New funding rules for defined benefit (DB) pension schemes could see British employers hit with a bill of up to £34bn (€38.7bn), based on official estimates buried in one of a series of recently published consultation documents by The Pensions Regulator (TPR), LCP research suggested.
Since the controversy over the under-funding of pension schemes such as Carillion in 2018 and BHS in 2017, the UK government has stated its intention to toughen up the DB funding regime, and the proposed new framework is now in its final stages, following the passage of the Pension Schemes Act 2021.
In July 2022 the Department for Work and Pensions (DWP) published a set of draft ‘funding and investment’ regulations for comment, whilst in December 2022, TPR published a second consultation on its proposed ‘funding code’.
Taken together, the final versions of these documents will set out the new funding regime, with the government intending the new rules to come into force in October 2023.
A central feature of the new rules is that pension schemes will have to be funded on a ‘low dependency’ basis by the time they are ‘significantly mature’.
The exact definitions of both of these terms are still to be finalised, but the basic idea is that once pension schemes are mainly made up of pensioners they should be taking little investment risk, and should not expect to call on their sponsoring employer for additional funding.
In addition, the proposed new law says that trustees should expect employers to pay down any deficits “as soon as reasonably affordable”.
A key challenge for plan sponsors, LCP said, is that their schemes may not currently be funded at this level and/or may not currently be planning to be funded at this level by the time they are mature.
Given that the DWP regulations give no indication of a transitional period, employers could find themselves receiving demands from schemes for large sums, collectively running into tens of billions of pounds, the consultancy noted.
Prior to the publication of the TPR code consultation in December there had been no official estimate of the impact of these new rules. Indeed, in July 2022 DWP declined to provide such estimates in its own consultation document on the basis that the impact of the new regime would depend on TPR’s code.
However, when TPR published several lengthy consultation documents in December, one of them included an estimate that the cost to firms of the new rules could be up to £34bn, LCP said.
The estimate can be found in TPR consultation “Fast Track and our regulatory approach”. The regulator has calculated the potential bill if all DB pension schemes that are currently funded below the proposed level were to ‘level up’ to the prescribed level, and assuming that none of the schemes that are currently funded above that level chose to ‘level down’.
According to LCP, there are some reasons why the £34bn figure is likely to be an upper estimate of the potential cost:
- TPR’s estimates were based on market conditions as at March 2021, and scheme funding will have generally improved since that date;
- some schemes may seek to adopt a ‘bespoke’ funding package, for example because their sponsor offers strong financial support or pledges so-called ‘contingent assets’ to stand behind the pension scheme, providing greater security and reducing the need for an immediate injection of cash.
Nonetheless, even if the final figure turns out to be lower than this, LCP said that there can be little doubt that for some employers these new rules will represent a significant new or additional burden.
For some firms – LCP had previously estimated around 200 – it may be impossible to meet the new rules whilst remaining solvent, and this might mean cuts to member benefits as a result.
Even for those firms that can meet these new obligations, the legal requirement to clear deficits ‘as soon as reasonably affordable could curtail other business activities in some cases such as paying dividends, improving wages of the current workforce or investing in the business.
Michelle Wright, partner at LCP, said: “The government needs to be open about the potential impact of these new funding rules. The legal requirement to improve funding for schemes will apply at the first regular ‘valuation’ of the scheme as soon as the new law is passed, which for some could be later this year. Employers could face demands from pension schemes collectively running into tens of billions of pounds over the following five years or so.”
She added: ”Whilst everyone wants to see company pension schemes properly funded, this needs to be done in a proportionate way, rather than imposing rigid new rules overnight. In many ways, these new proposals are responding to the funding problems of years ago, when today’s world of pension scheme funding looks completely different.”
Wright said there was still time for the government to “think again and give schemes and their employers time to adjust to the new funding regime”.
“Without this, some businesses could find they simply cannot afford what they are being asked for and could be at risk of insolvency, which is an outcome in no-one’s interest,” she said.
Reasonable affordability
A TPR spokesperson said: “Reasonable affordability is central to the regulations and our DB Funding Code, including that the sustainable growth of the employer should be taken into account. Employers will not be forced into contributions that would drive them to insolvency.”
The spokesperson added that the Scenario 3 in TPR’s Fast Track analysis was included as part of the regulator’s sensitivity analysis and illustrates an extreme scenario. “As we stated, it is not one that we would expect in practice,” the spokesperson noted.
The spokesperson explained that Scenario 3 shows the estimated deficit if all schemes with lower technical provisions moved up to Fast Track parameter levels and there is no “levelling down” by other schemes. This scenario is not one that is expected in practice – as schemes will use the flexibility available through the Bespoke route and some may take the opportunity to level down – rather it is included to illustrate a more extreme impact.
“The DWP regulations and proposals we have set out for consultation include flexibility for schemes and employers and take a proportionate approach,” the TPR spokesperson said.
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