DB final funding and investment regulations published

The much-awaited final version of the Funding and Investment Regulations was published on 29 January 2024 alongside the Government’s response to its July 2022 consultation (see our insight).

The regulations provide relevant detail regarding the new defined benefit (DB) funding regime that was introduced by the Pension Schemes Act 2021, and which will require DB schemes to have a funding and investment strategy (the FI Strategy) to provide benefits “over the long term” and to set out details of this in a statement of strategy (the Statement) which will need to be sent to the Pensions Regulator (TPR).

Subject to parliamentary approval, the regulations will come into force on 6 April 2024 and will apply to valuations with effective dates on and after 22 September 2024.

The new scheme funding legislation will be supplemented by a revised TPR DB funding code of practice providing further detail on the key concepts of the new regime set within a new twin-track compliance framework (fast track and bespoke). The final version of the code is not expected to be laid before Parliament until this summer so there is a slight gap in publication timing. TPR has also yet to publish its revised covenant guidance which schemes will be on the lookout for, especially given the focus in the new regime on employer affordability (a new principle in the recovery plan) and risk levels being dependent on covenant strength.

Changes to the final version of the regulations

Several changes have been made to the final regulations following consideration of the 92 respondents’ comments.

The Government believes that the regulations as amended will not only make “funding standards clearer” but, also support its Mansion House initiative to increase productive finance investment.

The revisions to the regulations address concerns on the following central themes:

Overview of the new funding and investment legislative framework

The FI Strategy

DB schemes will need to have a FI Strategy setting out how benefits will be provided in the long term, the scheme’s funding level and intended investment allocation at the date the scheme reaches significant maturity.

Significant maturity

By the time a scheme is significantly mature, it should have, at least, low dependency on the sponsoring employer – both in terms of funding and investment. Schemes will need a clear journey plan to show how they will reach this point.

The Statement

The Statement consists of two parts. Part 1 will contain the FI Strategy and will require the employer’s agreement. Part 2 will contain various supplementary matters (including implementation success and the main risks of implementing the FI Strategy). Part 2 only requires employer consultation, not agreement.

TPs, the recovery plan and employer affordability

The Pensions Act 2004 will require that a scheme’s technical provisions are calculated ‘consistent with’ the FI Strategy. When assessing recovery plan appropriateness, trustees will have to follow a new principle that the recovery period “must be as soon as the employer can reasonably afford”.

Employer covenant strength

How much risk can be taken during a scheme’s journey plan depends on employer covenant strength. This is defined for the first time in legislation and expanded upon in the funding code. As noted above, TPR will also be revising its covenant guidance.

The FI Strategy

The overarching principle of the FI Strategy remains that schemes will reach “at least, a state of low dependency on their sponsoring employer by the time they are significantly mature”.

Under the final regulations certain supplementary matters from Part 2 of the Statement have been moved over to the FI Strategy (Part 1 of the Statement).

The FI Strategy must now include, in summary, how benefits will be provided over the long term, the scheme’s funding level under the current valuation, expected maturity and valuation assumptions, discount rate information and the intended investment asset allocation at the relevant date.

Relevant date

The FI Strategy must set out both the intended funding level of the scheme and investments that it is intended will be held at the relevant date which must be no later than the end of the scheme year in which the scheme is expected to reach significant maturity.

The final regulations now cater for a scheme that has already reached significant maturity – the relevant date for such a scheme will be the effective date of the current valuation.

Valuation: The relevant date must be set out in each valuation – each time the FI Strategy is reviewed the relevant date must be adjusted if “necessary or appropriate”.

Scheme maturity

Definition: Maturity in the Regulations is measured by reference to ‘how far a scheme is through its lifetime’, in years using a specified duration of liabilities measure.

Volatility: To address concerns that the measure can be volatile in certain market conditions, the final regulations use a specific date (31 March 2023) to set the economic assumptions upon which maturity will be calculated.

Duration for significant maturity: To allow for revisions to be made in a suitable manner when market conditions change, the duration at which a scheme will become significantly mature will be set out in the funding code – the draft code set this as being when duration reaches 12 years. TPR will be able to set different durations for different scheme types¹ with specific reference in the consultation response to cash balance schemes.

Open schemes: In response to concerns regarding open schemes having to de-risk ‘unnecessarily’, the regulations now explicitly reference making an allowance for open schemes where using such assumptions would be reasonable and are based on a covenant assessment.

Valuation: Each valuation will need to include the actuary’s estimate of the date that the scheme will reach (or did reach) significant maturity and certain details of maturity.

Low dependency needed in both investment and funding

Low dependency at significant maturity means having both a low dependency investment and funding allocation.

Low dependency investment allocation: under amended wording this now means scheme assets being invested so that assets ‘relative’ to liabilities are “highly resilient to short-term adverse changes in market conditions”. The objective is to remove reliance from any future need for employer contributions, so appropriate de-risking will be required. The Government has dropped the reference to having the cash flow broadly matching benefit payments to address concerns around this requirement leading to ‘excessive de-risking’ and to allow for investment in higher growth seeking assets after a scheme reaches significant maturity (in line with the approach taken in the funding code).

