Low dependency funding basis

This code of practice applies to activities related to valuations with effective dates on and after 22 September 2024. For activities related to valuations with effective dates before 22 September 2024, refer to the 2014 DB funding code (PDF, 401kb, 51 pages).

1. A low dependency funding basis must use actuarial assumptions that are set so that if:
   1. the scheme was already funded on a low dependency basis, and
   2. the scheme’s assets were invested in accordance with the low dependency investment allocation, then it is expected that no further employer contributions would be required (the low dependency test).
2. Trustees should assess whether the low dependency test would be met under most reasonably foreseeable scenarios. Trustees are not required to eliminate the requirement for further employer contributions with certainty. Instead, they should be satisfied that the likelihood of requiring further contributions is small and, to the extent contributions are required, that they are small relative to the size of the scheme.

Setting individual assumptions

3. We do not expect trustees to stochastically model each assumption or set of assumptions to satisfy themselves that the low dependency test has been met.
4. Trustees should ensure that the assumptions are chosen prudently, and understand the risk in the funding basis so they can be satisfied that further contributions are not expected to be required.
5. Assumptions should refer to statistically credible data where relevant. This is data considered to be accurate, complete and large enough that it can reasonably be used to estimate future experience with a high degree of confidence. Trustees should consider the period the data is collected over, noting that the data should be drawn from a period expected to give a good guide to future experience. We would generally expect this to be the most recent data available, placing lower weight on any period where the data collected may be considered anomalous.
6. We recognise that trustees may choose to include a high level of prudence in some assumptions, while others are closer to a best estimate approach.
7. Some assumptions may also be more uncertain and have a greater effect on the measurement of liabilities than others. For example, scheme mortality is likely to be a material source of uncertainty, particularly for smaller schemes. Therefore, trustees should pay closer attention to the prudence included in these assumptions and ensure it is sufficient for them to be confident it would not undermine the low dependency test.
8. We expect trustees to take a proportionate approach in setting their low dependency funding basis in line with the above expectations. We expect more careful analysis in determining the assumptions to meet the low dependency test as a scheme approaches its relevant date.
9. We expect trustees will need to take advice from their scheme actuary on the actuarial assumptions for the low dependency basis.
10. The following sections set out our expectations for the main individual assumptions in the low dependency funding basis.

The low dependency discount rate

Approach to setting the discount rate

11. The main approaches we expect trustees to take when setting the low dependency discount rate are set out below. Trustees may take a different approach, provided they can evidence how their approach meets the legislative requirements.

Risk-free rate plus approach

12. Under this method, the discount rate could be expressed allowing for a margin over a risk-free yield.
13. An acceptable risk-free yield includes the:
    1. gilt yield, or
    2. yield on swaps if adjusted for the probability of default
14. Any margin added to the risk-free rate should be a prudent estimate of the return on the trustees’ low dependency investment allocation. This prudent estimate should have regard to material factors that may affect investment returns over the relevant time horizon, such as climate change and other systemic trends.

Dynamic discount rate approach

15. Where the matching assets chosen by the trustees for the scheme’s low dependency investment allocation are predominantly cash flow generative (in line with the criteria outlined in the low dependency investment allocation section of this code), and the trustees hold such assets in the scheme’s actual investment allocation, the discount rate can be based on the observed yield of those assets. The rate should be adjusted to allow for a prudent level of default informed and evidenced by historical data to give a return.

A combination of both approaches

16. Trustees may choose to use a combination of the two methods. For example, they may use the risk-free rate plus approach for parts of the liabilities with longer durations and the dynamic discount rate for liabilities backed by matching assets that match the scheme’s cash outflows. As and when further cash flow generative matching assets are bought and become appropriate, the associated liabilities can be moved to the dynamic discount rate approach.

Use of yield curves for the discount rate

17. Our general expectation is that yield curves should be used in determining the discount rate. If trustees consider it appropriate, they may use a single equivalent discount rate derived from the full curve. Larger schemes are more able to rely on projected cash flows as they are less prone to concentration risk than smaller schemes. This makes the use of the yield curve in deriving assumptions more appropriate for larger schemes.

