New scheme funding regime for defined benefit pension schemes could increase pension costs for employers

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The Department for Work and Pensions has issued, for consultation, draft regulations in connection with the provisions under the Pension Schemes Act 2021 (Act) for defined benefit (DB) pension schemes to put in place a strategy for funding benefits long term.

For our pensions briefing on the long term funding provisions under the Act, click here.

In a sea-change in how DB pension schemes are to be funded, trustees of DB schemes will now need to:

  • determine a long term funding objective (LTO) for ensuring that pension and other benefits can be paid over the long term;
  • put in place an investment strategy that supports the LTO; and
  • prepare a written statement on their long term funding and investment strategy (covering certain prescribed information) – the statement will need to be submitted to the Pensions Regulator (Regulator).

Trustees will need to review and revise their strategy in various circumstances i.e. as part of a subsequent statutory valuation or if there is a material change in the scheme's circumstances.

These requirements for long term funding will not replace but sit alongside the current scheme specific regime for on-going/ short term funding of DB schemes.

Code of Practice

To support the new requirements, the Regulator is expected to issue a Code of Practice. The Regulator consulted on the Code in March 2020 – amongst other matters floated in the consultation, were a twin-track compliance route to carrying out actuarial valuations: a “fast track” and “bespoke” route – see our earlier briefing here for more. There will be a second consultation on the Code of Practice that will provide clearer funding standards to support trustees and employers in planning their scheme funding over the longer term

Scope and timing

The consultation and draft regulations (Regulations) do not apply to those schemes that are currently exempt from the scheme specific funding regime, for example, public service pension schemes and money purchase schemes. The consultation closes on 22 October 2022.

The Regulator has previously confirmed that actuarial valuations will only come under the new Code of Practice once the new Code has been issued. So, it is unlikely that the new provisions will apply to schemes until the end of the year/ early 2023.

Key principles under the Regulations

The following key concepts and principles are floated under the Regulations:

  • Low dependency on the employer: trustees must ensure that there is a state of low dependency on the sponsoring employer by the time the scheme is significantly "mature". Low dependency means that under reasonably foreseeable circumstances, the scheme will not be expected to need further contributions from the employer.
  • Low dependency funding and investment strategy:

In order to achieve low dependency on the employer:

  • scheme assets must be invested in accordance with a low dependency investment allocation – this will mean that as the scheme reaches maturity, the assets must be invested in less risky investments; and
  • the scheme must be fully funded on a low dependency funding basis - the scheme must have a funding level (defined under pension legislation as the ratio of a scheme's assets to its liabilities) of 1:1 i.e. for every £1 of liability, the scheme must hold £1 of assets.

Trustees will be required to agree their scheme's low dependency funding level and investment strategy with the scheme's employer(s).

Scheme maturity: the concept is a measure of "how far a scheme is through its lifetime":

  • The maturity of a scheme (measured in years) is to be determined using a "duration of liabilities" measure, being the weighted mean time until the payment of pensions and other benefits under the scheme, weighted by the discounted payments.
  • A scheme with more active or deferred members, will be an immature scheme as it will be expecting to continue significant payment of pension benefits well into the future. A scheme with a high proportion of pensioner members will be more mature.
  • Further guidance around scheme maturity will be in the Regulator's Code of Practice. The consultation suggests that the Regulator may in its Code of Practice propose that a scheme will have reached maturity when it reaches a duration of liabilities of 12 years.

The employer covenant

  • The employer covenant, already a familiar concept under the scheme funding legislation as well as the Regulator's moral hazard powers (for a summary of the moral hazard powers as amended by the Act, see our earlier briefing, will now be put on a statutory footing. Currently, the employer covenant is only covered in the Regulator's guidance and not defined in pension legislation.
  • The Regulations define the employer covenant as the financial ability of the employer to support the scheme together with the level of support that can be provided by any contingent assets (such as a parent company guarantee). Detail are provide as to how the covenant should be assessed.
  • The Regulations add a new requirement on the trustees when determining whether a recovery plan is appropriate, to follow the principle that funding deficits should be recovered "as soon as the sponsoring employer can reasonably afford" to do so. The consultation asks whether this new factor should have primacy over the existing matters that the trustees are required to consider when preparing or revising a recovery plan (such as risk profile and liquidity requirements and the age profile of the scheme membership).

Delivery of benefits over the long term

Whilst the Regulations set a standard that schemes must achieve, schemes will remain free to decide how to deliver pension and other benefits over the longer term. Some schemes will 'run on' with low dependency on the employer when they reach significant maturity; others may target entering a consolidator or securing buy-out with an insurer and then winding-up.

How do the new LTO requirements sit with the current regime?

The current requirements for short-term/ on-going funding will continue to apply. The LTO requirements place an additional layer of obligations on the trustees and the employer as regards long term funding.

The Act provides that "the scheme's technical provisions" (being its liabilities over the short term) shall be calculated in a way that is consistent with the scheme's funding and investment strategy, as set out in the scheme's statement of strategy." As the scheme matures, the scheme's technical provisions will need to be aligned more closely/ match with the LTO.

Considerations for employers and trustees

The LTO regime is unlikely to be in force until the end of the year but employers and trustees should start considering how the new requirements will affect them (whether or not they are in the process of currently agreeing the next statutory valuation).

Once the changes come into force, trustees will need to put in place a strategy for ensuring that pension and other benefits can be paid over the long term and an investment strategy that delivers on that objective.

Employers could see a rise in their pension costs as trustees may seek accelerated funding for the scheme in order to meet the LTO. Many DB schemes already have a LTO (with a staged path to buy-out) – they will still need to comply with the new requirements. The spike in contribution requests from trustees is more likely with schemes that do not currently have a LTO.

Under the current on-going/ short term funding regime, trustees have to consult with the employer when putting in place a statement of investment principles for the scheme. When determining the investment strategy in connection with the LTO, however, the employer's agreement will be required. The change will be welcomed by employers seeking greater control over how scheme assets are invested but it will likely mean more protracted negotiations between the employer and the trustees over the long term investment strategy.

The details in the Regulations on the employer covenant will be welcomed by employers and trustees. However, if, as the consultation asks, the, "affordability" of the employer is to have primacy over other considerations when setting the recovery plan, employers could find themselves in greater/ in depth discussions with the trustees over the covenant. Employers with strong covenants may also find themselves with more demands from the trustees for accelerated funding for the scheme.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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