) is protected.

But, importantly, any new regime needed to retain the scheme specific nature of the regulatory funding and investment framework and also cater for those schemes that are still open and not inadvertently make it harder for them to continue to remain open.

Not an easy task in and of itself, but throw in the variety of schemes and sponsors across the more than 5,000 schemes - around 2,000 of which have less than 100 members - and the task is harder still.

A changing picture

During my time at the regulator, there were also external factors that made the task less straightforward. Would we have a hard or soft Brexit and what would the implications of that be on corporate sponsors and the investment markets? I then launched the first funding consultation at a point when I thought we were looking forward to a period of economic stability, only to have to deal with a pandemic shortly afterwards, then the Russia-Ukraine conflict and latterly turbulence in the gilts market. A hard task was made harder still.

Perhaps remarkably, the pandemic and the Russia-Ukraine conflict didn't undermine the analysis and underlying principles behind the code. Defined benefit (DB) sponsors came through the pandemic and continued to support and fund their schemes in a much stronger way than I thought likely. Whilst some thought that the pandemic undermined the rationale for the code, it seemed to me that the rationale and reasons for the new code remained sound.

However, the events of September 2022 have changed the picture significantly. Those schemes following a high allocation to growth assets, with no downside protection if the allocation to growth assets ran into problems, suddenly found their funding position radically improved.

These schemes, especially those with a weak covenant unable to support the level of risk being taken within the investment strategy, are arguably the ones that would be most impacted by the proposed funding code. Under the new code, they would need to measure the level of risk that they were taking, consider the ability of the sponsor to support that risk and potentially have to consider changing their investment or funding strategy to bring the level of risk closer to that which the sponsor could support.

A solution to a problem that no longer exists?

With the overnight improvement of the funding position of those schemes, is the funding code a solution to a problem that no longer exists?

I would argue that the underlying premise of the code to require all schemes to understand and measure the level of risk that they are taking on in their funding and investment strategy and consider that against the employer's ability to support the scheme still has some value. Clarity of the regulator's expectations on funding and investment, as well as a more efficient means of the regulator intervening where funding and investment strategies are inappropriate, are probably beneficial to all but the legal and advisory communities.

However, the funding code has new headwinds. The time to the next general election is rapidly reducing and the government has an ambition to bring forward a number of new regulatory requirements - implementation of the 2017 auto-enrolment review recommendations, a stronger value for money framework, multi-employer and at-retirement collective defined contribution, as well as a superfund authorisation regime, further roll out of TCFD requirements, oversight of professional trustees, work on improving equality of outcomes and even asking questions about the future role of DB schemes in supporting productive finance. Do both DWP and TPR have the resources to move all these things along in parallel?

The way forward

The Work and Pensions Select Committee has recommended a delay in the new funding code whilst the implications of the liability-driven investment crisis are considered and also further consideration is given to whether the new code might drive open schemes to consider closing.

In my personal view, the latter is largely a red herring. Many open DB schemes might well meet the requirements set out in fast track and others will readily satisfy the requirements of the bespoke regime. And if they don't fit into either of those regimes, perhaps the level of risk being undertaken should be reconsidered?

But it is undoubtedly true that the landscape has changed. LCP have developed thoughts on how the current regulatory framework could be reshaped to allow DB schemes to rethink their allocation to growth assets, underpinned by stronger protection provided by the PPF.

With both members and employers able to benefit from any upside that might then be generated, and a much-changed landscape, there is now an opportunity to look at the funding and investment regime afresh.

Does that completely undermine the rationale for the new funding and investment code? I would strongly argue not. It potentially strengthens the argument for the code, albeit with some relatively small adjustments to accommodate changes.

But the timetable before the next election is short, and there is a crowded regulatory agenda. If the regulations and code are not brought forward soon, the code might find itself heading towards grass that is getting increasingly long.

David Fairs is a partner at LCP. He was previously executive director of regulatory policy, analysis and advice at The Pensions Regulator