A brave new world for DB pension scheme funding
The Regulations require trustees of defined benefit (DB) pension schemes to adopt a funding and investment strategy that sets out the “end game” for their scheme and how they will get there. The Pensions Regulator is now consulting on its DB Funding Code of Practice (the Code), which provides guidance on how trustees should comply with their new obligations under the Regulations. The Regulations and the Code introduce significant changes to the way DB schemes should be funded and, arguably, shift power more in favour of trustees. This note sets out the key concepts and principles used in the Regulations and Code.
New funding basis
The Regulations require that by the time a scheme has reached significant maturity (i.e. broadly when the weighted mean duration of liabilities is 12 years):
- its assets must be invested in accordance with a low dependency asset allocation; and
- it must have a low dependency funding basis.
A low dependency asset allocation requires the cash flows from the scheme’s investments to be broadly matched to the payment of benefits. For cash flows to match benefit payments, the scheme will need to be predominantly invested in assets that produce fixed cash flows or cash flows linked to inflationary indices (for example government or corporate bonds, interest and inflation rate derivatives and cash). However, this does not mean growth assets have to be entirely excluded. The Code suggests a portfolio which includes 15% growth assets would still satisfy the broadly matching cash flow requirement.
Under a low dependency funding basis, a scheme’s assets must be invested on a low dependency asset allocation and the actuarial assumptions adopted must be such that no further employer contributions would be expected to be required. This is the case irrespective of whether the employer could continue to pay contributions.
To ensure no employer reliance, schemes may be expected (depending on their rules) to have an expenses reserve to cover all expenses reasonably expected to be required to fund the scheme through to the end. Having to fund expenses up front is a break from normal practice. Employers may want to consider whether there is any benefit to holding the expense reserve outside of the scheme (for example, in an escrow account), particularly if they are concerned about trapped surplus. Trustees and employers will also want to scrutinise the estimated expenses to ensure they are reasonable and necessary.
Trustees need to develop a journey plan for moving to this low dependency basis.
Bridging the gap
For some schemes, the gap between their current funding position and the low dependency basis may be relatively small and so the journey plan to bridge that gap should require limited changes to the investment strategy and amount of deficit repair contributions (DRCs). For others, however, the gap could be significant and, depending on the scheme’s level of maturity, may need to be bridged over a small number of years.
The extent to which the gap can be bridged by taking additional investment risk, as opposed to the employer paying additional DRCs, will depend on: (i) the strength of the employer covenant (with more risk being allowed where the covenant is strong); and (ii) how close the scheme is to reaching significant maturity. If a scheme is fairly mature and cannot justify taking additional investment risk, it would seem the only permissible way to bridge the gap would be additional DRCs. However, what if the employer cannot afford to pay those additional DRCs? The Regulations and the Code do not really address this scenario. Nor do they explain what action trustees should take if they can’t de-risk sufficiently before they reach significant maturity. Unless the Regulations and Code are amended, trustees and employers will need pragmatic advice as to what they can reasonably do within the confines of their circumstances.
The Regulator has developed a twin track approach to assessing valuations – Bespoke and Fast Track. The Fast Track route sets out parameters for things like, investment risk and technical provisions, and represents the Regulator’s view of tolerated risk for a scheme. If a scheme wants to take more risk, outside of these parameters, it is not prevented from doing so, but it will need to be able to justify its position and go down the Bespoke route. The purpose of these two routes is to allow the Regulator to triage actuarial valuations; with Fast Track valuations not expected to require additional scrutiny or engagement from the Regulator.
Employer covenant strength has played a key role in funding negotiations for many years now. The Code, however, goes much further than previous guidance in setting out how the covenant should be assessed. When assessing the employer’s financial ability to support the scheme, trustees are expected to consider:
- Visibility over employer forecasts. Trustees should consider cash flow, profit and loss account and balance sheet forecasts over a period of one to three years and assess their reasonableness, taking into account historic accuracy of forecasts and the assumptions used.
- Reliability over available cash. This is the period over which the trustees can have reasonable certainty over the employer’s ability to pay DRCs. As part of this assessment, trustees should consider the employer’s prospects (factors to be taken into account include: market position and outlook, ESG factors, diversity of operations and, if applicable, strategic importance within its group).
- Longevity of the covenant. This is the maximum period over which it can be assumed the employer will remain in existence to support the scheme.
