Pensions Essentials - July 2024

The Pension Schemes Act 2021 amended the Pensions Act 2004 to require trustees to have a funding and investment strategy (FIS) setting out the funding level the scheme should have achieved at the “relevant date” and the investments the scheme intends to hold on that date. Regulations also require the trustees to have a journey plan describing how the scheme will be fully funded at the point it reaches the relevant date. The FIS will require the consent of the employer where its consent is already required in relation to other funding documents. Otherwise, the employer will need to be consulted. The code of practice explains when consent is required and when consultation will be sufficient.

The code sets out the Regulator’s interpretation of how to comply with the statutory funding requirements. However, whilst some provisions in the code reflect legal duties and are referred to as things that trustees “must” do, much of it is only the Regulator’s view of what best practice is and the code says that trustees “may choose to follow an alternative approach… provided they are satisfied that underlying legal requirements are met”. Therefore, trustees need to ensure that they have actuarial, covenant and legal advice on how the new requirements apply to them and what is appropriate for the circumstances of their particular scheme.

Some key points to note from the new code of practice include:

• Significant maturity: The ”relevant date” for the purposes of the FIS is a date chosen by the trustees, not later than the end of the scheme year in which the scheme will reach “significant maturity”. “Significant maturity” is defined in the code as when a scheme has a duration of liabilities of 10 years (or, in the case of a cash balance scheme, 8 years), calculated in accordance with a specified formula. The calculation must be carried out using an actuarial basis that is the same as the scheme’s low dependency funding basis (see below), except for economic assumptions which must be chosen by reference to the economic conditions prevailing on 31 March 2023.
• Investment: The FIS must take into account the objective that, once a scheme reaches significant maturity, the assets required for full funding (but not any surplus) should be invested in a way that is highly resilient to short-term adverse changes in market conditions and no further employer contributions are anticipated. However, the code confirms that trustees “are not required to invest in line with [this] low dependency investment allocation” and gives examples of situations where the actual investment allocation may be different from the low dependency investment allocation, such as where there is a material surplus.
  
  The code sets out what a low dependency asset allocation might look like and how trustees can test resilience to market movements.  The level of detail the Regulator expects depends on how close the scheme is to maturity – the closer it is, the more granularity is required.  The code also looks at investment de-risking considerations as a scheme progresses along its journey plan.
• Funding: The FIS must follow the principle that the scheme should be fully funded at significant maturity on the assumption that no further employer contributions are made and the assets are invested in a low dependency investment allocation. The code says that trustees should assess whether this test would be met under most reasonably foreseeable scenarios but that they are not required to eliminate the requirement for further employer contributions with certainty, just to be satisfied that the likelihood of requiring them is small.
  
  The code sets out how the trustees should determine the assumptions to be used for the low dependency funding basis, including discount rates, inflation and mortality assumptions. Where there is no requirement under scheme rules for employers to meet expenses, the Regulator expects there to be a reserve for expenses and encourages trustees to consider a reserve in other cases.
• Employer covenant: The level of risk that can be taken in actuarial assumptions used in the FIS and in the journey plan is dependent in part on the strength of the employer covenant. Regulations set out issues which must be taken into account in assessing covenant strength, including the employer’s expected cash flow, the performance, future development and resilience of its business, and the likelihood of an insolvency event, as well as how long the trustees can be reasonably certain they can rely on an assessment of these matters.
  
  Trustees are expected to carry out a covenant assessment at each valuation as a minimum and they should document the approach taken and be able to justify why it is appropriate. For most employers, the code says that cash flow reliability will only be over the short to medium term (3 to 6 years) and covenant reliability will not exceed 10 years. However, some reliability periods may extend beyond this, based on specific circumstances.
  
  The code provides guidance on assessing covenant and the support provided by contingent assets and trustees will need to engage with covenant and legal advisers early on. In relation to contingent assets, trustees should identify when they will be called on and an appropriate method to assess their expected realisable value and guidance is provided on factors to take into account.  Trustees “should be satisfied that they have sufficient legal advice in relation to the enforceability of… contingent assets… They should then consider whether, on balance, taking into account any qualifications in the legal advice, if this supports taking additional risk.”
  
