Draft DB pension funding rules require schemes to assess employer covenant strength

The draft regulations (13 pages / 305KB PDF), published by the UK Department for Work and Pensions (DWP) will require defined benefit (DB) schemes to assess the strength of the ‘employer covenant’ in relation to the size of any scheme funding deficit or surplus. According to the DWP’s consultation (35 pages / 382KB PDF) on the regulations: “Even a successful and profitable employer might not provide a strong employer covenant if the pension scheme funding deficit is disproportionally large.”

Carolyn Saunders of Pinsent Masons said: “These regulations are the first example of an express statutory requirement for DB schemes to assess the strength of the employer covenant which, for the majority of schemes, is the most significant risk to which they are exposed. Not only that, but the regulations, in combination with a code of practice to be issued by The Pensions Regulator (TPR), will set out the matters to be considered in any covenant assessment undertaken as part of determining a scheme’s funding and investment strategy.”

She added: “This is a welcome endorsement of the importance of robust covenant advice and will presumably lead to greater standardisation of covenant reporting for this purpose and others.”

Her comments came after the DWP published a consultation on the draft Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023.

Under the regulations, trustees must ensure – when determining their scheme’s funding and investment strategy – that their schemes are in a state of low dependency on their sponsoring employer by the time they are significantly mature. This means that the scheme is not expected to need further employer contributions under reasonably foreseeable circumstances. According to the consultation, the draft regulations allow the characteristics of an open scheme to be taken into account in the projection of scheme maturity, with the upcoming TPR code to provide further guidance. Where a scheme appears to be falling short of its legal requirements, The Pensions Regulator (TPR) will be able to intervene.

The draft regulations state that a scheme reaches significant maturity on the date it reaches the duration of liabilities specified in TPR’s code. The code is expected to specify a duration of 12 years, although the contents of the code will be the subject of a separate consultation later this year. A scheme that has reached a low dependency state must invest its assets in a low dependency investment allocation and be fully funded on a low dependency funding basis.

Schemes’ funding and investment strategies must also specify both the funding level the trustees and manager intend the scheme to have achieved, as well as the investments they intend the scheme to hold at the “relevant date”. Trustees must first determine the date of significant maturity, on actuarial advice, and then choose a relevant date which must be on or before the end of the scheme year in which the scheme will reach significant maturity.

The trustees will then determine the low dependency asset allocation they intend the scheme to have achieved by that date and a low dependency funding basis consistent with that asset allocation. For open schemes that are not maturing, the relevant date can move into the future following each review of the funding and investment strategy, in which case no investment de-risking as a result of the scheme moving closer to that date is required.

Supportability principles will apply to the level of investment risk that trustees or managers can take and to the actuarial assumptions used as the scheme moves along its journey plan. The legislation does not prevent appropriate open schemes from investing in riskier assets, where there are potentially higher returns as long as the risks being taken can be supported and members’ benefits protected.

Saunders said: “These draft regulations are long-awaited and it is evident that real efforts have been made to accommodate industry concerns, including those around open DB schemes. Some details, however, remain to be filled in by TPR’s code of practice. That is not expected to be published for consultation until later in the year – and it is hoped that the code’s contents will be informed by the responses to this current consultation.”

The DWP’s consultation on the draft regulations will close on 17 October 2022.