Finally here: The DB Funding and Investment Strategy Regulations - key points and actions

Key action points from the DB Funding and Investment Strategy Regulations (the Regulations)

Closer scrutiny of employer covenant and future reliability on it

• Trustees - Further employer covenant analysis will be required by trustees (whether this is via a third party covenant advisor or provided by the sponsor). It will be vital to take into account the legal covenant as well as the financial covenant, e.g. strength of guarantees, the ability to enforce overseas and the legal structures of groups.
• Trustee and sponsor - A greater volume of financial information and legal documentation is likely to be required by trustees from employers. Now is a good time for trustees to revisit information sharing protocols with their sponsors, to ensure they are fit for purpose in light of the Regulations and if there are none, seek to put in place as soon as possible.

Sponsor affordability to pay off deficit and recovery plans

• Trustees/sponsors - The requirement for deficits to be paid off as soon as it is reasonably affordable will now be a legal requirement under the Regulations. When considering this aspect trustees must also now consider the impact on the sustainable growth of the employer.
• Sponsors – are likely to need to revisit any significant business expansion costs, given the increased focus on cash flow figures. 

Contingent assets

• Trustees and sponsors - Where contingent assets are already in place, these should be reassessed in light of the Regulations.
• Trustees - should reconsider whether any employer guarantees in favour of the scheme will continue to provide the legal and financial covenant reliance that is needed or whether, in light of the requirements of the Regulations, it would now be appropriate for them to seek to obtain a stronger guarantee. 

Background to the Regulations

The Pension Schemes Act 2021 (PSA21) requires defined benefit (DB) pension schemes to have a long-term funding and investment strategy recorded in a statement of strategy. The final Regulations provide the legal framework for that legislative requirement.

The Department for Work and Pensions (DWP), on behalf of the government, consulted on the draft Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023 in July 2022 (the Regulations). The draft Regulations set out the requirements for Defined Benefit (DB) schemes to take account of when determining their funding and investment strategy and statement of strategy.

However, a funding code of practice (The Pensions Regulator’s (TPR)) interpretation of how trustees should comply) is needed for the Regulations to take effect. The first tranche of the DB funding code consultation was published on 3 March 2020, before the first version of the draft Regulations was consulted on. That set out what TPR expected from trustees and employers in terms of funding defined benefit pension schemes in the future.

That was then followed, after the consultation on the draft Regulations, on 16 December 2022 by TPR’s long awaited second consultation of its draft Code of Practice (the draft Code) Draft defined benefit (DB) funding code of practice and regulatory approach consultation | The Pensions Regulator).

As part of the consultation on the draft Regulations, industry experts raised concerns over a potential mismatch between the draft Regulations and the draft Code, with particular concerns raised around the level of flexibility and considerations for open DB schemes.

However, the DWP in publishing the final version of the Regulations (on which it worked closely with TPR), addressed these concerns head-on. It confirmed that it had revised the Regulations to explicitly incorporate the flexibilities described in the draft Code: to ensure it struck the right balance between member security and employer affordability, whilst still supporting flexibility for sponsors and trustees on how legacy DB liabilities are managed.

Key changes from the draft version of the Regulations

The main requirement regarding the setting of a funding and investment strategy remains the same as per the draft Regulations, but there have been a significant number of changes made from the draft version of the Regulations as follows:-

Low dependency investment allocation

• This definition has been revised to bring it into line with that used by TPR in the draft Code.
• A key change, which was strongly lobbied for in the consultation responses, is the removal of the requirement contained in the draft Regulations, that assets be invested in such a way that the cashflow from the investments broadly matches with the payment of pensions and other benefits under the scheme.
• Schemes should invest in investments with sufficient liquidity to enable them to expected cashflow requirements and make a reasonable allowance for unexpected cashflow requirements.
• Amendments have been made to the final Regulations to clarify that surplus assets do not need to follow a low dependency strategy. This change is intended to allow schemes flexibility in how they can invest surplus and consistent with the government’s current focus on the use of surpluses.

Significant maturity

• Clarity is now provided on how duration will be calculated for working out when a scheme is mature, to prevent this moving with market conditions. This will be specified by TPR in the draft Code.

Relevant date

• The revised Regulations now provide for the relevant date for schemes already past significant maturity to be the effective date of the valuation to which the funding and investment strategy relates and clarifies that TPR is able to set a different date of significant maturity for different types of schemes.

Open schemes

• New provisions have been added that will explicitly allow open schemes to make a reasonable allowance for new entrants and future accrual in scheme maturity calculations, subject to the trustees’ assessment of the financial ability of the employer to support the scheme.

Covenant

• There are new requirements to consider the future ability of the employer to support a scheme. A financial covenant is underpinned by its legal framework and accordingly legal review is a vital part of covenant assessment.

Recovery plans

• While recovering deficits as soon as are affordable remains the prime requirement as mentioned above, trustees must also now consider the impact on the sustainable growth of the employer.

Statement of strategy

• Changes have been made to the provisions concerning investment strategy and risk to clarify that trustees continue to have the power to determine investment strategy. DWP has also clarified that the Regulations are not intended to interfere with the existing balance of powers under a scheme’s rules.
• Managing investment risk (both when a scheme is mature and also along the journey plan) has been moved to supplementary matters. Again this is to clarify that trustees retain the power to set investment strategies as trustees are only required to consult with the employer on the supplementary matters set out within the Statement of Strategy.