  Further draft guidance on covenant assessment is expected “in due course”.
• Trustees: The code says that trustees “should document their considerations and reasons for decisions and be in a position to be able to evidence and explain… all decisions made”. The Regulator may request to see documentation which is not formally required as part of the valuation process.
• Open schemes: The final version of the code allows greater flexibility for open schemes to take into account future accrual and new members when determining their maturity. There is also an acknowledgement that the scheme’s actual long-term objective may not align with the low dependency target set out in the FIS, particularly where there is no intention of closing to new members or future accrual.
• Statement of strategy: A formal statement of the FIS will need to be submitted to the Regulator in a format to be determined by it. The Regulator has consulted on the form of the statement and says that it expects to publish the final version in the autumn. The code confirms that “employers must provide trustees with information which the trustees and/or their professional advisers reasonably require” for the purposes of completion of the statement of strategy.
• Recovery plans: A recovery plan must be appropriate, having regard to the nature and circumstances of the scheme. In determining this, trustees must follow the overriding principle that steps must be taken to recover deficits as soon as the employer can reasonably afford. However, the trustees are also required to consider the impact of the recovery plan on the sustainable growth of the employer. The code explains the factors that trustees should take into account when setting a recovery plan and what reasonable affordability means in this context.

The Regulator has also issued a response to consultation on its proposed “Fast Track” approach, along with details of changes it is making to that approach. The Fast Track is a prescribed valuation approach which, if used, will result in less detail being required in the statement of strategy and less engagement from the Regulator. The Fast Track parameters cover the low dependency funding basis, technical provisions, funding and investment risk and recovery plans, and contain some simplifications for smaller schemes. Recovery plans must be limited to 6 years where a scheme has not reached significant maturity, or to 3 years where it has. The scheme actuary will need to confirm that a scheme meets the Fast Track parameters, and more information will be given about this in a future document.

Finally, it should be noted that the code of practice is not yet in force as it will need to lie before parliament for 40 days. The summer recess period (from 30 July to 2 September) will not count for these purposes, so the code will not actually come into force until October. Although this means there will be a gap between the FIS requirements applying to schemes with valuation dates on or after 22 September 2024 and the code being in force, this is unlikely to present any problems in practice as the gap will be short and we know what the code says.

The government believes that an “investment shift in defined contribution schemes could deliver £8 billion of new productive investment” into the UK economy and, in similar vein, says that action “will be taken to unleash the full investment might of the £360 billion Local Government Pension Scheme to make it an engine for UK growth”. 

A pensions review will be undertaken to consider how these aims can be achieved, and the measures in the new Pension Schemes Bill discussed above will form part of this initiative. The new Pensions Minister, Emma Reynolds, said “Over the next few months the review will focus on identifying any further actions to drive investment that could be taken forward in the Pension Schemes Bill before then exploring long-term challenges to ensure our pensions system is fit for the future… There is so much untapped potential in our pensions markets, with an industry worth around £2 trillion.” Work will be led jointly by the DWP and the Treasury, which is unusual, as pension reform is generally led by DWP. 

Beyond greater consolidation in both the DB and DC spheres, there is little indication of how the government intends to achieve its stated objectives. Schemes can already invest in the majority of asset types, with restrictions in place largely to limit investment in sponsoring employers (to protect assets in the event of employer insolvency) and to ensure that portfolios are properly diversified, members’ interests are considered, and trustees consider the security, quality, liquidity and profitability of the portfolio as a whole. These qualifications are intended to protect members, so careful consideration would be needed before any steps were taken to allow investment without regard to them. 

There will be a second phase of the review, due to start later this year, which will consider “further steps to improve pension outcomes and increase investment in UK markets, including assessing retirement adequacy”. It is not clear from the announcement what this second phase will cover, though the mention of “retirement adequacy” could indicate possible changes to the auto-enrolment regime.

