DWP consultation on the draft Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023
The DWP has issued a consultation (“the Consultation”) on the draft Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023 (“the Draft Regulations”) setting out details of the requirement for trustees to have a funding and investment strategy (“F&I Strategy”), and a written statement of that strategy (“Statement”). The proposals will supplement existing funding requirements under the Occupational Pension Schemes (Scheme Funding) Regulations 2005 (“the Scheme Funding Regulations 2005”).
In this response
We welcome the opportunity to respond to this consultation. In addition to answering specific consultation questions which are pertinent to our practice, or which we believe could give rise to difficulties in practice for our clients, we have provided some initial general comments.
We have the following concerns about the proposed approach outlined in the Draft Regulations:
Interaction with the scheme funding Code of Practice (“the Draft Code”) to be published by the Pensions Regulator (“TPR”)
- As the two are intrinsically linked, it is difficult to properly assess the impact of the Draft Regulations without first having seen the Draft Code, which is expressly referred to in several places in the Draft Regulations. It would be useful to have a further opportunity to comment on the Draft Regulations once the Draft Code is published for consultation.
- The new requirements will add extra steps for defined benefit (“DB”) occupational pension schemes to take as part of the scheme funding process. This will inevitably result in extra burdens on resource and costs, regardless of the size of the scheme. It would be helpful to understand how TPR expects to use the information contained in an F&I Strategy and Statement in practice, and to have a clearer understanding of TPR’s proposed enforcement approach where there is non-compliance.
- The Draft Regulations are being made under the Pension Schemes Act 2021 (“PSA 2021”), which specifically delegates a number of points to be dealt with in the Draft Regulations. In turn, the Draft Regulations purport to delegate a number of issues, such as what amounts to “significant maturity” and when a scheme reaches “the duration of liabilities”, to be determined by the Draft Code. This further sub-delegation does not appear to be authorised by the primary legislation.
Scheme-specific approach and open schemes
- In response to concerns expressed by the House of Lords regarding the position of open DB schemes, during the passage of the PSA 2021 through Parliament, important Government assurances were secured. In particular, not wanting to see “good and viable” DB schemes close unnecessarily, Baroness Stedman-Scott (on behalf of the Government) stated that both the regulations under the PSA 2021 and TPR’s revised Draft Code “will acknowledge the position of open and less mature schemes”, and that the scheme funding regime “will continue to apply flexibility to take account of individual scheme circumstances”.
- This sentiment is echoed in paragraph 1.3 of the Consultation, which states that the DB funding regime “is scheme specific and will remain so” and that it “applies flexibly to the particular circumstances of individual schemes and their sponsoring employers”. However, the rigid drafting of the Draft Regulations seems to be inconsistent with this policy intent. This would also appear at odds with TPR’s statutory objectives when exercising its scheme funding powers.
- As currently framed, the Draft Regulations do not appear to recognise that some open schemes may not be maturing in the same progressive way as closed schemes. We understand that it may not be practical for open schemes to identify the point at which the scheme will be “significantly mature”, as this may require an assumption to be made about the point at which no new members will join the scheme. Identifying the “relevant date” could have a significant impact on valuations for such schemes, accelerating funding requirements, since the F&I Strategy must be taken into account when setting technical provisions. We are aware that this is a key concern for many open scheme clients, and we expect responses from open schemes, and responses covering actuarial aspects of the consultation, will comment on this in further detail. However, we are concerned that the requirements will make good quality open DB schemes, with good sponsoring employer support and standards of member security, more expensive to run, encouraging cost-cutting measures such as benefit redesigns and scheme closures.
- Further comments on how the Draft Regulations appear to conflict with a scheme-specific funding approach are set out in answer to specific questions below.
- When exercising its scheme funding functions, TPR is subject to an overriding statutory objective “to minimise any adverse impact on the sustainable growth” of a sponsoring employer (section 5(1)(cza) of the Pensions Act 2004 (“PA 2004”)). There appear to be a number of tensions between the Draft Regulations and this statutory objective, one such example being in relation to the position of open DB schemes outlined immediately above.
