A guide to setting expense reserves under the new Funding Code

The new defined benefit (DB) funding code of practice (new Funding Code) requires all schemes to achieve funding levels that ensure low dependency on their sponsoring employer in the long-term. This means that schemes must strive for their funding position to be robust enough so that no further employer contributions are expected. 

To meet the objective of operating independently of employer support, in addition to having sufficient funds to meet the promised member benefits, schemes should be able to cover all their expected future expenses. Therefore, in line with The Pensions Regulator’s (TPR’s) guidance, lots of schemes will have to grapple with the concept of an expense reserve for the first time at their next actuarial valuation. 

For many schemes, especially smaller ones, the introduction of an expense reserve could easily prove to be the biggest single change of the new Funding Code. Indeed, it is not outlandish to think that some small schemes could see their liabilities increase by up to 20% because of introducing such a reserve. 

So, while it’s true to say that most schemes are well positioned to comply with the new requirements, the introduction of an expense reserve could be a nasty and unexpected shock for some. Moreover, with the potential for expense reserves to have such a big impact, there is a risk that setting an expense reserve itself becomes expensive. 

In this blog, we’ll explore the key points in the new Funding Code that you need to be aware of, as well as some suggestions for how you can pragmatically navigate the new regulatory waters.

Which schemes are expected to include an expense reserve in their low dependency basis?

TPR’s expectations for determining the expense reserve in the low dependency basis may appear convoluted – not least because the expectations can differ for two schemes that may look identical on the surface.

Specifically, the regulatory expectations depend on the specific provisions set out in a scheme’s governing documents, particularly in relation to the employer’s responsibility for paying the ongoing administrative expenses of the scheme. 

TPR’s guidance outlines two key scenarios:

1. If the rules don’t require the employer to pay expenses: Trustees will need to establish an expense reserve. 
2. If the rules do require the employer to pay expenses: TPR only encourages the inclusion of an expense reserve. But it is not mandatory.

So why the difference? The sticking point is that if employers are legally required to meet ongoing expenses through the rules, they would effectively have to meet these expenses twice if they are also asked to fund for them upfront via an expense reserve. 

However, to safeguard against future uncertainty TPR is hoping that schemes in this position include some sort of provision for expenses. This is especially the case for expenses that are expected to be incurred after the trustees can no longer reasonably be confident in the employer’s ability to fund the scheme. To manage against the risks of over funding, TPR suggests that affected schemes consider options such as establishing side agreements and/or setting up separate accounts for expenses.

Which expenses need to be reserved for?

All non-investment related scheme expenses that are expected to be incurred on and after the scheme’s relevant date (chosen for targeting low dependency funding) should be reserved for. 

TPR expects the expenses to be consistent with the long-term strategy (e.g. buyout or run-on) adopted by the trustees. 

Are schemes expected to include an expense reserve in the Technical Provisions (TPs) basis?

The simple answer here is yes. Beyond a scheme’s relevant date, the technical provision assumptions should be aligned with the low dependency basis. This effectively means the technical provisions basis should similarly reserve for expected expenses beyond the relevant date, as for the low dependency basis.

This is likely to increase deficits for some schemes, which will lead to higher short-term contributions being due for some employers. 

How should schemes estimate future expenses?

Estimating future expenses is not an easy task, as the costs of running a scheme are influenced by many variables, including:

• changing regulatory and legal requirements;
• improvements in technology; and
• changes in a scheme’s demographics

So how should schemes estimate future expenses? It is perhaps easier to first say how schemes should not go about estimating future expenses: 

1. Overly complex approaches and expensive analyses may only serve to produce spurious answers. Instead, trustees would be better served by adopting a large dollop of pragmatism. 
2. Another trap to avoid is to overly anchor your assumptions to recent experience. The presence of complex Guaranteed Minimum Pension (GMP) projects and a generational market shock (the 2022 LDI crisis) means that recent expense experience may be atypical. Instead, trustees should look at a broader range of data and consider what ‘normal’ expenses will look like for a scheme that has achieved low dependency on its sponsor.
3. Don’t forget that time is likely on your side. That is, most schemes will have a relevant date that is still some way into the future. Not only will the power of compound interest reduce the present-day value of these future expenses, TPR acknowledges that expense reserves will be refined over time.

In short, a simple, pragmatic and forward-looking approach is likely to be the most appropriate way of estimating future expenses.

How concerned should small schemes be?

Most expenses don’t scale with scheme size. Small schemes often have relatively fixed costs for tasks like pensioner payroll and monitoring. This means that expense reserve expectations will likely disproportionately affect smaller schemes. Indeed, as highlighted in the introduction, we do not think it would be unusual to have an expense reserve which increases liabilities by up to 20% for the smallest schemes.

TPR are clearly conscious of this issue, which likely explains why they appear to be extending an olive branch for small schemes in their Fast Track parameters. Specifically, TPR’s Fast Track parameters state that, for schemes with fewer than 200 members, “using the expense assumptions consistent with PPF guidance for section 179 purposes can be considered suitable for these purposes”.

The section 179 valuation expense assumption is designed as a wind-up reserve. This means the reserve may be much smaller than the ongoing reserve that is truly required for a long-term low dependency run-on strategy. Therefore, on the face of it, adopting the section 179 reserve and a Fast Track eligible valuation would appear to be a potential ‘get of jail card’ for some employers. 

This raises an interesting question - is TPR trying to be helpful to smaller schemes, or is this simply a way to ensure that schemes are sufficiently funded to protect the Pension Protection Fund (PPF)? 

Regardless, while potentially attractive for obvious reasons, small schemes should not necessarily rush to adopt the potentially lower section 179 reserve for a couple of reasons:

1. Firstly, TPR’s Fast Track parameters are not intended to constitute regulatory guidance. That is, TPR’s guidance is set out in the separate code. So, there is a question as to whether the section 179 reserve is consistent with the overriding code guidance. 
2. Most small schemes will ultimately seek to buyout with an insurer. The inclusion of a higher (and more realistic) ongoing expense reserve can therefore actually help to provide a more accurate and fair comparison when considering the cost of buyout versus the cost of continuing to self-administer. As a minimum, this may help fuel some important conversations about long-term planning – which is precisely the point of the new funding regime.

What should trustees do?

If you’re a trustee navigating these new requirements, there are a few key takeaways:

• Understand the rules: Review the scheme’s governing documents to understand the expectations for your scheme. 
• Assess the potential impact: Consider estimating how the introduction of an expense reserve might impact your scheme’s funding position, and the employer’s contribution requirements ahead of the next valuation. 
• Be pragmatic: Don’t panic, especially if the relevant date is some way off. You can always refine your expense reserve assumptions over time. It’s better to start with an approximate and proportionate estimate, which you can adjust as you get nearer your end goal.

By staying on top of these requirements and carefully considering the potential impact of an expense reserve, trustees can help ensure their scheme remains well-funded, compliant, and ready for whatever lies ahead.

Sophie Cooper, Actuarial Consultant, contributed to this blog