Background: the new DB funding regime

The new DB funding regime requires trustees to have in place a Funding and Investment Strategy and a Statement of Strategy in relation to scheme valuations with effective dates on and from 22 September 2024.

The Funding and Investment Strategy ("FIS") is how trustees intend the scheme to provide benefits over the long term. Scheme liabilities are calculated for those purposes on the basis that the scheme must have reached full funding on a low dependency (on the employer) basis at the point the scheme reaches the point of "significant maturity".

The Statement of Strategy documents the FIS in writing and also sets out a number of additional matters required by the legislation, including whether the trustees consider the FIS is being met, key risks faced by the scheme in implementing the FIS, and any significant decisions which the trustees have taken which are relevant to the FIS.

In addition to the new FIS and Statement of Strategy, which are focused on ensuring the scheme is funded appropriately over the long term, schemes will continue to conduct triennial valuations to assess the scheme's funding level based on the statutory funding objective. As a reminder, this is "to ensure that a scheme has sufficient and appropriate assets to cover its technical provisions." The technical provisions are derived from an actuarial assessment of the amount required to meet the scheme's liabilities. Under the new regime, they must now be calculated in a way which is consistent with the FIS.

Where schemes are in deficit based on the statutory funding objective, as previously, they will be required to put in place a recovery plan setting out the period over which the deficit will be recovered. Whereas under the previous regime, the period over which any deficit was recovered was not prescribed in legislation, under the new regime, legislation requires this to be done as "soon as is reasonably affordable" on the part of employer.

For further detail about the new DB funding regime see here.

Increased focus on covenant

Prior to the new DB funding regime coming into force, employer covenant was a key part of Regulatory guidance but did not form part of the underlying legislation. With the coming into force of the new DB funding regime, this has changed. The employer covenant is now defined in the legislation as, broadly:

• The financial ability of the employer to support its legal obligations to the scheme (including its funding obligations)
• The expected level of support for the scheme from any contingent assets to the extent the trustees could reasonably expect the contingent assets to be (i) legally enforceable by them and (ii) sufficient to provide that support at such time as the trustees may be required to enforce the support for the scheme.

Trustees will need to take into account strength of employer covenant both when setting the scheme's FIS and when preparing the related Statement of Strategy. A stronger employer covenant will allow the trustees to take a greater amount of investment risk. It may also be taken into account when setting actuarial assumptions used to calculate the scheme's liabilities and any recovery plan. These matters are important from an employer's perspective as they will impact the level of employer contributions to the scheme.

The role of contingent assets

Contingent assets can take various forms such as guarantees, asset security, surety bonds and holding structures such as escrow accounts. These type of assets, which become available to the scheme on the occurrence of pre-determined "trigger" events, have long been used in various pension scheme contexts, including supporting a funding plan agreed as part of a valuation.

As can be seen from the definition of the employer covenant referred to above, contingent assets are included within the new employer covenant definition as something which trustees can take into account when assessing employer covenant strength for the purposes of the new DB funding regime. In order to do so, however, trustees will need to ensure that the contingent asset in question meets the legislative requirements. Essentially this means that the trustees will need to be able to show that they reasonably expect that the contingent asset is legally enforceable and also that they will be able to access the support at the time it might be needed. For example, if a guarantee is being provided by an overseas parent, can the guarantee be enforced in the relevant overseas jurisdiction if necessary? If a guarantee can only be enforced on an insolvency event, what is the likely recovery and is insolvency the right trigger?

In addition to assessing whether a particular contingent asset meets the requirements under the legislation, trustees will need to take into account the parts of the Regulator's New DB Funding Code of Practice dealing with employer covenant, together with the updated covenant guidance published in December. The guidance, in particular, adds a lot of additional detail to the legislative framework (and also the Code of Practice). Although regulatory guidance is not binding, it can be taken into account when the Regulator or a court or tribunal is considering whether trustees have complied with their legal obligations.

