Keating and Clacher explain the threat from the proposed DWP funding regulations

DB Funding Regulations 

Iain Clacher and Con Keating

The story so far

The DB Funding Code is back on the agenda following the DWP’s draft funding regulations and comments in the FT from TPR Chair, Sarah Smart.

The proposals have brought a number of criticisms from leading pension consultancies

Steve Webb, speaking for LCP has also been critical

For Con Keating and Iain Clacher, the Regulations and the yet to be announced DB funding code (more of which in the Autumn) are an accident for British Companies, still waiting to happen.

This is the second blog in their series covering their responses to the DWP’s DB Funding Consultation. The first may be found here

There is no other published critique of these regulations and the versions of the DB funding code seen so far, that explains to the reader , just what the problems with the regulatory approach are. This is why I publish their work. And I’m pleased to see it both getting read and getting questioned.

Clacher and Keating  have received several enquiries requesting more detail on the underlying calculations we used for the illustrations and estimates in the first blog. These are  expanded on here  before moving to further consultation questions.

Their response  follows the same conventions as were used in that earlier blog in relation to highlighting relevant sections and emphasis of text etc. Blue text indicates sections of the draft regulations, normal text indicates Keating and Clacher’s responses . Green text has been introduced for sections of the Financial Services and Markets Bill laid before parliament on July 20th.

Illustrations and calculations used in the first blog

On duration

The small scheme with £120 million of projected liabilities had a duration of 14.2 years at the preliminary discount rate of 3%. At the revised final discount rate of 4.9%, the duration is 12.3 years. In other words, defining ‘maturity’ as a duration of 12 years would require moving to a low dependency portfolio within the next year. However, moving to such a lower return ‘low-dependency’ portfolio instantly would result in the duration of the liabilities rising to 14.2 years. The duration of the liabilities using the ‘low dependency’ portfolio expected returns as the discount rate does not fall below 12 years for some eight years. At that point in time, the total liabilities outstanding will have declined from the presently estimated £120 million to £92.4 million; the present value of liabilities will have fallen from the current £75 million to £62.2 million at that time at the low-dependency discount rate.

On funding costs

The £180 – £200 billion estimated cost of funding was arrived at by calculating the funding trajectories of our estimates of the aggregate projected cash flows of the universe of schemes closed to new members and future accrual. We show, as Figure 1, these trajectories for a low-dependency portfolio (2.5% discount rate) and for a diversified growth portfolio (5% discount rate).

Figure 1

The difference between these two funding trajectories is the cost of the low-dependency strategy. We show in Figure 1 the trajectories commencing from the point at which the low-dependency liabilities have a duration of 12 years ( with a 2.5% discount rate) – this is some sixteen years in the future. Over this period the total liabilities of this closed universe have declined by 42%. Total future projected liabilities are currently estimated at around £2.4 trillion; at the point of ‘maturity’ some £1.4 trillion will remain outstanding. The ‘low-dependency’ scheme would then have a funding requirement of £1.023 trillion which may be compared to the funding requirement of the growth strategy, £832 billion, giving an excess funding cost for sponsor employers of £191 billion and with that a direct cost to the exchequer estimated at £38 – £40 billion. In addition to this there will be significant new costs for implementation, such as additional actuarial fees. We will discuss these more fully in a later blog, in which we shall cover the Impact assessment.

In previous blogs, in response to TPR’s original proposed DB Funding Code, we discussed various strategies (and their costs), which may be followed from today with a view to arriving at the point of ‘maturity’ fully funded. We would also note that there are very considerable uncertainties associated with all of these cost estimates. In the attempt to deal with this, we have employed a number of different approaches to the analysis and expect to cover most of these in later blogs.