Balance of powers between trustees and employers
- It would be helpful to have more clarity on the employer’s involvement in the F&I Strategy, as the drafting of the PSA 2021 here is somewhat ambiguous. Once implemented, section 229(1)(za) of the PA 2004 will require employer agreement to the F&I Strategy “as set out in the scheme’s [Statement]”. It is unclear whether this is intended to mean that the F&I Strategy itself is subject to employer agreement, or only the way in which that strategy is encapsulated in writing.
- Draft Regulation 12 would require the allocation of assets to different classes at the relevant date to be set out in the F&I Strategy. Trustees are subject to investment duties as a matter of trust law and the existing pensions law requirements under sections 33 to 36 of the Pensions Act 1995 (“the PA 1995”). Whilst the balance of powers set out under scheme rules may differ, trustees are not obliged to seek employer agreement when exercising investment powers in accordance with the PA 1995. It is important that the new funding requirements do not inadvertently cut across or change the balance of powers between trustees and employers. In addition, if key investment decisions are to be made subject to employer agreement, this would require changes to be made to the PA 1995 provisions.
(i) Do you think that it would be better for the duration of liabilities at which the scheme reaches significant maturity to be set out in Regulations rather than the Code of Practice?
As per our general comments above, there is no clear legislative authority to delegate what amounts to “significant maturity” and when a scheme reaches “the duration of liabilities” to the Draft Code. As codes of practice have to be laid before Parliament, we would also question whether specifying a one-size-fits-all approach when it comes to the meaning of “duration of liabilities” (ie 12 years) offers sufficient flexibility or, indeed, is in keeping with the principle of scheme-specific funding.
Although codes of practice are not legally binding as such, they are admissible in evidence in legal proceedings and must be taken into account where relevant. Taking a rigid approach to when schemes reach significant maturity might conceivably heighten the risk of future funding disputes, when the parties are simply pursuing a scheme-specific approach in line with the primary legislation.
An alternative might be for the Draft Regulations to specify the approach which schemes should take once they reach significant maturity, with the Draft Code outlining TPR’s expectation as to when this might be (eg in line with the fast-track funding proposals), whilst also providing sufficient scope for open DB schemes, those following the bespoke route, and future shifts in the DB pensions landscape.
As a consequence, we consider it would be more consistent with existing pensions legislation, and with the principle of scheme-specific funding, for Draft Regulation 4(1)(b) to be reworked. For example, it could define the point of significant maturity by reference to a reasonable period, giving TPR power to set out its expectations of what this means but with sufficient leeway to deviate where appropriate.
(ii) If you think that the point of significant maturity should be specified in Regulations, do you agree that a duration of 12 years is an appropriate duration at which schemes reach significant maturity?
See comments in response to Question 1(i) above.
Low dependency investment allocation
Do you think that the definition of low dependency investment allocation provided by Draft Regulation 5 is appropriate and will it be effective?
Draft Regulation 5(1) refers to the objective that “further employer contributions are not expected to be required”. In contrast, paragraph 3.11 of the Consultation adds the words “under reasonably foreseeable circumstances”. Whilst in practice the two phrases might ultimately mean the same, the latter could prove more restrictive, only allowing for fairly extreme events. We therefore assume that no such qualification will be introduced into the Draft Regulations.
As Draft Regulations 5 and 6, as well as paragraph 3 of Schedule 1, will restrict trustees’ investment options once a scheme reaches significant maturity, the proper authority for making such changes would appear to us to be section 36 of the PA 1995.
In addition, we wonder whether more flexibility could be introduced to the definition of low dependency investment allocation while still meeting the DWP’s objectives, to reflect that a prescribed low dependency investment allocation may not be appropriate in all circumstances. For example, transitional arrangements could be introduced for schemes which are already at or near significant maturity which may otherwise have to make abrupt adjustments to their investment strategy to comply with the new requirements.
Low dependency funding basis
Do you think that the definition of low dependency funding basis provided by Draft Regulation 6 is appropriate and will it be effective?
Please see our response to Question 2 above.
Strength of employer covenant
i) Do you agree with the way that the strength of employer covenant is defined?
Need for a scheme-specific approach
Covenant advice is given in different ways to different schemes, reflecting the scheme’s structure, whether it is open to future accrual of benefits and new entrants, and the legal obligations of sponsoring employers. Draft Regulation 7 does not seem to accommodate a scheme-specific, proportionate approach.