Trustees’ independence in making investment decisions

• Amendments have been made with a view to clarifying that the Regulations are not intended to change the power of trustees to set investments (after consultation with the employer) in the interests of their members.

Investment

• The Regulations have been clarified to state that schemes can invest a ‘reasonable amount’ in a ‘wide range of assets’ after significant maturity. Therefore there are no constraints on actual investments.

Key points/requirements to note from the Regulations

The main points from the Regulations to consider and action where appropriate are set out below.

Funding and investment strategy

• Trustees must establish, review and, where necessary, revise a funding and investment strategy that has the objective of ensuring pension and other scheme benefits can be provided over the long term. This requires employer agreement.
• The regulations set out how schemes should set the strategy taking into account factors such as scheme maturity, asset allocation and employer covenant.
• Schemes are required to have a low dependency funding and investment strategy when they are significantly mature. There is now more flexibility on the low dependency investment strategy which only requires that the value of the assets relative to the value of the scheme’s liabilities is highly resilient to short-term adverse changes in market conditions so that further employer contributions are not expected to be required.

Covenant

• The Regulations now explicitly include the matters to be considered in assessing the financial ability of the employer to support the scheme, including the timescales over which the trustees can be reasonably certain of continued covenant support. This was previously delegated to the draft Code.

Significant maturity

• As mentioned above, the Regulations now prescribe a fixed date, which will be 31 March 2023, on which economic assumptions used to calculate maturity must be based. This is to give more certainty and prevent timescales moving around due to market volatility. They also provide for the duration at which a scheme reaches significant maturity to be set out in the draft Code. In the updated draft Code, TPR will reassess and revise the point of significant maturity (to allow the regime to adjust for market conditions), based on this revised regulation and updated analysis (TPR may set a different specified duration for cash balance arrangements).

Cash funding

• The Regulations still require that any deficit must be met as soon as the employer can reasonably afford. However, there is now also a requirement for trustees to consider the impact of the recovery plan on the sustainable growth of the employer.

Statement of strategy

• To facilitate better trustee engagement, and better understanding and accountability between trustees and TPR, schemes will be expected to submit a ‘statement of strategy’.
• The Regulations set out requirements for what must be included in the statement of strategy. This is divided into the headline funding and investment strategy and supplementary matters. The former must be agreed with the employer (in the same way as they would require to agree to the technical provisions and schedule of contributions) and, as mentioned above, supplementary matters only require employer consultation. Therefore, as mentioned, the balance of powers in scheme rules remains relevant in the same way as it was before.
• The form of the statement of strategy and the submission process will be specified by TPR. TPR will have power to exercise discretion as to the level of detail required to give a scheme specific approach.

Surplus

• Schemes are required to be funded at the “minimum funding level” with the aim of trying to avoid trapped surpluses arising.

Actions for trustees and sponsors coming out of the Regulations

It is crucial that trustees and sponsors (with input from actuarial, covenant and legal advisers as appropriate) fully understand the requirements of the Regulations. It is likely that there will be actions for both as follows:-

Closer scrutiny of employer covenant and future reliability on it

• Trustees - Further employer covenant analysis will be required by trustees in order to formally consider and record the risk of employer insolvency and the trustees’ view on covenant reliability. They must also comment on how this period compares to the length of the current plan and document this at each valuation.
  
  However, just to clarify there is still no obligation to take independent professional covenant advice and so where this is provided inhouse by the employer, updated information should be requested.
• Trustee and sponsors - A greater volume of information is likely to be required from employers. Therefore information sharing protocols should be revisited by the trustees and its scheme sponsor to ensure they are fit for purpose in light of the Regulations or, if those are not already in place, then trustees should be discussing with their scheme sponsor with a view to putting them in place as soon as possible.

Sponsor affordability to pay off deficit and recovery plans

• Trustees/sponsors - The requirement for deficits to be paid off as soon as it is reasonably affordable will now be a legal requirement under the Regulations. Employers’ future financial planning is therefore likely to require revisiting in light of that.
• Sponsors – will probably need to review business expansion costs given the increased focus on cash flow figures. 

Contingent assets

• Trustees and sponsors - Where contingent assets are already in place, these should be revisited and reassessed in light of the new funding code.
• Trustees - should reconsider if a guarantee will continue to provide the covenant reliance that is needed or whether, given the reliance on the covenant of the guarantor, it would now be appropriate to seek to negotiate a stronger guarantee. 

Industry comment

Generally, industry reaction has been favourable to the final version of the Regulations (for example Ros Altmann’s blog entitled “New DB Funding Code moves away from reckless conservatism”) albeit many are reserving opinion until the final Code is published to see how it will work together with the revised Regulations. There are also other interconnecting parts of the funding and investment strategy piece still awaited which will then provide a complete picture of how the new requirements will work in practice – both guidance on the form of the statement of strategy and updated covenant guidance.

Others within the industry do not think the Regulations go far enough in order to take advantage of the current climate in which increasing numbers of DB pension schemes are finding themselves in a surplus position and now able to consider alternative options to buy-out.

Get in touch

If you would like to discuss any of these changes or to go ahead with reviewing your benefits and/or any communications, please contact your usual Burges Salmon contacts or Clive Pugh.