UK Pensions Briefing: The final Funding and Investment Strategy Regulations – what has changed?

Introduction

After a long wait, the final version of the Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2024 was laid before Parliament on January 29, 2024. The Regulations are due to come into force on April 6, 2024, and will apply to defined benefit scheme valuations with effective dates on or after September 22, 2024.

The Regulations are introduced under the Pension Schemes Act 2021 and will implement major changes to the existing DB scheme specific funding requirements. They will be supported by a revised DB Funding Code from the Regulator, which is expected in May or June 2024. We also expect updated covenant guidance from the Regulator, together with new guidance on the form of the Statement of Strategy.

This briefing is an updated version of our September 2022 publication Funding Defined Benefit Pension Schemes – Proposed Funding and Investment Changes and it highlights how the final Regulations differ from the draft version. It examines the key concepts in the Regulations, and what trustees and employers should do to prepare for the new regime.

The Government’s objective

The Government and DWP’s broad objective is for schemes to set, and report on their progress towards, a funding level which reduces dependence on their sponsoring employer(s) at a future date when the scheme is mature - a “long term funding objective” (LTO). The Government’s rationale for this is to ensure that schemes are making investment decisions in a way that results in the highest probability of members receiving their pensions in full.

Since the original draft regulations were consulted on in 2022, DB schemes have been impacted by the LDI crisis and the Government has outlined its “productive finance” proposals in the Mansion House reforms. The final Regulations have been revised in the wake of these significant changes.

Changes in the Regulations

There are several changes in the Regulations as a result of extensive commentary from the pensions industry during the consultation:

• Low dependency investment allocation – cash flow from investments is no longer expected to be “broadly matched” with scheme liabilities. The Regulations no longer force schemes down a path towards low-risk investments in all cases. Assets above the minimum funding level set out in the Regulations need not follow a low dependency strategy and may be invested more flexibly.

• Significant maturity – there is now greater clarity in the Regulations and the duration measure used for calculating when a scheme is significantly mature is fixed according to the financial conditions prevailing as at March 31, 2023, rather than shifting with changes in the market. The actual duration in years is to be set out by the Regulator in its forthcoming DB Funding Code, but for closed schemes it is likely to be somewhere between 5 -15 years.

• Open schemes – for open schemes, the duration in years to significant maturity will depend on the strength of the employer covenant and the trustees’ reliance on it in terms of support for benefit accrual for existing and new members. However, open schemes will still need to fund for low dependency at some future point.

• The employer covenant – the employer covenant is now at the heart of the framework and has been set out on a legislative basis for the first time, rather than being left for the Regulator to clarify in its Code. New requirements mean the trustees will need to look at the employer’s “cash flow and future cash flow” when assessing the covenant, as well as the “future development and resilience of the employer’s business”. Contingent assets will need to be considered for their legal enforceability and the level of support they provide.

• Recovery plans – while funding deficits must be addressed “as soon as the employer can reasonably afford”, the impact on the sustainable growth of the employer’s business must now also be taken into account.

• Statement of strategy – concerns were raised during the consultation that the Regulations could have adversely impacted on trustees’ independence to make investment decisions. The Regulations have been revised to include clearer detail on the management of investment risk and how the trustees retain the power to invest the scheme assets, both at maturity and as the scheme moves along its journey plan.

Key concepts

Funding and Investment Strategy

The Regulations still require trustees to agree a funding and investment strategy (FIS) with the sponsoring employer. The FIS will detail the scheme’s LTO, and how the LTO will be achieved over the scheme’s lifespan. Trustees then consult with the employer on a regular written Statement of Strategy of their progress in achieving their FIS.

The Regulations specify the information to be covered in the Statement but the Regulator now has a discretion on the level of detail it requests in relation to the supplementary matters set out in Schedule 2. Well-funded schemes are likely to attract less attention from the Regulator.

In terms of what the Regulations say, they propose that from the point a scheme reaches significant maturity, the minimum requirement is for it to have appropriate and sufficient assets so that it is fully funded on a low dependency funding basis and invested in a low dependency investment allocation. The Regulations explain these terms as follows:

• Significant maturity: significant maturity is a measure of how far a scheme is through its lifetime and is to be measured in years on a duration of liabilities basis. A scheme reaches significant maturity on the date it reaches the duration of its liabilities in a period of years to be specified by the Regulator in the new Code. With cash balance schemes in mind, the Regulator can set a different date of significant maturity for different types of scheme. Duration of liabilities is the weighted mean time until the payment of pensions and other benefits, and guidance on its use is expected to be set out in the new Code.