Expectations for setting assumptions in the low dependency funding basis

18. Below, we set out our general expectations for trustees setting each individual assumption in the low dependency funding basis. However, when setting individual assumptions the trustees can and should consider the basis in aggregate and should not approach determining prudence for each assumption in isolation if that leads to what they consider excessive prudence overall.

Retail Price Index (RPI) inflation

19. Under the risk-free plus approach, the RPI assumption should be based on a market- derived assumption for inflation using an approach consistent with that used for setting the discount rate. For example, where a gilt yield curve is used to derive the discount rate, we would expect a yield curve approach based on gilts to be used to derive the inflation assumptions.
20. As the scheme is expected to be significantly hedged at the relevant date, our expectation is that no adjustment, such as an inflation risk premium, would be made to the market implied assumption.
21. If an adjustment is made, we may require further information to understand the justification for it. For the dynamic discount rate approach, an appropriate assumption should be made consistent with the value of the matching portfolio.

Consumer Price Index (CPI) inflation

22. The CPI assumption should be based on the RPI assumption, adjusted to reflect the expected difference between RPI and CPI, having regard to both historical trends and the planned changes in RPI expected to apply from 2030.

Inflation-related pension increases

23. The assumptions should be based on the relevant measure of inflation adjusted to allow for caps and floors based on a recognised method, such as, for example the Black or Black-Scholes, SABR, Jarrow-Yildirim, ‘hard capping’ or Truncated Gamma
    models, and an appropriate inflation volatility and other assumptions where required by the model.
24. In determining the appropriate assumptions, consideration should be given to past experience and as to whether this provides a guide to the future, given current market conditions, or how that experience should be adjusted to derive an appropriate assumption.

Cash commutation

25. Members may be assumed to commute part of their retirement pension for a cash lump sum. Where prudent, the proportion commuted should be no higher than recent experience and any projections should allow for any decreasing trend.
26. Also, where prudent, the assumed commutation factor should be no lower than currently agreed factors, and/or, where appropriate, future factors where it has been agreed in principle they will be implemented. This will include market-based factors where it is agreed the factors will be automatically updated.
27. It can be appropriate to assume that a commutation factor is a percentage of the liabilities where such an assumption would be consistent with the previous principles. When appropriate, consideration should be given to making an allowance for future improvements in mortality.
28. For example, where the trustees have the sole power to set cash commutation factors and those factors reflect the actuarial value of the pension commuted, we would expect an allowance for future improvements to factors to be made consistent with the trustees expectations for how mortality will improve in the future.

Mortality base table

29. This is based on current expectations of mortality using appropriate mortality tools. For example:
    1. a ‘postcode’ analysis and/or experience to adjust standard tables where recent credible information is available, or
    2. a bespoke mortality table based on experience
30. We expect many schemes will want to commission such analysis and would generally expect all trustees to have considered doing so. If this analysis is not done, standard tables may be used and consideration should be given to choosing a table reflecting the size of the pension where this might be appropriate as a guide to the socio- demographic status of the membership.
31. However, where such a standard approach is taken, we would expect the uncertainty of experience to be reflected in a more prudent set of rates being chosen. Different groups of members can have different base mortality tables where there is evidence to justify their different treatment.
32. For example, those qualifying for an ill health pension might exhibit different mortality to those retiring with standard benefits.

Mortality improvements

33. We expect appropriate assumptions for future mortality improvements should be chosen based on prudent principles allowing for the uncertain nature of future mortality improvements. Consideration should be given to socio-economic factors specific to the scheme and how this should be reflected in the assumptions chosen.

Salary increases

34. The salary increase assumption can be a single rate or more complex, for example, making allowance for promotional increases. Where not constrained by the rules of the scheme or an established policy communicated to employees, we would expect salary increases to be at least as high as an appropriate inflation assumption.

