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Article | Pensions Briefing

Regime change: the new DB scheme funding requirements

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By Adam Boyes | February 19, 2020

What might the UK Pension Schemes Bill and upcoming changes to the funding regime mean for managing DB schemes?

Upcoming changes to the funding regime are designed to drive risk out of the system over time, something for which the Pensions Regulator was criticised in the early-to-mid 2010s. However, the political climate appears to have changed following some high-profile corporate failures involving underfunded pension schemes. Following the Government’s consultation in 2018, there is now a general acceptance that most schemes should be planning on the basis of reaching a suitably low risk state once the scheme is mature.

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What is a “funding and investment strategy” under the Pension Schemes Bill?

A strategy for ensuring benefits can be provided over the long term that specifies the intended funding level (possibly on prescribed assumptions) at specified times as well as the intended investments to be held.

The funding and investment strategy must be documented in a new “statement of strategy” that includes:

  • The detail of the funding and investment strategy
  • The trustees’ opinion on how successfully the strategy is being implemented, and any steps and timing proposed to remedy the position where it is not
  • The main risks faced by the scheme in implementing the strategy and how the trustees intend to mitigate or manage them
  • Reflections (including lessons learned) on any significant decisions the trustees have taken that are relevant to the strategy
  • The signature of the trustee chair

The changes were brought to Parliament in January 2020 through the Pension Schemes Bill. This introduces a new requirement for trustees to document and agree with the sponsor, a clear long-term strategy for how the scheme will be managed, which will be known as a “funding and investment strategy”. This will set out the intended ultimate approach for delivering members’ benefits, which could be the ongoing management and run-off of the scheme or an outsourced approach with the responsibility for paying benefits passed to an insurer. In practice, many schemes may well target a strategy giving flexibility between these potential book-ends.

Much of the detail will be specified in regulations that are yet to be revealed. The Pensions Regulator is expected to launch an initial consultation in early March that will inform changes to the regulations and lead to a revised code of practice on scheme funding. The expectation is that this new code will articulate the Regulator’s expectations about how funding and investment strategies should be set in view of a scheme’s particular circumstances, including their proposed options of a “fast track” or “bespoke” approach to regulatory review.

Industry needs to be wary that the new requirements do not lead to unintended consequences. On the whole, the current funding regime introduced in 2005 has worked, although by its ‘scheme-specific’ nature has given rise to a wide variety of approaches to managing defined benefit pension schemes. We believe there remains a compelling case for a regime that reflects individual scheme circumstances. However, the flexibility and inherent subjectivity of the current approach has presented challenges for the Pensions Regulator in policing the landscape of some 5,400 defined benefit schemes effectively and efficiently.

The short-term element of strategies is expected to be more like the existing regime, with the current circumstances of the scheme and the sponsor’s covenant taken into account. However, the Regulator’s intention is clearly for schemes to agree long-term funding objectives that will be much less reliant on covenant as the scheme matures.

Putting in place such strategic plans may in some cases mean higher funding targets and more onerous contribution requirements unless any gap is met through investment outperformance.

The Government is clearly hoping that the discipline of articulating a clear long-term strategy, and the trustee chair being expected to account to the Regulator for how this is being achieved, will focus minds on monitoring and managing the associated risks.

Defining an approach for delivering benefits in the long term

In our experience, many (but certainly not all) schemes have already established some form of long-term funding plan that is kept under periodic review and against which the scheme is managed. For such schemes the new requirements will be an opportunity to revisit and reaffirm those plans, ensure they are consistent with their ongoing funding approach and check that there are no other gaps under the new regulatory requirements.

Depending on where the new code of practice lands, schemes will also want to consider what changes would be needed to clear the Regulator’s “fast track” hurdle and assess the pros and cons of going down that route versus the “bespoke” regime. There is also likely to be some work needed to ensure that any plan is documented in a manner consistent with the new legislation and the new code of practice. For some of these schemes, any requirement to agree the long-term strategy formally with the sponsor could present challenges when compared with the existing position.

In many cases, trustees and sponsors will want to consider developing a clearer path to delivering benefits in the medium to longer term. We suspect that while some will set out a clear intention to buyout with an insurer, the majority will want to retain greater flexibility. We expect that for many larger schemes, the plan will be to retain the scheme in a run-off mode over the long term, albeit still with an increasing appetite for managing longevity risk over time (e.g. through longevity swaps and buy-ins) as this becomes the increasingly dominant risk to the successful delivery of the strategy.

Trustees may be concerned with the prospect of being required to agree certain investment strategy matters with the sponsor, where to date all that has been required in connection with investment is sponsor consultation.”