• Low dependency investment allocation: this is when a scheme expects to have sufficient assets under a low dependency investment strategy to provide accrued pensions without further employer contributions being needed. However, there is now more flexibility in this concept as the Regulations now provide that the value of assets to liabilities should be “highly resilient” to short-term adverse changes in market conditions, rather than “broadly matched” to the amount required to pay benefits.

• Low dependency funding basis – this remains unchanged and is where liabilities are calculated on the assumption that no further employer contributions would be expected to be required if the scheme’s assets are invested according to the low dependency investment allocation.

In terms of how trustees are expected to pull together these key concepts into a FIS, the Regulations indicate that trustees are to have regard to the matters and principles set out in a schedule to the Regulations and include:

• The actuary’s estimated date of significant maturity, and the estimate of maturity of the scheme as at the valuation date to which the FIS relates.

• Consideration of investment and liability risk on a scheme’s journey to significant maturity, and the level of risk possible depending on the strength of the employer covenant and how near the scheme is to significant maturity.
• Thinking about liquidity and unexpected requirements on the journey and after significant maturity.

Statement of Strategy

The Regulations also set out the matters the Statement of Strategy must cover, including how maturity is expected to change over time; the level of investment risk to be taken in the context of the trustees’ assessment of the strength of the employer covenant; the action trustees will take if any risks identified in the FIS materialise; how low dependency will be achieved by significant maturity; how the scheme assets are held in investments of sufficient liquidity; and any comments the employer has requested to be included.

Overall, the Statement of Strategy must clarify the risks of implementing the scheme’s FIS and the planned mitigation if those risks materialise. A Chair of trustees must sign the Statement and provide it to the Regulator “as soon as reasonably practicable” following its preparation or revision, along with the valuation to which it relates. The submission process will be detailed in the Regulator’s code.

Timing and Preparations

Trustees must have their first FIS in place within 15 months of the effective date of their first scheme valuation on or after September 22, 2024, and reviewed within 15 months of each valuation thereafter or if there is a material change in the circumstances of the scheme or employer.

Trustees need to therefore understand what is expected of them and take preparatory action. Questions to be posed now include:

• Where the scheme is in its valuation cycle i.e. when will the changes be likely to impact the scheme?

• If the actuary should be asked to advise on the scheme’s current maturity, and when it will reach (or has it already reached) significant maturity?

• Will an employer covenant assessment be needed, or need to be revised, who will do this and what is the cost?

• Broadly, will any existing end game need to be devised or revisited?

• Does a Chair of trustees need to be appointed?

Issues for employers to consider are:

• Where the new regime may have the effect of accelerating the scheme’s existing funding strategy (and any recovery plan), employers will need to consider affordability. They should engage early with the scheme’s trustees.

• The headline statement of strategy needs to be agreed between the employer and the trustees, with certain supplementary details needing only consultation between them.

• The Regulations put covenant assessment on a formal legal footing for the first time, so this will be an area of increased focus for the trustees. They may well seek more detailed information from the employer regarding its business and the general outlook for the related industry. The Regulator has promised updated covenant guidance, which will set out its expectations of employers and trustees. Costs for trustees, funded by employers, will inevitably increase.

• The employer and trustees should discuss the timescale for preparing their first FIS and the related Statement.

Overall, trustees and employers will need to engage with their advisers to prepare for setting a scheme FIS and Statement of Strategy.

Comment

The changes made in the Regulations from the earlier draft have largely been well-received. However, there are some views that there has been a missed opportunity in not making legislative provision for “trapped surplus” at this stage, given that this is seen as a real possibility with the shorter recovery periods envisaged. Easier access to surplus funds for the sponsoring employer is seen as a priority for future legislative changes if the Government is to encourage schemes to support its productive finance agenda. The first step has been taken in the reduction of the tax payable on DB surpluses from 35 to 25 per cent with effect from April 6, 2024. We expect a consultation later this year on changes to DB surplus rules. However, further change may depend on the outcome of the election.

The Regulations make no mention of the proposed “fast track” and “bespoke” funding approaches which the Regulator first consulted on in 2020. Again, we await the new Code to see how these plans may have evolved in the intervening period and how they would work alongside the revised Regulations.

As matters stand, without the new Code in hand, trustees and employers cannot yet know the exact requirements. What is clear, is that the changes will require trustees and employers to work much more collaboratively in the future. This will apply at and between scheme valuations particularly in light of the new statutory requirements for employer covenant analysis, and generally in respect of funding and investment.