Proportion with partners eligible for survivor pensions and age difference

35. Where the scheme provides for survivor pensions, trustees should make appropriate allowance for the proportion entitled to survivor benefits and the age difference with the survivor.
36. When considering each assumption, where there is reliable and statistically credible scheme specific evidence available, we would expect the strength of assumptions chosen to be no lower than that implied by recent experience. Where such evidence is not available, we would expect the assumptions to be:
    1. based on generic statistical tables, adjusted where necessary to allow for the scheme specific nature of the assumptions and, in the case of proportion married, for the rules of the scheme determining eligibility for survivor benefits, or
    2. at least as strong as that provided by the Pension Protection Fund (PPF) guidance on relevant assumptions to use in their section on assumptions for contingent benefits when undertaking a valuation in accordance with Section 179 of the Pensions Act 2004¹

Discretionary benefits

37. Where there is a reasonable expectation that discretionary benefits will be granted in the long term, trustees should consider whether it is or is not appropriate to make reasonable allowance for these benefits in the low dependency funding basis and set an assumption accordingly.

Other assumptions

38. There may be some assumptions needed as part of the valuation where we have not given our expectations in this module, for example, retirement ages, withdrawal rate, or the allowance for scheme options other than cash commutation. In setting assumptions where we have not given guidance, the following principles should be applied.
    1. Assumptions can draw on scheme experience where statistically credible analysis of recent experience is available, and the expectation is that the past remains a good guide to future experience.
    2. If this information is not available, standard tables or estimates may be used but the level of uncertainty in respect of scheme-specific factors should be reflected in additional prudence in the assumptions chosen.
    3. The impact on the liabilities can be considered when choosing assumptions, so for example, a more approximate method would be reasonable where the choice of assumption will not significantly affect the liabilities.
    4. More generally, if it is an assumption not specific to the scheme and we have provided no guidance, we would expect, where relevant, the derivation to be consistent with the derivation of other assumptions where guidance or specification has been provided.

Allowance for expenses in low dependency liabilities

39. Our expectations depend on whether at least one statutory employer has a legal obligation under the scheme rules to pay scheme expenses.

Schemes where there is no requirement under the rules for the employer to pay expenses

40. We expect the low dependency basis to include a reserve for expenses. That expense reserve should be the value of all non-investment related expenses of the scheme, including annual levies and adviser fees, expected to be incurred on and after the relevant date discounted to the valuation date.
41. The expenses should be consistent with the long-term strategy adopted by the trustees. For example:
    1. if the strategy assumes the scheme will run on, it should be all the expenses associated with this
    2. for a scheme that is targeting buy-out, it should include the expenses associated with that strategy
42. Where an employer has an obligation under the rules to meet part of the expenses, we expect the low dependency basis to include a reserve for at least the expenses not met by the employer.
43. For immature schemes, we recognise the expense reserve will be an approximate estimate. This estimate can reflect that the scheme may incur lower ongoing adviser fees once it achieves its long-term target funding and investment strategies and that the scheme may be smaller by the relevant date. As a scheme approaches its relevant date it should be possible to make that estimate more accurate.
44. For schemes at or past the relevant date, the expense reserve should be a more accurate estimate which we expect to be monitored and updated in line with experience.

Schemes where there is a requirement under the rules for the employer to pay expenses

45. We encourage trustees to consider an expense reserve. If the scheme is relying on the employer to pay ongoing expenses in future this generates some dependency on the employer and trustees should carefully consider if this is compatible with a low dependency basis.
46. As a minimum, trustees could consider whether to reserve for expenses beyond the reliability period.
47. We recognise that funding for a reserve might lead to overfunding and the trustees might want to explore ways to reduce the possibility of this happening.
48. For example, by establishing a side agreement and separate account for expected expenses, or allowing a suspension of the requirement for the employer to pay expenses when the scheme is at or beyond relevant date and fully funded on a low dependency basis.
49. If a reserve is used, the guidance above, for schemes where there is no requirement under the rules for the employer to pay expenses, could be an appropriate starting point for determining the amount.

Legal references

¹ Article 162 of The Pensions (Northern Ireland) Order 2005

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