A new, more prescriptive, approach to scheme funding has long been on the cards. Now with the new Department for Work and Pensions (DWP) consultation on draft scheme funding regulations, we have more detail on what the future might look like.
The consultation makes clear that there will still be flexibility in the regime for less mature schemes, but for those with no active members or a dwindling population of actives, the new regime is focused on reducing reliance on the employer and reaching a state of low dependency, so that no further employer contributions are expected to be needed. Further detail will be provided by way of a revised defined benefit (DB) funding code, which will be published by the Pensions Regulator in due course.
Below we explore the key concepts from the draft regulations and how they fit together.
Significant maturity
This is the key new concept in the draft regulations and determines the point at which schemes are to have reached a low dependency funding level. Many schemes already have self-sufficiency (or buy out) built into their long-term funding target, but the draft regulations require schemes to aim to achieve their target of a low dependency funding level by the 'relevant date'.
This is a date linked to the expected duration of the scheme's liabilities and must not be later than the end of the scheme year in which significant maturity is expected to be reached. The Regulator's revised Code is likely to specify what duration of liabilities will mean a scheme is 'significantly mature' and the consultation indicates this may be 12 years. The relevant date can be revised from time to time to take account of the actuary's latest estimate of when significant maturity will be reached – this will provide flexibility for schemes with active members and which are open to new joiners, for example.
Low dependency investment allocation
Trustees are to invest in such a way as to achieve a low dependency investment allocation when the scheme reaches significant maturity. A low dependency investment allocation will mean scheme assets are invested to match scheme cash flows and that the portfolio is resilient to short-term volatility. Once a low dependency funding level is reached, a low dependency investment allocation is to be maintained. This assumes that no further employer contributions are expected to be required to provide benefits.
Strength of the employer covenant
Not surprisingly, the draft regulations explicitly recognise the strength of employer covenant as a factor that will impact on the amount of risk taken by a scheme on its journey to low dependency. The draft regulations set out the factors to be considered in assessing covenant, and further details will be set out by the Pensions Regulator in its revised Code. An assessment of the employer covenant needs to be included in the 'statement of strategy', which is submitted to the Regulator and the Regulator will also have sight of the trustees' covenant assessment. This could mean a new level of scrutiny of some schemes' covenant assessments.
New liquidity principle
A new liquidity principle is proposed, whereby the scheme's investments must be sufficiently liquid to allow for cash flow requirements, with an allowance for unexpected demands on cash flow. This will sit alongside existing regulations that set out principles to be complied with in investing scheme assets.
Investment risk
The amount of investment risk that a scheme takes will be expected to reduce as the scheme moves towards significant maturity. This is intended to avoid an 'investment spiral' whereby a mature scheme with increasing demands for cash to meet its growing pension payroll is exposed to market volatility and as a result has an increasing deficit and growing reliance on the employer for contributions. The draft regulations envisage that it might be possible to take a greater level of investment risk where there are guarantees or other contingent assets available to support the scheme.
Low dependency
After low dependency is reached, the draft regulations envisage that a low-risk investment allocation will be maintained, but one point being consulted on is whether more risk might be permitted, possibly if backed by an appropriate contingent asset. The consultation paper suggests that this support might be limited to, for example, 5% of total liabilities.
Funding and investment strategy and statement of strategy
The above concepts are to be drawn together in the trustee's funding and investment strategy which will amount to a journey plan for reaching self-sufficiency. The funding and investment strategy is to be put in place within 15 months of the scheme's first valuation date following the date at which the regulations come into force in 2023, and so will tie in with production of schemes' valuation reports. Trustees will be required to document the strategy in a 'statement of strategy'. The scheme's funding and investment strategy, and the statement, will then be reviewed and if necessary revised at subsequent valuations, as well as if there is a material change affecting for example the employer's covenant.
The statement of strategy must be submitted, together with the actuarial valuation to which it relates, to the Regulator. The statement of strategy must be submitted 'in a form as set out by the Regulator', which may assist trustees in making sure they have included all detail necessary to achieve compliance.
The matters to be included in a statement of strategy include:
- the current level of investment risk being taken by the scheme, and how this is intended to change as the scheme moves along its journey plan
- how the new liquidity principle is being complied with
- the funding level of the scheme, the assumptions the trustees have chosen for assessing the scheme's low dependency funding level and how these assumptions differ from those used in calculating technical provisions for the purposes of the relevant actuarial valuation
- an assessment of the employer covenant.
The statement of strategy will need to be signed by the chair of trustees.
At present, it appears that trustees will in many cases have to agree their funding and investment strategy with the employer. This has given rise to questions about whether this will impact trustees' current unilateral power (set out in the Pensions Act 1995) to set the scheme's investment strategy.
The consultation suggests this is not the case; the funding and investment strategy is intended to only contain high-level information about the scheme's intended asset allocation, and not details of specific scheme investments. The statement of strategy will contain further information, as set out in the draft regulations, and the trustees will need to consult the employer on this document (rather than agreeing it with them) and to confirm in the statement of strategy that this has taken place.
Next steps
The regulations are expected to come into effect in 2023 but we'd suggest reviewing how they may affect you sooner rather than later. For trustees, this may mean thinking, together with your advisers, about whether the current journey plan your scheme is on meets the new requirements (taking account of the Regulator's revised Code in due course). For employers, this may mean understanding the impact these changes may have on your scheme's recovery plan and the costs of running your scheme. If you'd like to discuss the regulations in more detail, please get in touch.
