UK: DWP Publishes Final Draft Funding And Investment Strategy Regulations

The DWP has published final draft funding and investment strategy regulations for defined benefit pension schemes that amend the funding regime as required by the Pension Schemes Act 2021. A Government response to its consultation on an earlier draft of these regulations (which was published in July 2022) explains why some changes have, and have not, been made.

The new regulations will apply to a scheme's first actuarial valuation with an effective date on or after 22 September 2024.

The Pensions Regulator's revised Code of Practice on scheme funding, which will set out more details of how schemes are expected to comply with the new regulations, is expected to be published in the second quarter of 2024.

The main requirement under the new regime remains unchanged from the previous draft regulations. This is for a scheme to set a funding and investment strategy that is consistent with reaching a state of 'low dependency' on the sponsoring employer by the time the scheme is mature. There are however a number of differences compared to the previous draft, as outlined below.

Scheme maturity

A key requirement of the regulations is that once a scheme is mature it should be in a state of low dependency on the sponsoring employer. Scheme maturity will be measured using the duration of liabilities determined according to a standard 'weighted mean time' approach. In a change from the original proposals this calculation will have to be carried out by reference to economic conditions at 31 March 2023 rather than at the effective date of the valuation. The relevant duration for determining what is 'significantly mature' will be set by TPR in its Code of Practice, with the regulations giving scope for TPR to vary this duration across different 'descriptions' of schemes, for example, requirements for cash balance schemes may be different from those for traditional DB schemes. It seems likely from the consultation response that the 'significant maturity' duration will now be set at less than 12 years, but we will need to wait for TPR to publish the revised Code before this is confirmed. Trustees must then set a 'relevant date' no later than when significant maturity is expected to be reached, with the strategy being based on the principle that the scheme must be fully funded on its low dependency basis by this date. Primary legislation requires that the technical provisions be consistent with a scheme's long-term funding and investment strategy.

Low dependency requirements

The final regulations retain the requirement that for a scheme to be in a low dependency state there should be no expectation of further employer deficit contributions being needed. This requirement applies regardless of the Trustee's assessment of the sponsor covenant. In spite of feedback provided during the consultation, the regulations do not provide for any reliance on contingent assets in establishing a low dependency funding basis.

In setting a low dependency funding basis, schemes must presume that the assets needed to cover their liabilities are invested such that the value of assets relative to liabilities is 'highly resilient to short-term adverse changes in market conditions' (a requirement which The Pensions Regulator had previously said 'could be consistent' with investing 20%-30% in growth assets). While the regulations lack clarity, the policy intent of the changes to the wording appears to be to exempt surplus assets from this requirement.

The requirement for schemes to be broadly cashflow matched has been dropped.

The consultation response states that 'the Regulations do not constrain actual investments and even mature schemes can invest in a wide range of assets'. The regulations themselves do not however include any explicit wording to that effect. In addition, the information on investment risk to be included in the Statement of Strategy is in respect of 'the intended investment of the assets of the scheme relating to the actuarial valuation to which the funding and investment strategy relates', not the current actual investment strategy. DWP's intention in making this change is to avoid overriding the current trustee powers in relation to how a scheme's assets are invested.

Employer covenant

Employer covenant will be defined in legislation for the first time. In considering employer covenant, trustees will have to assess the likelihood of employer insolvency, the employer's cash flow and how other factors may affect the business. The final draft regulations provide for a wider set of factors to be taken into account when assessing the sponsor covenant than provided for in the previous draft, and remove any cross references to the Regulator's Code.

In a change from the previous draft, Trustees must now consider for how long they can be 'reasonably certain' that the employer will be able to continue to support the scheme.

Contingent assets can be taken into account provided they are legally enforceable and provide sufficient support in the circumstances in which they may be required (although as noted above they cannot be relied upon when establishing a low dependency funding basis).

The journey plan

The journey plan principles are broadly unchanged from those included in the previous draft regulations. The amount of investment risk that can be taken while on a Journey Plan to the low dependency target and the strength of the actuarial assumptions chosen for funding purposes are dependent on both the strength of the employer covenant and how near the scheme is to reaching significant maturity.

Recovery plan

In spite of concerns expressed during the consultation process, the regulations introduce a new legal requirement for any recovery plan to be met 'as soon as the employer can reasonably afford'. The consultation suggests that this has primacy over the other Recovery Plan requirements. There is though a new additional factor for trustees to consider in respect of Recovery Plans, and that is the effect of any Recovery Plan on the sponsor's sustainable growth.

Investment strategy

As with the draft regulations, the statement of funding and investment strategy (which needs to be agreed with the employer for most schemes) must include a specification of the intended high level allocation between different asset classes at the relevant date (ie the date on which the scheme is expected to reach significant maturity).

Contents of the statement of strategy and its review

The regulations set out a number of detailed requirements for the statement of strategy, which include a number of new requirements for information on maturity, liquidity and investment strategy. This will need to be revised at each future actuarial valuation, but will also need to be reviewed and if necessary revised if there is a material change in the scheme funding position, or a material change to the employer covenant.

There have been a number of changes to the requirements under Part 1 (which generally requires employer consent) and Part 2 (which generally only requires consultation with the employer), with some movement between the two. Summary information on the valuation and Recovery Plan will need to be included, but some of the more administratively burdensome detailed requirements have been removed and simplified.

Open schemes

The final regulations clarify that when determining the point at which the scheme is expected to reach significant maturity, schemes that are open to new entrants and/or future benefit accrual may take account of expected future benefit accrual, although in making this assessment they have to consider amongst other things the period over which they are 'reasonably certain' that the sponsor can continue to support the scheme. No other flexibilities or exemptions from the requirements have been made for open schemes, since the Government does not think that it is reasonable to assume that a scheme will remain open indefinitely and will have an evergreen covenant.