Wider Issues

Our major concern is the effect that these regulations will have on climate change investment. The UK has set its net zero by 2050 objective in legally binding form. The costs of this have been estimated by The Department for Business, Energy & Industrial Strategy (BEIS) at £70 billion per year (though with absolutely no detail) and over £1 trillion in total. The proposed regulations will result not just in the estimated additional costs but will also limit the ability of schemes to reorient their overall investment portfolios towards achieving this existential climate change objective. The £1.7 trillion of scheme assets could have gone far in achieving that objective. This appears to us to be at odds with the climate change obligations introduced in section 124 of the Pension Schemes Act 2021.

We were greatly surprised by these Regulations as we saw nothing in Schedule 10 of the Pension Schemes Act (or elsewhere in that Act) which foreshadowed them in this form and complexity.  With the sponsor covenant playing such a central role, this is a holistic balance sheet approach.  This was considered and rejected in the development of the EU’s IORP II Directive. Recital 77 to that Directive states: “The further development at Union level of solvency models, such as the holistic balance sheet (HBS), is not realistic in practical terms and not effective in terms of costs and benefits, particularly given the diversity of IORPs within and across Member States. No quantitative capital requirements, such as Solvency II or HBS models derived therefrom, should therefore be developed at the Union level with regard to IORPs, as they could potentially decrease the willingness of employers to provide occupational pension schemes.” [Emphasis Added]

Overarchingly, we are left wondering as to the wisdom of this approach, while these blogs are, and will be, dominated by responses to questions posed regarding specific issues arising from the approach.

Resuming Keating and Clacher’s  responses to the consultation questions.

Question 4:

  1. Do you agree with the way that the strength of employer covenant is defined?

 Are the matters which trustees or managers must take into account when assessing it, as provided by draft regulation 7, the right ones?

 Does draft regulation 7(4)(c) effectively capture the employer’s broader business prospects?

 In order for our responses to these questions to be coherent, it is necessary to reproduce regulation 7 in its entirety:

Strength of the employer covenant – Regulation 7

 (1) For the purposes of these Regulations, the strength of the employer covenant has the meaning given in paragraph (2) and is assessed in accordance with paragraphs (3) to (6).

(2) The strength of the employer covenant means

 (a) the financial ability of the employer in relation to the scheme to support the scheme; and

(b) the level of support for the scheme from any contingent assets (whether from the employer in relation to the scheme, group undertakings or other persons), to the extent that such contingent assets

 (i) are legally enforceable by the trustees or managers of the scheme; and

 (ii) will be sufficient to provide that support at such time as the trustees or managers may be required to enforce the support to the scheme. [Emphasis Added]

 We feel that phrasing this in terms of support to  the scheme rather than ensuring the security of the benefits of scheme members is inadvertently overly restrictive as it would exclude support such as pension indemnity assurance where the insurer steps in and assumes and services the liabilities to scheme members.

 (3) The strength of the employer covenant is assessed in relation to an assessment of the difference between the value of the assets of the scheme and the value of its liabilities. [Emphasis Added]

 It seems that these are discounted present values and later in section 5 (b) they are to be modified to take account of any claim under Section 75 of the Pensions Act 1995 in insolvency. We are concerned that there may be some meaning we cannot discern from the convoluted expression assessed in relation to an assessment.

 (4) For the purposes of paragraph (2)(a), the matters to be considered in assessing the financial ability of the employer in relation to the scheme to support the scheme are

 (a) the cash flow of the employer, as set out in a Code; [Emphasis Added]

 (b) the likelihood of an insolvency event, within the meaning of section 121 of the Pensions Act 2004 (insolvency event, insolvency date and insolvency practitioner)(a), occurring in relation to the employer; and [Emphasis Added]

 (c) other factors which are likely to affect the performance or development of the employer’s business, as set out in a Code. [Emphasis Added]

As a list of the factors to consider when evaluating the quality of the credit worthiness of a sponsor company, this is grossly inadequate.