Employers have statutory duties to auto-enrol employees who meet age and earnings criteria into a scheme that also meets minimum criteria. Most employers use DC schemes to satisfy their auto-enrolment duties and generally, employer and employee contributions must equal 8% of the member’s earnings between £6,240 and £50,270, with the employer paying contributions of at least 3%. An employer is required to complete a declaration of compliance within 5 months of first becoming subject to the auto-enrolment obligations, giving prescribed information about how it has complied with them. Where an employer does not comply with its auto-enrolment obligations, the Regulator has a discretion to impose fines, ranging from a £400 fixed penalty to an escalating penalty varying from £50 to £10,000 per day.

In a number of recent cases, employers successfully appealed the imposition of auto-enrolment penalties:

• In Cofal v Pensions Regulator, a small employer became subject to auto-enrolment duties on 6 May 2023. It complied with its duties except for the requirement to submit a declaration of compliance. Having sent an initial reminder letter in July, the Regulator issued a compliance notice on 1 November 2023, followed by a fixed penalty notice of £400 on 29 December 2023. The owner appealed. The Regulator argued that it was “not plausible” that the employer was unaware of its obligations in relation to the declaration of compliance and it was “irrelevant” that other auto-enrolment duties had been complied with. The tribunal disapplied the penalty notice and remitted the matter to the Regulator, concluding that it would have been “bizarre” for the employer to delay filing the statement of compliance if it had understood the requirements. In addition, although the duty to file a declaration was a significant means of enabling the Regulator to confirm compliance, “the Regulator should maintain a sense of proportion and not indulge in overblown rhetoric which denigrate[s] the purpose for which it was created”.
• In Giannis Glasgow Ltd v Pensions Regulator the Regulator had contacted the employer’s former accountant several times in relation to auto-enrolment breaches and, receiving no response, imposed first fixed and then escalating penalties. The first notice the employer actually received was a notice to his personal email address stating that £14,400 of penalties had been incurred. He immediately responded and asked for a review, which the Regulator declined. The tribunal held that the employer was responsible for notifying the Regulator he had changed accountants and therefore the £400 fixed penalty would stand. However, the point of an escalating penalty was that it acted as an incentive, and there could be no incentive where there was no effective communication. In addition, a proper consideration of the circumstances of the breach, including the lack of intent, the failure of the Regulator to use all available means of communication and the absence of harm to employees meant that the impact of the escalating penalty was “wholly disproportionate and oppressive”.
• Finally, in Cambridge Rare Books v Pensions Regulator, the employer failed to pay contributions for several months and the Regulator issued a notice requiring payment by a specified date. The employer failed to comply with this and two further deadlines, and fixed and then escalating penalty notices were issued. Eventually, the employer requested a review on the basis that a director had been very unwell, the business had been going through a very difficult time and that they would pay the unpaid contributions by paying one month's unpaid contributions every month going forward. The Regulator extended the deadline for paying the contributions by just over a month and the employer appealed. The tribunal upheld the fixed penalty notice, as illness and financial difficulties were not a reasonable excuse for not paying pension contributions. However, in relation to the escalating penalty notice, having been told that the employer had recognised its default, attempted to agree a payment plan and resolved to pay off an amount per month, it was not reasonable or proportionate to set a date for compliance that did not allow time for that reasonable proposal to be put into operation. 

Whilst all three of these cases relate to small employers, there are lessons to be learned for other employers and trustees. The Regulator holds itself out as a proportionate and risk-based regulator and it seems that the First-Tier Tribunal expects it to act in a manner consistent with that (and will hold it to account if it does not). This means that if penalties are imposed and parties are aware of mitigating factors, at the very least they should ensure that they are pointed out to the Regulator and related back to its aim of acting in a proportionate way. Also, if an escalating penalty is imposed, consideration should be given to whether the penalty can properly be regarded as an incentive to behave in a compliant way or if there are factors which mean that it cannot operate as an effective incentive.