How charities and housing associations should get ready for the new pension funding regime

We now have key details of the new defined benefit (DB) pension scheme funding regime, which will apply to scheme valuations with effective dates after 22 September 2024. We work with a range of not-for-profit organisations (NFPs), including charities and housing associations. Any NFP with a DB scheme will be impacted and will need to consider the implications which could include higher pension contributions. However, they will also have the opportunity to shape the future strategy for their scheme.

What is changing?

LCP’s news alert sets out the detail but, in brief, for all triennial valuations with an effective date after 22 September 2024:

• NFPs will need to be involved in setting a formal “funding and investment strategy”, working with the pension scheme trustees. The pension scheme trustees will need to assume that risks are reduced in their investment strategy to a low level by the time the scheme is “significantly mature” (broadly when most members’ benefits are in payment) - or sooner if it appears the employer will not survive that long.
• The net impact of the new regime is likely to mean more prudence and higher funding targets for many schemes. Whilst schemes are now generally better funded than in the recent past, which will mitigate the impact, this will mean higher contributions for some NFPs.
• Those contributions must be paid as quickly as the NFP can “reasonably afford” - a difficult concept to define for charities in particular.

There are also additional reporting requirements, most notably a “Statement of Strategy” that will summarise some of the evidence that has been gathered to support decisions on the funding strategy (with some easements for schemes of less than 200 members or very well-funded schemes).

What’s new?

An important aspect of the new regime is the legal requirement for pension scheme trustees to consider the financial strength (or “covenant”) of the employer that supports their scheme. The final Funding Code (the Code) has a brief section dedicated to covenant assessments for NFPs. While this is only a single page it also has some sensible references to additional factors that should be considered when concluding on NFP’s prospects, eg reputational risks and possible restrictions on uses for a charity’s cashflow.

A lot of the points raised on NFPs in the Code are repeated in the recently issued Covenant Guidance (the Guidance) – see key general themes arising from this in our LCP Pensions Bulletin 2024/47. The Guidance helpfully also sets out ways that covenant assessments and affordability reviews may need to be approached differently for NFPs, in particular regarding assessments of future cash flows, prospects and affordability, which are all key concepts.

There are lots of new concepts introduced by the new regime which are not straightforward, and we think it inevitable that both pension trustees and sponsors will need to take more professional advice on the employer covenant as part of the valuation process. From the NFP’s perspective, taking a proactive approach can ensure the pension trustees reach well-informed conclusions at the outset and reflect the NFP’s objectives in their initial decisions, rather than needing to persuade them to change their minds at a later date. This could help to mitigate the risk of contribution increases, particularly for less well funded schemes.

Anything particular for NFPs?

We did have some concerns around how the need for deficits to be paid off as quickly as “reasonably affordable” would be interpreted when it came to charities and other NFPs. However, the Guidance recognises that charities are fundamentally different from corporates and helpfully sets out where flexibilities can be considered. For example it is noted that pension scheme trustees should be aware that excessive pensions funding may put donors off and that this risk should be taken into account. We are pleased to see this point acknowledged explicitly.

The Pensions Regulator (TPR) recognises that NFPs run reputational risk if too large a proportion of its available cash gets diverted to a DB scheme, and given charitable projects are critical to a charity’s purpose there is not an expectation that these should cease. The Guidance specifically notes that cash spent on charitable activities aimed at further enhancing the charity’s reputation could enhance its prospects and therefore might be reasonable to consider as a form of sustainable growth, which may result in lower deficit contributions being required over the coming years. Albeit in these circumstances it may be necessary for pension trustees to try and offset the scheme’s risk by obtaining contingent asset support (for example security over investments or property).

What should NFPs do to be ready for the changes?

1. Understand the likely impact of the regime on your scheme – if you are fortunate to have a scheme in a strong funding position this will mitigate a lot of the impacts but if not then it is best to know now.
2. Take control of the areas where you have a role – the funding and investment strategy normally needs to be agreed between the NFP and pension trustees so you can lead the discussions and influence the direction. This will be critical to the level of contributions payable and ultimate costs of meeting all benefits due.
3. Prepare for the additional information that the pension trustees will request about your covenant – both in terms of the additional work and how you position any responses so you are clear with pension scheme trustees what projects are critical to the NFP’s purpose. Being proactive in this area is likely to save cost and time, and could avoid undue increases in contributions.
4. Where there is a potential for increased contributions under the Code, consider any alternative security which could be offered to support the risk rather than cash into the Scheme.

In summary, we think TPR has done a good job in recognising that the business model of a NFP is very different from a corporate, with helpful points made around where easements could be appropriate. Taking the action we have outlined here will put NFPs in the best possible position to be ready for the changes, and have a more proactive role in determining the pension strategy.