Consider the likelihood of an insolvency event. The problem as posed is indeterminable. In the fullness of time all companies can be expected to fail. The question here is limited to the likelihood of failure within the currently projected life of the scheme, but the consequence of scheme failure will vary with each point in time over that life as the liabilities and the market value of scheme assets vary. We note that the Pension Protection Fund utilises the services of an external agency for a rather more limited purpose, the likelihood of failure in the current year.

To consider corporate cash flow, without more detail, is, to put it mildly, strange. Uber had gross cash income of $29.1 billion in its most recent quarter but Uber’s share of this was $8.1 billion. ($21 billion was paid to drivers.) However, it also reported operating expenses of $8.8 billion and fully loaded expenses were $9.0 billion. Free cash flow was therefore $-0.9 billion. In fact, Uber has only survived this far by spending an estimated $32 billion of shareholders’ funds. The Regulation does not in fact specify how cash flow is to be utilised in the covenant assessment, even if its particular form and calculation were specified in a Code. As we do not believe they possess the highly specific competence in this regard, we are extremely uneasy that all of this should be left to the Pension Regulator and a Code as yet unseen and uncosted.

These concerns extend to the other factors. Of course, it would simply not be possible to list all possible factors. This whole covenant assessment process can all too easily infringe corporate commercial confidence and indeed business activity. In drafting the Code and specifically the listing of other factors, the Regulator should seek to minimise any adverse impacts on the sustainable growth and competitiveness of sponsor employers .

This would accord with the current thrust and ambition of government financial services regulation. According to HM Treasury, the Financial Services and Markets Bill (FSMB) laid before Parliament on 20th July contains provisions such that:

 “…financial regulators will also have greater responsibility for setting the rules that govern UK financial services, and for the first time, they will be given a new secondary objective to promote growth and competitiveness of the sector. 

 This will complement their existing objectives ensuring the safety and soundness of firms, protecting and enhancing the integrity of the UK financial system, promoting competition in the interests of consumers, and ensuring that consumers receive an appropriate degree of protection.” [Emphasis Added]

We are concerned that the dominant statutory objective of TPR is to protect the PPF, it is not to ensure a vibrant DB pensions system.

There is a further relevant aspect to the FSMB: it will enable the reform of Solvency II, which could lead to a reduction in excessive capital buffers and give insurers more flexibility to invest in long-term assets like infrastructure, which may well result in a radical revision to the pricing of bulk annuities, and these are baked into the proposed valuation methods.

(5) For the purposes of paragraph (3)

  (a) the assessment of the difference between the value of the assets of the scheme and the value of its liabilities is by reference to

  1. i) the actuary’s estimate of the value of the liabilities calculated on a low dependency funding basis, and
  2. ii) the actuary’s estimate of the solvency of the scheme; and

This valuation is further qualified by Regulation 7 below and Regulation 7(6) of the Occupational Pension Schemes (Scheme Funding) Regulations 2005(c). This is a valuation on the basis of the current market for bulk annuities, “…of the type described in section 74(3)(c) of the 1995 Act.” It is concerned with the immediate –  the short term – while the objective is a matter of the long term.

(b) in considering how much weight is be given to each of the estimates referred to in sub-paragraph (a) for the purposes of the assessment, account is to be given to the likelihood of an event occurring which would result in an amount being treated as a debt due from the employer to the trustees or managers of the scheme under section 75 of the Pensions Act 1995 (deficiencies in the assets)(b). [Emphasis Added]

 This is a major departure from existing actuarial practice. It appears that many estimates of the present value of future liabilities are now to be required, and that these estimates must be weighted in some indeterminate manner. Moreover, it seems that the likelihood and consequence of an insolvency event must be considered in deriving these estimates; this is no trivial task given the time horizons of schemes.

 (6) Where an assessment of the strength of the employer covenant is being carried out for the purposes of a determination, review or revision of a funding and investment strategy, or the subsequent preparation, review or revision of a statement of strategy setting out that funding and investment strategy, the actuary’s estimates referred to in paragraph (5) are to the estimates set out in the actuarial valuation to which the funding and investment strategy relates.