Draft Regulation 7 also raises challenges for multi-employer schemes which are not formally segregated, and therefore not covered by the amendments made by Draft Regulation 20(9), as well as formally segregated schemes with multi-employer sections. It appears to require trustees to carry out the same covenant assessment for each sponsoring employer without taking into account the employer’s specific legal obligations. This could give rise to a misleading impression of the covenant.
TPR’s existing guidance on assessing and monitoring the employer covenant (which we understand will be revised as part of TPR’s consultation on the Draft Code) emphasises the importance of taking into account the circumstances of each scheme and each sponsoring employer in relation to that scheme. Particularly for schemes with more complicated structures which necessitate a more sophisticated covenant review, a prescriptive list of requirements would be unhelpful.
TPR’s guidance also outlines further considerations for non-associated multi-employer schemes, such as the mechanics of employer withdrawal and trustees’ powers to impose contributions. We consider that latitude is needed for a similarly scheme-specific approach here.
Appointing covenant advisers
While pension scheme trustees are legally required to appoint certain professional advisers such as auditors and actuaries (and legal advisers where trustees intend to rely on their advice), they are not currently required to appoint a covenant adviser. It is not clear from the Draft Regulations who should appoint the covenant adviser, the trustees, sponsoring employers or both. Is this intentional, as it could give rise to disagreement in practice?
Section 47 of the PA 1995 (appointment of professional advisers by trustees) does not appear to specifically cover the appointment of a covenant adviser. Is it intended to expand this section to require this?
ii) Are the matters which trustees or managers must take into account when addressing it, as provided by Draft Regulation 7, the right ones?
This is difficult to assess without seeing the proposed Draft Code which will set out further factors (under Draft Regulation 7(4)(c)). There should be sufficient flexibility for trustees to take into account a wide range of factors appropriate to the circumstances of their specific scheme and sponsoring employer(s).
iii) Does Draft Regulation 7(4)(c) effectively capture the employer’s broader business prospects?
Please see our response to (ii) above.
Does it work in practice to set a minimum requirement for the relevant date to be no later than the end of the scheme year that the scheme is estimated to reach significant maturity?
We have no comments in relation to the timing of the relevant date, but please note our general comments above in relation to the impact on open DB schemes of the requirement in Draft Regulation 8(1) for all schemes to set a relevant date.
Expanding on this, for open DB schemes the “relevant date” may be of little practical significance to the scheme’s long-term strategy, since this will be a moving target and some way in the future. As mentioned in our general comments above, some open schemes may not be increasing in maturity. Having to identify the “relevant date” at which the scheme will have a low dependency asset allocation, and to take the F&I Strategy into account when setting technical provisions, could therefore result in the very real risk that open DB schemes will face increased funding pressure and the need for accelerated employer (and possibly member) contributions.
Does your scheme already have a long-term date and how is it calculated?
Our expectation is that schemes will not have set long-term targets on the same basis as the “relevant date” and “low dependency asset allocation” are defined in the Draft Regulations. This could mean that schemes targeting self-sufficiency will need to revise their journey plan to comply with the Draft Regulations. Mature schemes in particular may need to make significant changes to their current investment strategy. Transitional protections could help manage this change.
Where the F&I Strategy is being reviewed out of cycle with the actuarial valuation, would it be more helpful to require it to align with the most recent actuarial report?
This would seem sensible, as would providing trustees with a discretion to decide here.
Minimum requirements on and after the relevant date
Do you think that these minimum requirements are sensible and will provide additional protection for the accrued pension rights of scheme members?
We consider that the minimum requirements are restrictive. In particular, that they do not allow for additional flexibility where the sponsoring employer covenant is strong and could support higher levels of investment risk.
i) Should such limited additional risk at and after significant maturity be permitted, if supported by contingent assets? If so, to what percentage of total liabilities should this be limited?
We agree with the principle that additional risk at and after significant maturity should be permitted if it is adequately supported, but we are unclear why this support would be limited to contingent assets only, rather than allowing the wider sponsoring employer covenant as a whole to be taken into account.
In our view, the level of risk permitted should be linked to the overall level of ongoing support being provided.
ii) What additional risks to members’ benefits might be posed as a result, and what safeguards should apply to protect members?
