However, there is some new information in the consultation document. In particular, schemes will be required to be fully funded and invested on a low dependency basis by the time their remaining duration is 12 years (clearing up how “significantly mature” will be defined under the regime). For a typical scheme which has a current duration of 18 years, this might mean a period of 12 – 15 years until the low dependency funding and investment requirement kicks in.

That doesn’t mean that it can be kicked into the long grass though – the new regulations require an assessment of when the scheme is expected to become significantly mature at each triennial actuarial valuation “check point”.

Statement of strategy

Importantly, there will be a requirement to submit a “Statement of Strategy” to TPR providing a rationale for the low dependency assumptions and the plan for moving from the current funding position to this low dependency target over the required timeframe.

Whilst the consultation provides no mention of “fast-track” or “bespoke”, it is reasonable to expect the Statement of Strategy to be a simple statement of compliance under a fast-track approach. Bespoke will be a more involved process.

What is becoming apparent is that the new regime will mean smaller pension schemes will need to spend a higher proportion of their budgets on developing and documenting their funding and investment strategies in order to comply. Indeed, DWP’s impact assessment that was published alongside the draft funding regulations identified that smaller schemes typically lag behind larger schemes when it comes to setting a journey plan to a low dependency target, and went on to expressly state that “the proposed changes are expected to have a disproportionate impact on small schemes”.

A twin-track regime with “standardised bespoke” available through DB master trusts

Although we await details of TPR’s second consultation in response to DWP’s draft funding regulations, a key feature of TPR’s first consultation back in 2020 was that schemes could either meet the requirement to move towards a low dependency target in a prescribed way (the “fast-track approach”) or through a “bespoke approach”. Clearly there is some detail still to be confirmed in TPR’s second consultation, but assuming these two key principles broadly remain then in general we expect:

Smaller schemes with fewer resources could be more likely to opt for fast-track and face a significant increase in funding cost as they simply do not have the resources to implement a compliant bespoke strategy.

This is where DB consolidation has an important role to play in reducing the escalating costs and risks associated with managing legacy DB pension obligations.

How can DB master trusts help?

DB master trusts open up the investment universe and efficiencies readily available to large schemes to their smaller counterparts.

Through efficient implementation of a sophisticated but streamlined investment approach targeting a long-term portfolio that is largely fixed income based (more on this later), we believe a lower long-term funding target is entirely justifiable and indeed preferable in order to control over-funding risk. This is not about avoiding the new fast-track/bespoke regime, which we think has significant merit, but is about using the additional sophistication and capital efficiency that small schemes can potentially access through a master trust to make sure the scheme’s investments are working as hard as they can whilst still delivering on the principles of the new funding regime.

Lowering the funding target by, say, 4%, which may be entirely justifiable based on a sophisticated integrated investment and funding plan within a DB master trust, could have a material impact on funding costs.

A sample scheme

Consider a pension scheme that has fast-track liabilities of £50m which aims to target a low dependency target based on a discount rate of 0.5% p.a. above gilts. This scheme has assets of £44m and has a resulting shortfall of £6m. Let’s assume that annual contributions of £1m for the next 6 years would be payable under a fast-track approach.

Through careful integration of funding and investment strategies, the same scheme could justify a bespoke liability valuation of £48m (a 4% reduction) based on a discount rate that is slightly higher than the anticipated fast-track level but still very much consistent with a journey towards a low dependency investment strategy. The deficit would be 33% lower at £4m rather than £6m and annual contributions may be reduced by £333k each year to £667k.

Potential investment strategies

It is possible to develop model investment portfolios appropriate for each stage in a scheme’s journey to its long-term objective. The principle is simple and not a new one (i.e. as a scheme matures and its funding level increases, the reliance on contractual yield increases which provides a match for underlying benefit cashflows).

However, what is different is the operational efficiency in delivering this principle en masse within a DB master trust framework, and passing the resulting efficiencies onto the underlying sections.

The charts below show typical “growth” and “low dependency” investment strategies that might exist within a master trust.

The low dependency model solution is predicated on a belief that assets which provide a contractual return give the best chance of being able to pay all member benefits without the need for any new contributions. Both solutions are well-diversified – initially with a material allocation to growth asset classes but with an increasing allocation to “low turnover fixed-income” assets across private as well as public markets.

At the point of low dependency, the expected yield is largely contractual and expected to be around 1% in excess of gilts (net of charges). Key residual risks will be default of issuer and liquidity; the latter can be managed through cash flow modelling and the former through a prudent margin being deducted in the funding discount rate. Allowing for these risks, a prudent discount rate could be in the range 0.7% p.a. to 0.8% p.a. above gilts based on spreads between gilts and other fixed income assets. It will be important to keep such a premium under review and not necessarily default to an approach which retains a fixed assumption over gilt yields.

This approach seems to be consistent with the new draft regulation (5) which defines a low dependency investment allocation as one where “the assets of the scheme are invested in such a way that the cash flow from the investments is broadly matched with the payment of pensions…” and “the assets...relative to the value of the scheme’s liabilities is highly resilient to short term adverse changes in market conditions”.

What about the other expense and cost savings of a DB master trust?

A typical pension scheme could save around 30% in running costs as a result of DB consolidation. Sticking with our £50m example scheme from earlier:

Coupled with the funding savings above, a DB master trust might provide total savings of c. £0.4m per year over the deficit recovery period (or around £3m over the lifetime of the scheme).

Is it prudent to avoid over-funding?

Over-funding of pension schemes is a real concern for scheme sponsors and trustees. Sponsors might view this as a poor use of resources and trustees could be faced with a dilemma in terms of how best to use any surplus. With a competitive insurance market, more risk transfer solutions in the offing and uncertainty over ownership and use of surplus, a gradual journey to buyout rather than overshooting the target might be more preferable.

Conclusion

We welcome the publication of the draft regulations for the new DB funding regime and support the principles underlying this. However, the new regime may present smaller schemes with some challenges that they may struggle to overcome on their own.

Consolidating within a DB master trust could help smaller schemes achieve compliance more easily, but more importantly it could also help those schemes work towards a low dependency position in a more efficient manner, which benefits trustees, sponsors and members alike. We eagerly await the detail of the TPR’s draft funding code in the autumn.