The new funding regime for defined benefit pension schemes – what employers need to know

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.

We highlight below the key issues for employers:

• Low dependency basis: by the time a scheme reaches significant maturity (broadly when the weighted mean duration of liabilities is 12 years) it must be funded on a low dependency basis; meaning the cash flow from its investments must be broadly matched to the payments due from the scheme and assuming no further employer contributions.
  
  Schemes need to develop a journey plan for moving from their current position to a low dependency basis. The level of investment risk they can take to get there will depend on the strength of their employer covenant. Depending on the level of prudence currently built into a scheme’s technical provisions and its level of maturity, some schemes could have quite a steep curve on their journey to move to a low dependency basis; meaning some employers could see demands for significantly higher amounts of deficit repair contributions (DRCs).    

• Fast Track or Bespoke: trustees and employers will have the option of adopting either the Fast Track or Bespoke approach for their actuarial valuations.
  • Fast Track – the Regulator has set a number of parameters that need to be met and which reflect its view of tolerated risk for a scheme. Schemes that satisfy these parameters should not be subject to any further regulatory engagement.
  • Bespoke – a scheme specific funding approach. Trustees and employers might opt for this approach if they consider the employer covenant supports an increased level of risk or a longer recovery plan is required. Trustees will need to provide detailed information to explain why they have adopted a Bespoke approach.  
• Assessment of employer covenant: the Code is more prescriptive about how trustees should assess employer covenant strength. Trustees are expected to scrutinise management forecasts to understand the employer’s prospects and available cash flow and the period over which the trustees can reasonably rely on that cash flow to be available. The extent of the information employers need to provide for the covenant assessment will depend on a number of factors, including the maturity of the scheme and its funding position.
  
  Some employers could find they are subject to more extensive information requests from trustees.  Employers should discuss with trustees what, if any, additional information they are likely to require and, if the employer does not ordinarily produce that information, what a suitable proxy might be.  If the information requests result in additional costs and/or resourcing demands, employers could try to argue they are disproportionate. That said, if employers provide only limited information the trustees could decide to reduce the reliance placed on the covenant meaning less investment risk can be taken and, potentially, larger DRCs are needed. Therefore, a balance may need to be struck.    

• New principle for paying off deficits: there will now be an overriding principle that deficits must be paid off as soon as the employer can reasonably afford. Affordability has always been one of a number of factors taken into account when agreeing a recovery plan, however it will now have a much greater influence and employers can expect more scrutiny over how they propose to use their available cash.
  
  This scrutiny will not only extend to distributions to shareholders (which employers have come to expect), but also to discretionary payments to other creditors (such as early repayment of debt facilities) and investment in the business. Employers will need to be prepared to justify using available cash to invest in the business, as trustees are expected to assess both the risks and potential benefits to the employer and the scheme.     

• Pensions Regulator powers: The Regulations and the Code could make it easier for the Regulator to exercise its power to impose a schedule of contributions. Take for example a situation where an employer and trustees have decided to take the Bespoke route because they want to take more risk and/or adopt a longer recovery plan. If the Regulator disagrees with the justification for this approach, it could look at the schedule of contributions and recovery plan that would have been required had the scheme adopted the Fast Track approach and seek to impose that.   

Considerations for employers

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), corporate groups with defined benefit schemes may want to consider how to prepare for the new funding regime. 

Key points to consider are listed below.

• Whether any surplus in the pension scheme can be returned to the employer and if not what options might proportionately be used to avoid a trapped surplus.
• What funding and investment strategy would best fit with the group’s business objectives and management of its other liabilities? Would the group prefer the trustees to de-risk their investments sooner even if this requires increased DRCs?
• How to evidence cash flow forecasts so that trustees can show a sufficient “reliability period” to avoid DRCs needing to be accelerated.
• What information to provide to trustees on planned and expected investments or discretionary debt repayment to demonstrate the benefit to the scheme and the employer and how to protect business flexibility.
• The merits and demerits of providing or widening contingent assets such as parent company guarantees and escrows.

To help prepare, some information may be needed from the trustees, such as the scheme’s maturity, the funding level, the amount of DRCs required on a Fast Track basis and the trustees’ own preferred strategy.  Not all of this information may be available but early engagement and a considered plan will help avoid pension scheme liabilities disrupting business objectives.

We have written a more detailed note explaining the key concepts and principles used in the Regulations and Code, which you can read here.