Decisions to take additional investment risk would be subject to the existing legal duties on pension scheme trustees when exercising their investment powers. In our view, there would not be material additional risks to members’ benefits if investment risk is adequately supported by legally enforceable contingent assets, or the wider sponsoring employer covenant, and if the level of risk is appropriate taking into account the strength of that support.
Investment risks on journey plan
Do you think that the provisions of paragraph 4 of Schedule 1 will allow appropriate open schemes to continue to invest in growth assets as long as that risk is appropriately supported?
We have no particular comments on this specific provision in isolation, but please note our general concerns outlined above in relation to the impact on open DB schemes of the proposals as currently framed.
Risk in relation to calculation of liabilities on journey plan
Do you think that the principles in paragraphs 4 and 5 of Schedule 1, requiring funding risks and investment risks to be linked primarily to the strength of the employer covenant, are sensible?
These principles seem to be in line with TPR’s existing approach in relation to integrated risk management. However, please note our general comments and response to Question 13 in relation to the policy aim of maintaining a scheme-specific approach.
Do you think that the new liquidity principle set out in paragraph 6 of Schedule 1 is a sensible addition to the exiting liquidity requirement of regulation 4(3) of the Occupational Pension Schemes (Investment) Regulations 2005?
It would be helpful for paragraph 6(2) of Schedule 1 of the Draft Regulations to clarify that the assessment of liquidity can take into account expected cash flow into the scheme (ie regular member and employer contributions to open DB schemes, and deficit recovery contributions and investment returns).
Will the matters and principles set out in Schedule 1 enable the scheme specific funding regime to continue to apply flexibly to the circumstances of different schemes and employers, including those schemes that remain open to new members?
Schedule 1 is significantly more prescriptive than the current funding legislation and will be difficult to apply to certain types of schemes, in particular DB schemes open to new members. To comply with the Draft Regulations, trustees will in effect need to treat the matters and principles as akin to minimum funding and investment requirements. As currently drafted, it may be misleading to refer to “principles” which suggests a level of flexibility not permitted by the prescriptive nature of the Draft Regulations.
F&I Strategy – level of detail
Is the level of detail required for the F&I Strategy by Draft Regulation 12 reasonable and proportionate?
Please see our general comments above in relation to the impact of the Draft Regulations on open DB schemes, as well as the balance of powers between trustees and employers.
Again, it is difficult to see how trustees should establish the “relevant date” in an open DB scheme, unless it is permissible for it always to be “x” number of years away.
Do you think the requirement for high level information on expected categories of investments will impact trustees’ independence in making investment decisions in the interests of scheme members?
Please see our general comments above as to the potential for the Draft Regulations to cut across trustees’ existing investments powers and obligations. As currently drafted, there is a risk that sponsoring employers that disagree with trustees’ investment choices could withhold their consent to the Statement.
Determination, review and revision of F&I Strategy
Are the requirements and timescales for determining, reviewing and revising the F&I Strategy in Draft Regulation 13 realistic?
The timeframe for determining, reviewing and revising the F&I Strategy should align with the existing timeframe and triggers for reviewing scheme funding documents. As currently drafted, trustees will be required to review and if applicable revise the F&I Strategy “as soon as reasonably practicable after any material change” in the circumstances of the scheme or sponsoring employer (Draft Regulations 13(2)(e) and 13(3). This requirement could potentially result in frequent “out of cycle” reviews, as this trigger could capture a very wide range of scenarios, requiring schemes to undertake reviews where it would not be pragmatic or proportionate. For example, is it intended that a material change will be triggered by short-term market fluctuations which impact the scheme’s assets or liabilities, or higher inflation or gilt rates?
This wording also appears to capture a wider set of circumstances than, for example, the requirement to review a recovery plan where trustees “consider that there are reasons that may justify a variation to it” (under regulation 8(5) of the Scheme Funding Regulations 2005). It may be that the Draft Code will interpret “material change” more restrictively so as to reduce the impact on schemes and sponsoring employers.
As mentioned in our general comments above, we would therefore welcome the opportunity to review the Draft Code when it is published for consultation, in tandem with an updated version of the Draft Regulations.
Statement of strategy
Are there any other assessments or explanations that trustees should evidence in Part 2 of the Statement?
