Last month the government published its response to the draft Occupational Pension Schemes Regulations 2023 consultation. This has set the stage for the new defined benefit (DB) funding regime which goes into effect in April and will apply to valuations from 22 September. To what extent will the new framework change the status quo, and what areas need further refinement?

The new funding regime calls for schemes to take appropriate actions to protect their members’ benefits by lowering investment risk and reducing sponsor dependency at the point of significant maturity. Although these principles were part of the draft code, the initial version was overly rigid about trustees’ decision-making. 

To resolve this, the government revised the regulations to make it clear that neither trustees nor managers will be required to strictly invest with a low dependency investment allocation. This is a welcome improvement and strikes a fair balance between allowing trustees to retain their autonomy and achieving the regime’s long-term objectives for members.

The draft code required schemes to use the duration of liabilities as a measure of scheme maturity. This approach, while relatively straightforward, is nonetheless vulnerable to shifting economic conditions that could disrupt long-term plans. Indeed, events like the mini-budget crisis underscore how abruptly schemes can be forced to push their proposed significant maturity date. 

Given such risks, the framework now includes a prescribed date of 31 March 2023 as the reference date for economic assumptions used to calculate maturity. This mitigates volatility in the duration measure. However, the regulators still need to clarify the duration at which a scheme reaches significant maturity – hopefully soon once the actual DB funding code is published. 

Interestingly, our Pension Risk Transfer Report 2023 shows that many schemes were already within five years of reaching their endgame around the prescibed date. Therefore, most are unlikely to be affected by the definition of significant maturity, unless it comes with stricter de-risking requirements. 

The draft code was mostly tailored for closed DB schemes, which left little scope for open schemes which operate under an entirely different set of circumstances when calculating maturity. Moreover, making them follow a stricter funding and investment path forces them to de-risk too rapidly which in turn increases their technical provisions. 

The updated regime fixes this by allowing open schemes to account for new entrants and future accrual as they calculate their point of significant maturity. It also permits these schemes to extend the period before they are expected to reach low dependency. Most importantly, open schemes will continue having scope to invest in growth assets under the new regime. 

While the framework is more accommodating towards open schemes, data from our annual pension risk transfer report also shows that many schemes pursuing run-off are underfunded and will need to continue investing in riskier, less liquid assets to close their funding gap. Given the more relaxed approach to de-risking, the new funding and investment framework will likely continue to support that. 

The original framework’s affordability principle called for trustees to recover funding deficits as soon as it is reasonably affordable for the employer to do so. This was sound in principle, yet it created a challenge for schemes and sponsors and in some ways conflicted with TPR’s statutory objective to minimise the impact on the employer’s ability to grow. Another downside was that this approach dissuaded schemes from risk-taking, which would have limited their ability to close deficits with investment returns. The draft DB funding code was also challenging because it forced sponsors to release capital to support schemes so rapidly that they left the scheme at risk of having a trapped surplus. 

In the updated framework, supporting the sustainable growth of employers will remain a central consideration alongside affordability. The new regime also clarifies that reasonable affordability will have prevalence over other considerations. Finally, the updated version no longer requires schemes to evidence their discount rates or the appropriateness of their strategy.

This is important because most of those targeting run-off still use a ‘gilts plus’ discount rate. In most cases this level of risk seems warranted because most of these schemes have strong covenants and much longer time horizons than those pursuing buy-out.

Interestingly, our Pension Risk Transfer Report 2022 shows that schemes with funding deficits were the ones most likely to impede their sponsor’s ability to grow. However, this may be less of a problem today given that DB funding levels have improved dramatically since then. 

The government’s pragmatic response to the industry’s concerns has provided much needed clarity and direction but, for now, it seems that it will have limited impact on the funding and investment strategy. 

Nevertheless, several important areas require further attention. One such issue is how to make surplus extraction easier for schemes. Fortunately we may have direction on this soon now that the Department for Workforce and Pensions (DWP) has launched a consultation seeking views on surplus extraction.

The Regulator is also looking to improve its Fast Track parameters, revising the point of significant maturity and seeking views on the statement of strategy to lessen trustees governance burden.    

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