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Draft DB funding and investment regulations: the next step in the journey

  • United Kingdom
  • Pensions

03-08-2022

The DWP has issued its long-awaited consultation on new draft funding and investment regulations for DB schemes (the Draft Regulations). These set out some of the detail of the proposed framework for the government’s new (and quite different) DB funding regime.

The Draft Regulations say, broadly, that schemes must aim to be fully funded on a low risk basis (with low risk investments and low dependency on the sponsoring employer) by the time they are “significantly mature”. They introduce some new terminology, define for the first time in legislation what “employer covenant” means and specify that any deficit “must be recovered as soon as the employer can reasonably afford”. More detail and some suggested action points are set out below.

Background

The Pension Schemes Act 2021 (the Act) says that DB occupational pension scheme trustees must put in place a funding and investment strategy to make sure that benefits under the scheme can be provided over the long term. They will have to prepare (and revise at least every three years) a written statement of strategy that describes this and related matters, then send it to the Pensions Regulator. These provisions of the Act are not yet in force.

The Draft Regulations (the draft Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023), which will be made under the Act, set out how the DWP sees this new funding regime working. There will be more detail in the Regulator’s forthcoming (second) consultation on a new DB funding code of practice (the New Code), expected in autumn.

What do the Draft Regulations say?

In broad terms, the Draft Regulations say that schemes should aim for a state of “low dependency on the sponsoring employer” by the time they are “significantly mature”. This means that assets should be invested in a “low dependency investment allocation” and fully funded on a “low dependency funding basis”. The meaning of those terms is explained below.

Schemes can plan for how they will deliver this in different ways – for example running on with low dependency on the sponsor, buying out with an insurer or entering a DB consolidator.

What does “significantly mature” mean?

Schemes with mostly active and deferred members are likely to be immature whereas those with a high proportion of pensioners are likely to be more mature, as the time before most of the benefits need to be paid out is shorter.

The Draft Regulations say that the maturity of a scheme is to be measured by the duration of its liabilities, meaning the discounted average time until pensions and other benefits are paid. The exact meaning of “significantly mature” will be set out in the New Code but the DWP suggests that this is likely to be when that duration reduces to 12 years.

What does “low dependency” mean?

Low dependency on the sponsoring employer – this means the scheme has sufficient assets invested in a “low dependency investment allocation” to provide for accrued benefits and is not expected to need further employer contributions (except in respect of active members).

Low dependency investment allocation – this means the scheme is not expected to rely on further employer contributions to provide for accrued liabilities, even if investments do not perform as well as expected. Cash flow from investments should be broadly matched with the payment of pensions and the value of assets is highly resilient to short term adverse changes in market conditions.

Low dependency funding basis – this means actuarial assumptions should be consistent with low dependency on the employer and a low dependency investment allocation.

Employer covenant

The level of investment and funding risk that can be taken as a scheme moves along its journey plan depends primarily on the strength of the employer covenant. For the first time, the Draft Regulations set out a proposed statutory definition of covenant – this is the financial ability of the employer to support the scheme and support from legally enforceable contingent assets.

There is a list in the Draft Regulations of matters to be considered in assessing the financial ability of the employer – this includes cash flow, likelihood of insolvency and other matters which will be set out in the New Code.

The strength of the covenant must be assessed in relation to the size of the deficit. Even a very profitable employer might not offer a strong covenant if the size of the deficit is disproportionately large.

The journey plan and recovery plan

Trustees must have a journey plan to achieve low dependency on the employer by the time the scheme is significantly mature. The journey plan depends on the strength of the employer covenant and how close the scheme is to significant maturity – the closer it gets, the less risk that can be taken.

Notably, the Draft Regulations say that the deficit “must be recovered as soon as the employer can reasonably afford”. The related consultation asks if this should be the primary factor to consider when setting the recovery plan. If that approach is adopted, it could have a significant impact on recovery plans, and corporate activity more generally.

Statement of strategy and trustee chair

The Act says that trustees must prepare and submit to the Regulator a new “statement of strategy” setting out the funding and investment strategy and related matters. These include whether the strategy is being successfully implemented, key risks and mitigations, trustees’ “reflections” on key decisions taken and other matters. An assessment of the strength of the employer covenant is one of these other matters.

The statement of strategy must be signed by the chair of the trustee board. Schemes that do not have a chair will need to appoint one. There is a (quite broad) description in the Draft Regulations of who can act as chair.

Comment

The proposed funding regime is more specific than the current approach. The thrust of the Draft Regulations is towards low risk investments for mature schemes and employers who can afford to do so paying off deficits quickly. This will no doubt prompt debate, particularly when set against the current challenging economic and investment background.

The statement in the Draft Regulations that the deficit “must be recovered as soon as the employer can reasonably afford” could prove significant and will no doubt worry some employers who plan to invest in the business or pay dividends over the coming years.

Trustees of mature schemes hoping to make up deficits through riskier investments may need to change their strategies, with a knock on impact on employers in terms of additional contributions and/or legally enforceable contingent assets.

The DWP estimates in its impact assessment (published a few days after the draft regulations) that small schemes and those with no current long term funding objective or only an aspirational one are more likely to incur costs due to these changes. However, it seems to us that additional work and advisory costs (including around trustee/employer negotiations) are likely to be incurred by the vast majority of DB schemes.

The Regulator’s first funding code consultation in 2020 proposed a twin-track approach with a fast-track funding option and a bespoke, scheme specific alternative. It is not apparent from the Draft Regulations or consultation how the bespoke option will be catered for – they are not mentioned.

It is notable that an assessment of employer covenant is one of the matters to be included in the statement of strategy (and sent to the Regulator). This will sharpen the focus on covenant assessment and there is a risk that historic reliance by schemes on “soft” covenant support – that is not set out in a legally binding document – may fall away.

In addition, the proposed requirement to include in the statement of strategy the main risks in implementing the funding and investment strategy, how trustees intend to mitigate them and what action the trustees intend to take if the risks materialise, goes further than some schemes currently do in terms of contingency planning. 

It is clear that the DWP has listened to concerns that the new funding regime might result in open schemes being forced into inappropriate de-risking. The DWP says that it does not want “good schemes to close unnecessarily, or to introduce a one-size-fits-all regime”. However, open schemes are not explicitly addressed in the Draft Regulations.

The Act says that the employer must agree the funding and investment strategy with the trustees. Nonetheless, trustees continue to be responsible in law for making investment decisions. There is a tension between these two concepts which may prove challenging to reconcile. It is not yet clear how in practice this will change the long established balance of power in relation to investment. 

We would expect to see more information on the above issues in the New Code.

Timing

The consultation on the Draft Regulations is open until 17 October 2022 and the New Code is due to be issued for consultation in autumn (though that timing could slip). It is unlikely that the new funding regime will be in place before autumn 2023, though 2024 seems more likely.

The first funding and investment strategy must be in place within 15 months of the first valuation effective date after the new regulations are in force.

Immediate action points

Once the new regime is in final form there will be much work for trustees (and employers) to do in setting out their new journey plans. In the meantime, some suggested action points are:

 

  • consider with your advisers how the proposed approach could potentially affect your scheme, including any existing long term funding target and journey plan, covenant assessments and looking at where your scheme sits on the maturity spectrum
  • if your DB scheme does not currently have a chair of trustees, start planning for this
  • consider responding to the consultation, which closes on 17 October
  • watch out for the Regulator’s New Code consultation, expected in autumn.