The Regulator acknowledges in the covenant guidance that trustees can take a proportionate approach to assessing the value of any contingent asset (and assessing covenant more generally). Where trustees are placing material reliance on a contingent asset, a more thorough assessment will be required to ensure that the value of the contingent asset can support the level of funding and investment risk being taken, than were the level of reliance is small relative to the size of the contingent asset.

Look through guarantees

One particular area of the covenant guidance (and also certain parts of the associated DB Funding Code of Practice) which has generated discussion is in relation to the Regulator's approach to guarantees.

The Regulator has always expected trustees to carefully assess how much value (and consequently reliance) they should be placing on guarantees as part of the covenant support provided to the scheme. However, the updated covenant guidance has adopted a far more prescriptive approach than has previously been the case, with the Regulator pointing to a particular type of guarantee, which it refers to as a "look-through" guarantee, as effectively constituting a gold standard type of guarantee. The significance of meeting the Regulator's requirements for a "look-through" guarantee (see below) is that the Regulator considers that these can be used by trustees to support additional funding and investment risk. A guarantee which does not meet the Regulator's requirements for a "look-through" guarantee can still be put in pace and trustees may still place a value on it. However, trustees will need carefully to assess the reliance placed on such a guarantee and the purposes for which it can be taken into account. Trustees are likely to be more limited in terms of the value and the purposes for which they can take the guarantee into account than if a full look through guarantee is in place. The updated guidance contains examples to assist with this.

The guidance contains the following list of requirements which must be present in relation to the guarantee in order for the Regulator to consider it a "look-through" guarantee. The Regulator notes that these may be documented across more than one legal agreement.

• An underpin for the full section 75 deficit (broadly, an amount equal to the deficit on a buy-out basis)
• Recovery of any missed deficit repair contributions
• A legal mechanism allowing the trustees to "look through" to the guarantor's cash flows when setting contributions
• No time limitations on the duration of the guarantee (evergreen)
• No onerous conditions that could compromise the trustees' or Regulator's powers
• Legally enforceable in the UK and any relevant overseas jurisdictions (supported by appropriate legal advice)
• An information sharing protocol ensuring that the trustees can monitor the strength of the guarantor.

The intented effect of these conditions is that the guarantor would "largely replicate" the obligations placed on a statutory employer - the Regulator wants trustees to be able to take account of the financial strength of the guarantor in any assessment of contribution affordability and the appropriate duration of a recovery plan to meet a scheme's deficit under a schedule of contributions. This goes much further than has traditionally been the market standard for guarantees in a pension scheme context, including guarantees which have been put in place for PPF levy purposes. In particular, the requirement for there to be legal mechanism allowing the trustees to "look-through" to the guarantor's cash flows when setting contributions is not something which has typically been included in guarantees.

Trustees will, in conjunction with their employers, need to weigh up the ability to take more risk (in terms of both investment and funding risk) against other commercial factors involved in the giving of a guarantee which meets the stringent "look-through" requirements.

The covenant guidance can be found here.

Key takeaways

Understand how the new covenant guidance impacts your scheme. Employers and trustees should engage with their legal and covenant advisers to understand how the new covenant guidance will impact their particular scheme: Where existing guarantees are in place, trustees should be prepared to work with their legal and covenant advisers to understand whether or not they meet the requirements for a "look through" guarantee and, if they do not assess the value which can be placed on them in the context of the new regime.

Factor in additional time: where contingent assets are being provided as part of the funding support package, trustees may need to allow additional time to assess and agree these. It will be particularly important to document how decisions about the value of contingent assets have been reached. As the Regulator notes, the new requirements for guarantees may be documented across more than one legal agreement.

Information sharing protocols. Trustees and employer will need to ensure that information sharing protocols are in place if they wish to meet the requirement for a look through guarantee. Even if trustees are not needing to meet the formal requirements for a look through, it would be good practice for trustees to ensure that these are in place and up to date.

The new guidance in other contexts. Whilst the updated covenant guidance strictly only apples in the context of scheme funding, it is possible that we could see the Regulator taking a similar approach to contingent assets adopted in the updated covenant guidance (including in relation to guarantees) where they are being provided as mitigation to any detriment caused to the scheme, for example as a result of a corporate transaction.