Big improvement on previous proposals which would have
driven most schemes into supposedly low-risk bonds, while giving
up on long-term investment returns
Regulations are published at last after six years but new
Regulatory Guidance is still not ready – schemes need it urgently
to prepare ahead of September 2024 start
The new code may help some scheme trustees back more
productive finance but the delays have meant fewer schemes will
do so
DWP Funding Code rightly moves away from the ‘reckless
caution’ and LDI: The Department for Work and Pensions
(DWP) has published the long-awaited new DB Pension Funding Code,
which is due to be in force from April 2024, and apply to
valuations from September 2024. Thankfully this looks much more
sensible than the original proposals, having dropped the
requirements that would have driven most schemes into supposedly
ultra-low-risk assets such as high quality bonds. Herding into
such investments would have prevented most funding investing , if
anything, in higher expected-return assets such as equities,
small cap growth companies, infrastructure and productive
capital.
Good to see greater flexibility for open
schemes: It is welcome to see that the Regulations
explicitly allow for more flexibility in open DB schemes, which
clearly have longer time horizons than those heading for buyout
and will enable trustees to use a wider range of assets so they
can benefit from higher expected long-term returns, and back
illiquid assets and patient capital. It is also good news that
trustees will be able to take account of employer growth as well
as affordability, so that there is room for better returns over
time. The original focus on securing past benefits by
‘de-risking’ led to massive falls in asset value and was a wasted
opportunity for better returns for many schemes. It is good that
the term ‘broadly matched’ is no longer being used, since clearly
this misled trustees about the reliability of expected
risk-return models.
Closed schemes also need to benefit from more flexibility
and tPR should encourage more diversification, to avoid herding
that caused large losses: During 2022, low-risk assets
and Liability Driven Investing by DB schemes added to market
disruption when the Bank of England had begun QT (Quantitative
Tightening) and this created massive losses in asset value for
pension portfolios. The previous draft code suggested that
schemes which are mature, regardless of employer strength, should
have 90% of their interest and inflation risks hedged, with a
broad cash-flow matching strategy that was destined to ensure
little room for higher returns and created added costs and risks
as the gilt markets plunged when QE ended. This was not a prudent
strategy, even if it had been considered to be so by many. It has
long been the case that DB pension funds have been reducing
investments in higher expected return assets, that take away the
upside potential which can be so helpful in securing long-term
benefits.
Although DB funding seems to have improved, the loss of
asset value is real and the liability forecasts are only
estimates, which may prove flawed: It is important
to help DB pension funds take advantage of higher return assets,
rather than minimising modelled risks. With so many hundreds of
billions of pounds in DB pensions, trustees have a chance to
invest in assets that can perform much better than bonds.
Minimising risk did not work in terms of asset preservation and,
in a post-QE world, where long-term interest rates have been
distorted by money-creation since 2009, the concept of investment
risk is also less reliable. The case for diversification into
other types of asset is strong in this new world.
New Regulatory Guidance is urgently needed: It
has taken six years to get the new code, during which the
landscape has significantly shifted, so it’s good to see DWP
recognising original flaws: The first Green Paper on a new DB
Funding Code, to replace the Scheme Specific Funding Regime, was
published in 2017 with a Consultation in 2020 that proved
controversial. Then, in 2022, a new Draft Code was published, but
it failed to take account of the massive changes that saw LDI and
low-risk investments causing huge losses. The new Regulations are
now published, but the new Regulatory Guidance is not yet ready,
despite the intention that the legislation will be in place by
April 2024 and will start this September. The Guidance is
urgently needed to ensure schemes can prepare themselves.
Will the new code help drive more schemes into productive
finance, as the Government wants? The new Guidance
will make long-term planning and implementation of higher
return investment strategies easier and new flexibilities should
allow more diversification of these enormous sums of pension
assets. It is important for as many pension schemes as possible
to benefit from upside returns available above just gilts or
bonds and to also back productive investments or equity markets
that can deliver better growth. It is to be hoped that the
Regulation will used the discretion to enable more schemes to
stop obsessively trying to protect their downside and allow them
to aim for higher expected returns over time.