The proposed supplementary matters are extensive, and we do not suggest including any additions. Our comments on draft Schedule 2 are as follows:
- Trustees will be required to include in the Statement various information about the sponsoring employer covenant, including an assessment of the strength of the employer covenant (at paragraph 14). Trustees will also need to explain the evidence on which this is based (under Draft Regulation 15(4)). Covenant assessments often rely on employers agreeing to share sensitive commercial information with trustees, typically subject to confidentiality terms and sometimes involving negotiation. Trustees cannot require employers to share such information, and sponsoring employers may be more reluctant to do so if it would then be disclosed in the Statement. This could cause issues in carrying out covenant assessments and potentially make the assessments more limited.
- As things stand, the Statement will only need to be shared with TPR. It is currently unclear how TPR will use the detailed information which will need to be provided and the degree to which this will enhance (if at all) the information already shared with TPR as part of the scheme funding process. Subject to redacting confidential information, we expect that some trustees may want to share relevant parts of the Statement with members and/or some members may expect it to be published. We wonder whether the comprehensive detail to be included in the Statement will make it difficult for trustees to adapt the Statement to audiences other than TPR (either voluntarily or in the event wider disclosure becomes a requirement in the future – for example as part of schemes’ summary funding statements under the PA 2004). A shorter Statement could provide equally helpful information to TPR and be more suitable for sharing with members.
- For some schemes, there is likely to be a significant additional administrative burden associated with preparing the Statement. Please also see our comments in response to Question 24.
Requirements for chair of trustees
Do you agree that these are the appropriate requirements for the scheme trustee board when appointing a chair? Are there any other conditions that should be applied?
The requirements recognise the wide variety of highly skilled chairs and are not overly prescriptive, and we have no other suggested conditions.
Do you consider that the new affordability principle at Draft Regulation 20(8) should have primacy over the existing matters, if they do remain relevant?
We consider there could be inadvertent consequences in treating this requirement as having primacy over existing requirements:
- When exercising its scheme funding functions, TPR has a statutory objective to minimise any adverse impact on the sustainable growth of employers. This does not sit comfortably with the proposed requirement under Draft Regulation 20(8). It would be helpful if this could be clarified in the Draft Regulations and/or the Draft Code.
- The proposed requirement under Draft Regulation 20(8) that, in setting recovery plans, trustees must follow the principle that “funding deficits must be recovered as soon as the employer can reasonably afford” could represent a significant change of emphasis in the scheme funding legislation. The impact may depend on how “reasonable affordability” is ultimately interpreted. It would be helpful if this could be clarified in the Draft Regulations and/or the Draft Code.
Will the requirements in Draft Regulations 20(9) work in practice for all multi-employer pension schemes?
As noted in our response to Question 4 above, we do not consider the definition of strength of the employer covenant in the Draft Regulations works for all multi-employer pension schemes.
As a minor comment, the definition of “Funding and Investment Strategy Regulations” in Draft Regulation 20(2) refers to the Draft Regulations as dated in “2022”. Presumably, this will be updated to reflect the final name of the Draft Regulations.
Business burdens and regulatory impacts
Do you agree with the information presented in the impact assessment for the F&I Strategy?
Please see our response to Question 24. The extent of the impact on schemes and sponsoring employers is only likely to become clearer once TPR has published its proposed Draft Code.
Do you expect the level of detail required for the F&I Strategy to increase administrative burdens significantly?
The extent of the administrative burden is difficult to assess in the absence of TPR’s proposed Draft Code. But preparing an F&I Strategy and Statement in compliance with the Draft Regulations will inevitably increase administrative burdens, primarily for pension scheme trustees. We expect most schemes and sponsoring employers will need to make material adjustments to their existing funding review processes, and to build in additional time allowance and resources for compliance. There will also be an initial impact when the new requirements are first introduced, so ample time will be needed for trustees and sponsoring employers to familiarise themselves before the “go-live” date, taking into account other pensions developments which may be being implemented around the same time.
We are concerned that the impact will be especially significant for smaller schemes. Increasing regulatory burden can cause particular issues for any smaller DB schemes which find the financial and resource cost of regulatory compliance disproportionate, since there are comparatively limited options for such schemes to consolidate or otherwise transfer their risks.
Do you agree with the information presented in the impact assessment for the Statement, referenced in paragraph 6.1?
Please see our response to Question 24. The impact on schemes and sponsoring employers may become clearer once TPR’s Draft Code is published.