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Targeting “low dependency”
A key principle of the new requirements is that DB scheme trustees must aim to achieve “low dependency” by the time the scheme reaches “significant maturity”.
Low dependency means both:
- Investing the scheme assets in line with a low dependency asset allocation (expecting no further employer contributions for accrued rights; with cash flow from investments broadly matching benefit payments; and the value of assets relative to liabilities being highly resilient to adverse short term market movements); and
- Ensuring the scheme is fully funded on a low dependency funding basis (a 1:1 funding level, assuming no further employer contributions and a low dependency asset allocation).
Some in the pension industry with long memories have commented that the new low dependency funding basis looks like a “new minimum funding requirement (MFR)” – although with considerably tighter actuarial assumptions than under the Pensions Act 1995 MFR regime.
What is a scheme’s significant maturity?
In layman’s terms, a scheme’s significant maturity will be found by:
- Calculating how long on average it will be until the benefits under the scheme are due to be paid (applying discounting for investment return, so that benefits further into the future have a lower weighting than benefits payable earlier) – this average time is known as the scheme’s “duration of liabilities”;
- The scheme will reach its significant maturity when its duration of liabilities is the number of years specified by the Pensions Regulator (TPR) in a Code of Practice. (Previous indications are that TPR will specify 12 years, but this could change.)
For example, assuming that TPR specifies 12 years, a scheme whose duration of liabilities is 20 years (so the average discounted benefits will be payable in 2042) will reach significant maturity in 2030 (2042 less 12 years).
However, shifts in market conditions can alter the factors used for discounting future benefit payments, and therefore change a scheme’s duration of liabilities and its time to significant maturity. Increasing yields (and discount factors) will reduce the value of future benefit payments and will shorten the period before a scheme reaches significant maturity (or may mean that the scheme has already reached that point).
Another concern is that a scheme which has bought in its pensioner liabilities (so its obligations to pay current benefits are matched by a bulk annuity policy) will have the same significant maturity as a scheme with an identical membership but which is relying on return-seeking investments to pay its current pensioners. Logically, liabilities which are matched by a buy in policy should be excluded from the calculation of a scheme’s significant maturity.
Funding and investment strategy
Trustees will have to adopt a “funding and investment strategy” (FIS) and, in most cases, must agree this with the sponsoring employer. The level of risk which may be taken (with investments and in the actuarial assumptions) should be linked to the strength of the employer covenant and the length of time to the scheme’s significant maturity.
Trustees must also prepare a statement evaluating how the FIS has been implemented, including steps to remedy any defects in its implementation.
Actuarial valuations and recovery plans
In actuarial valuations, the scheme actuary will have to estimate the scheme’s funding level on the low dependency funding basis (in addition to the funding position on the technical provisions (scheme specific) basis and the buyout (section 75) basis).
The draft regulations also propose that scheme deficits should be recovered “as soon as the employer can reasonably afford”.
Consultation
The regulations have so far only been issued in draft and are still subject to consultation. It remains to be seen whether concerns raised by the pension industry (to which we are contributing) will be taken into account in the final regulations.
Authored by the Pensions Team.