Adam Boyes
Head of Trustee Consulting

Trustees may be concerned with the prospect (under the Pension Schemes Bill) of being required to agree certain investment strategy matters with the sponsor, where to date all that has been required in connection with investment is sponsor consultation. Conversely, sponsors may see this as an opportunity to have more influence over the investment side of the funding equation in return for signing up to a long-term plan for managing the scheme. Much will hinge on precisely what the regulations require and how these interact with existing trustee investment powers; in particular, how much detail needs to be included on the investments that the trustee intends to hold and the consequences of deviating from those intentions. It also remains to be seen how quick the Regulator will be to use its powers where agreement isn’t reached, including its new-found power to direct how a scheme must revise its funding and investment strategy.

The implications for actuarial valuations

Process

The nuts and bolts of the funding regime remain largely unchanged, with schemes still needing to set technical provisions and to agree a recovery plan if there is a deficit on that basis. One new requirement of the primary legislation will be that technical provisions have to be calculated “consistently” with the scheme’s funding and investment strategy. The statutory 15-month actuarial valuation deadline remains unchanged despite the additional requirements; when developing a funding and investment strategy for the first time it will be important to work closely with the Scheme Actuary, making as early a start as possible, in order to ensure consistency and avoid any difficulties in meeting the deadline.

The Pensions Regulator’s code of practice on funding is expected to be overhauled significantly and will, for the first time, be specific about what valuation parameters (e.g. assumptions, recovery periods) would be deemed satisfactory in given circumstances. This will establish a “fast track” approach to regulation, whereby trustees and sponsors can be confident that where those prescribed parameters are met, there will be no regulatory scrutiny or intervention.

Where schemes are already meeting these requirements or where the funding implications are tolerable, this fast track approach may be an automatic or attractive route to follow. For these schemes, this may simplify the existing valuation process.

Other schemes will choose the “bespoke” option and engage with the Regulator to explain how their approach satisfies the various legal and regulatory requirements, in much the same way that the system has worked in the past.

David Fairs, the Regulator's Executive Director of Regulatory Policy, describes the choices schemes will face as follows: “Those that want a prescribed approach will have one. And those that cannot or choose not to go down that route will be able to continue to use some flexibilities in the system. Those schemes that abuse the current flexibilities in the system are likely to find life much more difficult.”

If many schemes take the fast-track route the remainder may find that intervention from the Regulator is both more likely and, when it comes, more in-depth.

Setting the right hurdle for entry into the fast-tack route is going to be a critical challenge for the Regulator over the coming months.

Open schemes, as well as those with significant levels of future accrual for current members, may find developing a strategy that satisfies the Regulator’s views on long-term objectives particularly challenging and may be less likely to follow the fast-track route.

Assumptions

It is anticipated that the Regulator will expect the trustees of most schemes to aim to reach their long-term objective in 15 to 20 years, dependent on scheme maturity, with funding discount rates at that point in the region of 0.25% to 0.5% per year above gilt yields.

Aiming now to fund towards these levels over time could come as a short-term shock to sponsors of schemes that still run material amounts of investment risk and where funding plans have to date had little or no regard for future de-risking – especially where such schemes may recently have been moving closer to full funding. However, many schemes may find they are already largely on track to meet this type of target within these timeframes.

There could be some ambiguity about the requirement for technical provisions to be “consistent” with the longer term funding and investment strategy. This might simply mean that the technical provisions lead to contributions that, combined with investment outperformance, are expected to be sufficient to deliver the scheme’s long-term objective; others however, might interpret this as requiring explicit convergence between the technical provisions and the long-term funding target over time. Regulations may provide more clarity in due course, but the latter could have a more significant effect on funding. Employers may find that hard to swallow if it requires a greater rework of the current approach and implicitly adds prudence to long-term funding strategies.

Possible consequences

The aim of the enhanced funding regime is to increase the security of members’ benefits over time.

The table below sets out some of the other possible consequences that could arise for some schemes when trustees and sponsors apply the new regime.

Table showing the possible consequences that could arise for some schemes when trustees and sponsors apply the new regime.
Driver Possible Consequences
Higher long-term funding targets
  • Increased use of contingent funding
  • Higher employer contributions
  • Benefit reductions (future accrual)
  • Member options / liability management exercises
  • Possible pressure to increase investment return expectations (or not de-risk as quickly) in the short to medium term
Articulation of long-term strategy and risks
  • Enhancements of IRM dashboards/monitoring
  • Increased interest rate/inflation hedging
  • Increased longevity hedging through buy-ins and longevity swaps
  • Higher transfer values if de-risking becomes ‘hard coded’ in the scheme’s strategy?
Sponsor agreement to strategy
  • More complicated and challenging discussions at the next valuation
  • Possible downward pressure on existing trustee long-term funding targets
  • Possibility for sponsors to have more direct influence over schemes’ investment strategies
Increased Regulator powers and penalties
  • The Regulator directing funding and investment strategies where there are legislative failings
  • Fines for non-compliance and/or prosecutions
Contact

Adam Boyes
Head of Trustee Consulting

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