Although the world of defined benefit (DB) pensions is declining – with the number of employees accruing benefits falling from 3.5 million to just under 900,000 between 2006 and 2022 – it is ever evolving. This is highlighted through two major interlinked regulatory initiatives which are redefining the world of DB pensions.
The first, dates back to last summer, when the Department for Work and Pensions (DWP) opened a consultation on the draft Occupational Pension Schemes Regulations 2023 which has deep ramifications.
The regulations require trustees of defined benefit pension schemes to adopt a funding and investment strategy that sets out a strategy of low dependency for mature schemes. This means to minimise the potential for further employer contributions by being invested in low risk fixed income assets.
“The intention is to have better, and clearer, funding standards, but not to move away from the strengths of a flexible scheme specific approach,” said the then minister for pensions Guy Opperman, when the consultation was launched.
But Matthew Arends, partner and head of UK retirement policy at Aon, questions whether this is the case. “While we support the overall objective of the draft regulations, we have major doubts over whether the proposed legislation is sufficiently flexible and whether the consequences of these potential changes have been properly addressed.”
A point also highlighted by the trustees of Railpen in a written response to the proposals. “The draft regulations are more prescriptive than the existing funding regime, which we believe could exacerbate systemic risks to the UK economy,” it read.
Before this hits the statute book, there remain concerns about the unintended consequences of the regulation. One is that the impact of the draft regulation will vary significantly between different schemes.
“For some schemes, for example, those that are close to full funding on a buy-out basis, it may mean very little in practice,” says Faye Jarvis, partner at law firm Macfarlanes.
Assuming, she notes, these schemes have appropriately de-risked, then they should have a limited dependency on the employer for future funding.
“Therefore, the main impact is an increase in compliance as these schemes will still need to complete the statement of strategy and submit it to The Pensions Regulator (TPR).”
This presents just one potential headache for DB schemes.
Tight deadline
However, for others, the implications could be numerous and varied.
For example, if a scheme is close to significant maturity but is not invested on a ‘low dependency’ basis it may have to make substantial changes to its investment strategy over a relatively short timeframe. “The changes to its investment strategy may also result in an increased demand for deficit repair contributions required from the employer,” Jarvis adds.
Charles Cowling, chief actuary at consultancy Mercer, offers his assessment of the regulations. “It means we will see more schemes de-risking and heading towards eventual settlement. “Schemes will have to target a low risk – ‘low dependency’ – funding, investment position which should have low or negligible reliance on the employer,” he adds.
There is an impact here for schemes regarding their investment strategy that sets out their ‘endgame’. “For those schemes targeting buyout as their endgame, they will need to consider what to do with their illiquid assets as schemes will need sufficient liquid assets to transact with insurers,” Jarvis says. “Depending on where schemes are in their journey plan will determine how much of an issue their illiquid investments might be.”
The new rules could trigger a rise in transactions on the secondaries market, as schemes look to sell-off such investments. “For schemes that decide to run on, one of the key issues will be how to manage any surplus that arises in the scheme,” Jarvis adds. “We are already starting to see schemes and their advisers come up with structures that will enable employers to access this surplus.”
For schemes that are already close to, or at significant maturity, it is not clear what the changes mean for them.
Faye Jarvis, Macfarlanes
Power shift
On the back of the Occupational Pensions Scheme Regulations, the regulator is also consulting on a new code which outlines how schemes should best implement these new rules, the DB funding code.
David Fairs, TPR’s executive director of regulatory policy, advice and analysis, sets out the regulator’s objectives. “In line with DWP’s draft regulations, our draft code is clear that all DB schemes should have the necessary long-term funding approach to ensure savers have the best chance of receiving the benefits they expect,” he says.
“We want to provide schemes with the continued flexibility around funding to suit their circumstances, while requiring trustees to think carefully about risk management to improve security for their members,” he adds.
The regulations and the code therefore introduce significant changes to the way DB schemes should be funded and, arguably, shift power more in favour of trustees.
This latter point is picked up by Jarvis. “There are some significant changes in relation to the trustees’ assessment of employer covenant,” she says. “The code is more prescriptive about how trustees should assess employer covenant strength.
“Trustees are expected to scrutinise management forecasts to understand the employer’s prospects and available cashflow and the period over which the trustees can reasonably rely on that cashflow to be available,” Jarvis adds.
Here, the extent of the information employers need to provide for the covenant assessment will depend on a number of factors, including the maturity of the scheme and its funding position.