Low dependency funding basis (no change in final regulations): means having an asset to liability ratio of 1:1 on actuarial assumptions which are chosen on the premise that no further employer contributions will be expected and that the assets are held in accordance with a low dependency investment approach. [Details of the funding level on a low dependency basis will have to be included in each valuation.]

The journey plan

The journey plan details how the scheme will get from its current position to the ‘relevant date’, i.e., the date the scheme reaches its long-term funding target (significant maturity).

The consultation response confirms that the journey plan (so far as it relates to funding, not investments to avoid potential concerns regarding encroachment on trustees’ investment powers) will form part of the FI Strategy and it has amended the regulations to make this clear.

Strength of the employer covenant

Employer covenant strength is the key consideration for funding risk decisions during a scheme’s journey plan. It will now have a legal definition. Changes have been made to the definition, mainly to provide clarification.

The regulations define ‘strength of the employer covenant’ as the employer’s financial ability relating to its legal obligations to support the scheme plus support that can be expected from legally enforceable contingent assets.

The references to certain detail being in the funding code have been removed to keep the definition on a statutory footing.

Matters to be considered and principles to be followed

Three specified matters must be taken into account and three principles followed when producing a FI Strategy.

• Matter 1: The actuary’s estimate of the significant maturity date.
• Matter 2: The maturity of the scheme at the effective date of the respective valuation.
• Matter 3: Investment Objective and surplus – The Investment Objective that on and after the relevant date scheme assets (up to full funding on low dependency basis) are invested in line with a low dependency investment allocation. Framing the Investment Objective in this way means that it only applies up to full funding and does not therefore include surplus, thereby allowing additional risk in respect of surplus funds.

• Principle 1: A minimum funding level on and after the relevant date of assets to liabilities of 1:1 (full funding based on low dependency funding basis).
• Principle 2: The amount of risk that can be taken when choosing liability assumptions on the journey plan is dependent on covenant strength and how far away significant maturity is – the stronger the covenant and the longer away the relevant date is the more risk that can be taken.
• Principle 3: The Liquidity Principle has been reworded to remove reference to it applying both before and after the relevant date to address concerns that liquidity planning would be needed over too long a timeframe – it now simply refers to having sufficient liquidity as regards the current strategy for expected cash flow needs and reasonable allowance for unexpected needs.

Timescales

The first FI Strategy must be produced no later than 15 months after the effective date of the first actuarial valuation on or after 22 September 2024. Following this, a FI Strategy will need to be completed within 15 months of the effective date of a valuation and, as soon as reasonably practicable, after material changes in either scheme or employer circumstances.

The Statement 

The Statement must include a written statement of the FI Strategy (Part 1) (employer agreement required unless, broadly, trustees determine contribution rates without employer agreement in which case only consultation needed) and the following supplementary matters (Part 2 – employer consultation rather than agreement needed). It must be signed by the chair of trustees.

Implementation

Whether the FI Strategy is being ‘successfully implemented’ – if not, what remedial action is intended to keep the FI Strategy on track with timing information.

Risks

The main risks for the scheme in implementation of the FI Strategy and how these will be mitigated or managed.

Significant decisions

“reflections…on any significant decisions taken…in the past…relevant to the [FI Strategy] (including any lessons learned)…”

Other supplementary matters including the following:

• Valuation and recovery plan details (which will allow the scheme return to be revised to avoid repetition).
• Actuary’s estimate of scheme maturity.
• Intended investment risk and how this complies with the Investment Objective.
• How investments comply with the Liquidity Principle.
• Employer covenant assessment.
• Appropriateness of the FI Strategy.

Review: Part 2 of the Statement must be reviewed and, if need be, revised as soon as reasonably practicable following a FI Strategy review (even if the FI Strategy is not revised).

TPR discretion: TPR will have discretion as to the level of detail required on the Part 2 supplementary matters. This is to allow TPR to adopt an approach tailored to scheme specifics including whether to ask for information on a certain matter at all.

Submission to TPR: Rather than being submitted with a valuation as envisaged in the draft regulations, the Statement will have to be provided to the Regulator as soon as reasonably practicable when the FI Strategy has either been prepared or revised (whether or not this coincides with a valuation cycle).

New recovery plan principle

The regulations introduce a new standalone principle, that the deficit “must be recovered as soon as the employer can reasonably afford”, when assessing recovery plan appropriateness. Respondents expressed concern over this principle having ‘primacy’ over current matters. The consultation response says that, to address this, the revised regulations retain the principle and its ‘primacy’ but add in as one of the matters that will need to be considered by the trustees when producing a recovery plan “the impact of the recovery plan on the employer’s sustainable growth”.

Next steps

Trustees should familiarise themselves with the final regulations and the final version of the funding code when published and liaise with their advisers to understand the impact for their scheme. They will want to work out when the first FI Strategy and Statement is due and whether they need to obtain employer agreement (or to consult only) in respect of the FI Strategy. Discussions will also be needed with the employer as regards implementation of the new regime.

The new requirements may have limited impact on those schemes that are already funding in line with a low dependency target at significant maturity, but changes may be needed for those that either do not or cannot both in terms of additional funding and/ or time and flexibility constrictions. Schemes with valuation dates before 22 September 2022 will be subject to the current funding regime but will wish to have in mind the new requirements when preparing valuations.

¹ Regulation 4(1)(b), Funding and Investment Regulations