The Government is consulting on draft regulations regarding the funding of defined benefit pension schemes.
The regulations flesh out more of the detail on the requirement introduced by the Pension Schemes Act 2021 for schemes to have a formal funding and investment strategy. They also introduce a specific requirement that deficits should be cleared as soon as the employer can reasonably afford.
Schemes to reach "low dependency" on sponsoring employer
The key principle which trustees must follow when setting the funding and investment strategy is that the scheme should have reached a state of "low dependency" on the employer by the time it is "significantly mature".
What does "low dependency" mean?
"Low dependency" describes the scenario where the scheme is not expected to need further employer contributions to fund accrued pension rights, and the scheme is invested in a low dependency investment allocation. A low dependency investment allocation means that:
- cash flow from investments is broadly matched with benefit payments under the scheme; and
- the value of the assets relative to the scheme's liabilities is highly resilient to short-term adverse changes in market conditions.
When is a scheme "significantly mature"?
Under the draft regulations, a scheme reaches "significant maturity" on the date it reaches the duration of liabilities in years specified by the Pensions Regulator (TPR) in a Code of Practice. The regulations define the duration of liabilities measure as the "weighted mean time until the payment of pensions and other benefits under the scheme, weighted by the discounted payments". The consultation says that this measure is well understood by the pensions industry, though the government expects TPR to provide guidance in its Code. It suggests TPR's draft Code is likely to propose a figure of 12 years for this purpose.
Date of reaching significant maturity is key
A key concept under the draft regulations is that of the "relevant date". Broadly, this is the date on which the scheme is expected to (or did) reach significant maturity, though the regulations allow the trustees some discretion over exactly which date to use, allowing the date to be aligned with the scheme year end date. The trustees' funding and investment strategy will be required to specify the funding level the trustees intend the scheme to have achieved as at the relevant date and the investments the trustees intend the scheme to hold on that date. At each review of the funding and investment strategy, the trustees will be required to review and, if appropriate, revise the relevant date.
The regulations provide for schemes to stay at low dependency on the employer after reaching significant maturity, but the consultation seeks views on whether limited risk taking should be permitted if supported by high quality contingent assets (eg cash in an escrow account).
What is the "journey plan"?
The regulations use the term "journey plan" to mean the scheme's planned progress in accordance with its funding and investment strategy as it moves towards the date on which it will reach significant maturity.
What level of risk is acceptable?
The regulations set out principles regarding the level of risk that can be taken, both in relation to scheme investments and actuarial assumptions. A key principle is more risk can be taken when the employer covenant is stronger. Subject to the employer covenant, more risk can be taken when a scheme is further away from the date when it is expected to reach significant maturity. Employer covenant is defined to mean the financial ability of the scheme's employer to support the scheme, and also the level of support provided via any legally enforceable contingent assets.
Content of funding and investment strategy
Matters which must be covered by the strategy include:
- the way in which the trustees intend that scheme benefits will be provided over the long term (eg via a buy-out or running the scheme on with low dependency);
- the actuary's estimate of the maturity of the scheme as at the effective date of the actuarial valuation, and how this is expected to change over time;
- the proportion of assets intended to be allocated to different categories of investments at the relevant date and as the scheme moves along its journey plan;
- the level of investment risk that the trustees intend the scheme to take over the course of the journey plan, and how the investments comply with the requirement for the scheme to have sufficient liquidity;
- what action trustees intend to take if identified risks materialise;
- actuarial assumptions used, how the discount rate may change over time, and how the level of risk taken complies with the principles set out in the regulations regarding acceptable levels of risk;
- an assessment of the employer's covenant strength, including how long it is reasonable to rely on this assessment, and any changes since the last review; and
- any comments that the employer has asked to be included in the statement of strategy.
Trustees will be required to submit their funding and investment strategy statement to TPR along with the actuarial valuation.
Changes to the funding and investment strategy
The funding and investment strategy will need to be reviewed following each subsequent actuarial valuation and as soon as reasonably practicable after any "material change" in the circumstances of the scheme or its employer. A material change includes a change in the value of the assets of the scheme relative to the value of the liabilities, the maturity of the scheme, or the strength of the employer covenant.
Requirement to clear deficit as soon as employer can reasonably afford
The draft regulations specifically provide that deficits should be cleared as soon as the employer can reasonably afford. They also require an actuarial valuation to include the actuary's estimate of the scheme's funding level on a low dependency funding basis as at the valuation date.
When will the new regime take effect?
The current consultation runs until 17 October 2022, and the changes to be introduced by the new regulations are dependent on TPR's new DB funding code being in force. TPR has said it plans to carry out the second consultation on its DB funding code in Autumn 2022 with its new code becoming operational from September 2023, though these timescales could be subject to change. The new regime will only apply to actuarial valuations with an effective date after the code comes into force.
The draft regulations signal a move to a more prescriptive funding regime, with schemes that no longer admit new members expected to have a clear "end game" and a strategy for achieving that. When the Pension Schemes Act 2021 was first published, some argued that the requirement for the employer to agree the funding and investment strategy shifted the balance of power in favour of the employer. However, the express requirements for schemes to target low dependency and seek to eliminate deficits as soon as affordable mean that the legislation will not give the employer the power to force trustees to adopt high risk funding strategies.
Given the key role to be played by TPR's yet to be published DB funding code, we do not yet have a full picture of what the new funding regime will look like. The consultation does not address the question of what should happen when affordability constraints mean there is no prospect of the scheme achieving low dependency before reaching significant maturity.
The focus of the consultation is on the majority of DB schemes that are inevitably maturing as they are closed to new members. The consultation makes clear that the intention is not to impose investment de-risking strategies on schemes that are open and not maturing.