Some employers could find they are subject to more extensive information requests from trustees. “It should mean better funded schemes with lower risk and an increase in settlements and buyouts,” Cowling says.
A costly move
A new single code of practice from TPR was expected to come into force this year but has been pushed back until April. The new code will require schemes to establish an effective system of governance and carry out an own-risk assessment.
Similar to the DWP, the focus of the TPR is on flexible change. “We want to provide schemes with the continued flexibility around funding to suit their circumstances, while requiring trustees to think carefully about risk management in order to improve security for pension savers,” Fairs says. “We will engage closely with the DWP and industry as we finalise the code after consultation.”
There is an additional factor Jarvis has identified that will impact on DB schemes. “The new regulations and code will further increase the costs of administering a DB scheme,” she says. “This, coupled with things like the more extensive information requests for covenant assessments and improved funding positions, may cause more employers to look at buyout as a serious option in the short-to-medium term.”
This could, therefore, have big consequences for DB schemes.
Added all together the changes on the regulatory front amount to what could in fact be the lessons of last year’s gilt crisis, and its severe impact on DB pensions, are being learnt fast. Or at least the crisis has speeded up thinking that has been taking place for some time within the DB scheme space.
Emerging trends
The big question surrounding this is simple: are DB schemes up to speed with the changes that will hit them?
“For those schemes that are poorly funded and/or with weak covenants, potentially they will have a short period of time to get to 100% funding on a low dependency basis,” Cowling says. This could be challenging for some.
“For all schemes, the events of last September and October – and the challenges with leveraged LDI – highlighted governance challenges and the fact that pension schemes are not always the best at the day-to-day monitoring of investments which can sometimes be needed,” Cowling says, adding that even so called ‘low risk’ investment strategies still contain material risks that trustees need to manage to keep on top of.
The new rules are likely to trigger changes to investment strategies. “There will possibly be a greater use of cashflow-driven investment strategies and also more use of delegated investment mandates,” Cowling says. “Over the longer term, there will be a big increase in insurance company buyouts.”
The meaning of change
What is essential is that schemes should already be discussing the implications. “We would expect most schemes to have had some discussions with their advisers about the proposed changes to the funding regime and what they mean for their scheme,” Jarvis says.
Although she adds confusion could also be a problem. “For schemes that are already close to, or at significant maturity, it is not clear what the changes mean for them.”
Here Jarvis highlights something of an anomaly: the regulations and code do not address what schemes should do if they are already at significant maturity but do not have a low dependency funding and investment basis. “Hopefully, the final version of the regulations and/or the code will address this issue,” she adds.
Cowling takes a different position, noting that the developments should, overall, be positive. “The move to lower risk investment strategies should be welcomed by members and trustees,” he says, but warns: “There’s still a huge amount of work to do to get the industry buyout ready, particularly with member administration data and legal due diligence.”
Jarvis does though identify potentially troubling challenges ahead on two fronts. The first connected to potential risks of herding within matching assets. And the second could be even more problematic, echoing a point made by Railpen’s trustees. “There could be the potential for systematic risks within gilt markets if lots of schemes want to sell gilts and there are no natural buyers,” she says.
Muddy waters
To add more complexity to the whole situation, the parallel Work and Pensions Select Committee inquiry into DB schemes raises several interesting questions on the future of such schemes.
Its remit originally emanated from investigating DB schemes and the liability-driven investment debacle of last year, but has led to a wider look into the working of DB schemes.
This could be seen as muddying the waters of the DB debate, when it is trying to offer clarity. “It seems odd to have such an inquiry at the same time as the DWP and TPR are finalising significant changes to the funding regime for such schemes,” Jarvis says.
But Work and Pensions Committee chair Sir Stephen Timms said this was an appropriate time for such work. “Now is a good time to investigate whether the regulatory framework is set up to enable private sector DB schemes to continue to thrive under good governance and provide positive outcomes for scheme members. We will also examine the way DB schemes can be consolidated or bought out.”
But with TPR confirming its DB Funding Code has been pushed back until April 2024 it puts the DB rules and regulatory picture in a potential state of flux.
But Jarvis adds that a delay may not be a bad thing. “A delay would seem to make sense, given the inquiry,” she says. “The issue of how to manage surplus in a DB scheme is topical at the moment.”
On this issue, there are, she adds, steps that could be taken by government to make it easier to return a surplus to employers. “Something that perhaps should be considered, given the amount employers have had to pay into schemes in deficit repair contributions in more recent years.”
So the DB pensions regulatory picture could take longer to resolve than anticipated. Or put another way: the new world for DB schemes could be only just beginning.
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