Employers are expected to provide trustees with the information required to assess covenant. Depending on the funding position and maturity of the scheme, some employers could find themselves subject to additional demands for forecasts and other information. The Code states that if trustees are not provided with appropriate information, they should consider reducing their reliance on covenant in their funding and investment strategy. Trustees and employers should discuss, at an early stage, what information the trustees are likely to require and what information the employer can reasonably provide in order to identify any gaps and agree how they can be addressed.
Contingent assets can still be taken into account when assessing the employer covenant, but there is now specific guidance on how these should be assessed. We expect some trustees have placed greater reliance on a contingent asset (particularly, parent company guarantees) than the Code would allow. Trustees and employers may now be advised that if they want to continue to place the same reliance on the contingent asset, they will need to make certain amendments to it (for example, removal of terms that result in the guarantee terminating or removal of any cap).
Recovery plans – a new overriding principle
In a significant shift from the current funding regime, legislation will now require that when determining the recovery plan trustees “must follow the principle that funding deficits must be recovered as soon as the employer can reasonably afford”. While employer affordability has always been one of the factors trustees considered when determining the length of any recovery plan, it must now be the overriding consideration.
In order to determine what an employer can reasonably afford, the Code directs trustees to assess the employer’s available cash. Available cash is effectively an employer’s free cash after taking account of reasonable operational costs but before things like DRCs, investment in the sustainable growth of the employer, distributions to shareholders and discretionary payments to other creditors (e.g. early repayment of a loan).
Trustees are expected to consider whether an employer’s proposed alternative uses for their available cash (i.e. other than using it to pay DRCs) are reasonable, adopting the below principles.
- The lower the funding ratio, the less reasonable it will be to use available cash for discretionary payments to other creditors (such as early repayment of a loan) or that would result in covenant leakage.
- The more mature the scheme, the greater the need for available cash to be paid to the scheme in the near term.
- Available cash should not be used for discretionary payments to other creditors or to effect covenant leakage where this would require DRCs to be paid after the period in which available cash is considered reliable.
- Investment in the employer’s sustainable growth will be a reasonable use of available cash where the trustees are confident of resulting benefit to the scheme and employer.
The last principle, in our view, raises the most concerns. The Code expects trustees to assess the benefits and risks of proposed investments in the business to ensure they understand, and presumably agree, with the risk benefit analysis. We are not convinced it’s appropriate for trustees to be second guessing the employer’s views on such matters. Some have suggested that if, say, the benefits of an investment would not begin to materialise until 10 years out and the trustees’ end game is to buy-out in a shorter timeframe, there would be no benefit to the scheme from the investment and so some, or all, of the cash should be paid to the scheme rather than used for the investment. It is worth noting that the Code only provides “guidance” to trustees on assessing what the employer can reasonably afford. A court may not consider that reasonable affordability should exclude proper long-term investment in the business merely because it may not benefit the scheme.
The key point however is that trustees are being advised to assess the benefit to the scheme and the employer of the employer’s use of its available cash and employers will need to prepare to engage with them. Employers should also expect greater scrutiny of, for example, cash pooling arrangements and transfer pricing.
Documenting the funding and investment strategy
Trustees must record their proposed strategy for how the scheme will achieve its end game. This statement of strategy has two parts:
- Part 1 records the funding and investment strategy and must be agreed with the employer; and
- Part 2 records various supplementary matters (including, for example, how well the strategy is being implemented and the main risks) on which the employer must be consulted and it must be prepared at the same time as a scheme’s actuarial valuation and submitted to the Pensions Regulator.
One area that could be a cause for contention between trustees and employers is the description that must be included in Part 2 of the trustees’ assessment of the employer covenant. Trustees are expected to provide cash flow and liquidity information, the covenant visibility and reliability period, and covenant prospects with an estimate of the covenant longevity. It is quite possible that trustees and the employer may disagree over, for example, the trustees estimate of the maximum period the employer is likely to remain in existence (i.e.covenant longevity). If this is the case, employers are likely to be concerned about how this is presented to the Regulator. It will be important for parties to engage early on the drafting of the statement of strategy to ensure there is sufficient time to address any concerns.
While the Regulations and Code will only apply to actuarial valuations with an effective date after they come into force (expected to be 1 October 2023), employers and trustees may want to conduct some initial analysis now to prepare for the new funding regime.
Questions they should consider include:
- Does the scheme fall within the Fast Track parameters?
- How far away is the scheme from significant?
- Will additional information be required by the trustees for future covenant assessments? If so, is this information the employer can reasonably provide?
- Will the trustees be able to place the same reliance on contingent assets (where relevant)? If not, are there any steps that could be taken to improve the position?