 (7) In this regulation— (a) in paragraph (2)(b), “contingent assets” includes guarantees; and                

(b) in paragraph (5)(a)(ii), “the actuary’s estimate of the solvency of the scheme” has the

meaning given in regulation 7(6) of the Occupational Pension Schemes (Scheme Funding)

Regulations 2005(c).


Regulation 7(6) states:


6) In paragraph (4), the actuarys estimate of the solvency of the scheme” means

(a)except in the case referred to in sub-paragraph (b), an estimate by the actuary of whether, on the effective date of a valuation, the value of assets of the scheme to be taken into account under paragraph (1) of regulation 3 exceeded or fell short of the sum of

(i) the cost of purchasing annuities, of the type described in section 74(3)(c) of the 1995 Act (discharge of liabilities by purchase of annuities satisfying prescribed requirements) and on terms consistent with those in the available market, which would be sufficient to satisfy the liabilities taken into account under paragraph (2) of regulation 3, and

(ii)the other expenses which, in the opinion of the actuary, would be likely to be incurred in connection with a winding up of the scheme,

and the amount of the excess or, as the case may be, the shortfall;

(b)where the actuary considers that it is not practicable to make an estimate in accordance with sub-paragraph (a), an estimate of the solvency of the scheme on the effective date of the valuation made in such manner as the actuary considers appropriate in the circumstances of the case.”

Response to the specific questions posed:

It seems to us that this entire section is not fit for purpose and indeed its requirements are probably not even feasible. The section needs to be entirely rethought and redrafted.

Do you agree with the way that the strength of employer covenant is defined? [Emphasis Added]

No, it is not possible to agree, as this section does not in fact define the strength of the employer covenant. It does define the term ‘employer covenant’, but it does not propose or address any processes or measures for the assessment of the strength of a covenant.

Are the matters which trustees or managers must take into account when assessing it, as provided by draft regulation 7, the right ones?

No. The issues raised earlier in this blog indicate just a few of the problems. We would note that there really can be no comprehensive listing of factors. ESG scores illustrate the nature and extent of the problem – different providers use a total of (at least) 705 factors in compiling their scores.

Does draft regulation 7(4)(c) effectively capture the employers broader business prospects?

We would also note that the state and composition of the economy are a material concern as they condition the credit quality of an employer. Indeed, many of the ‘problem’ legacy pension schemes have their difficulties rooted in such societal and economic change. Can schemes really be expected to foresee, decades ahead, the decline or growth of their industries, and their role within that? We would also note that companies and the products and services they offer can change profoundly over the lifetime of a pension scheme.

These requirements are in addition to the existing requirements of Part 3 of the Pensions Act 2004. The actuarial costs of these processes and valuations seem likely to be far larger than those previously required, as well as being additional.

We wonder if there are still some former telegram messenger boys drawing their Post Office pensions?



About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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3 Responses to Keating and Clacher explain the threat from the proposed DWP funding regulations

  1. Eugen N says:

    There is only one way this issue with DBs is going, getting them fully funded with low risk assets.

    I asses a lot of UK companies for investment purpose, and apart of very few like Unilever, Diageo, there are very few which probably will be around in 20 – 40 years with a strong balance sheet. I am mostly concern for banks, oil and gas companies, industrials, and separately many Universities.

    I think this inevitable.

    With regards, of possible investments, I would not be that worried, the majority of DB schemes avoid UK equities. UK companies should get their investment act together, and manage to show higher returns to capital employed. Unfortunately, they give the money back to investors through high dividends, and buybacks of own shares.

  2. Pingback: “The theoretical and analytical basis for the DWP’s funding regulations are not fit for purpose”. | AgeWage: Making your money work as hard as you do

  3. Pingback: Keating and Clacher’s conclude their evisceration of DWP’s proposed funding regulations. | AgeWage: Making your money work as hard as you do

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