Defined benefit scheme valuations in 2025: key actions for sponsoring employers

The new defined benefit funding regime places a number of additional obligations on both trustees and employers, but the biggest shift for sponsoring employers arguably comes in the form of the greater prominence afforded to the employer covenant as part of the valuation process.

We take a look at how the enhanced focus on covenant will affect sponsoring employers and the steps that they can take to proactively engage in the valuation process and ensure a good outcome.

Overview of the new regime

The new funding regime applies to all scheme valuations with an effective date on and after 22 September 2024. It requires trustees to put in place a:

• Funding and Investment Strategy (FIS) setting out how they intend to provide benefits over the long term. For this purpose the scheme liabilities must be measured on the basis that the scheme will be fully funded on a low dependency basis at the point of significant maturity.
• Statement of Strategy (SOS) detailing the trustees' assessment as to whether the FIS is being met, the main risks in implementing the FIS (and how the trustees intend to mitigate these) and any significant decisions they have made in relation to the FIS.

The new requirements for a FIS and a SOS will sit alongside the traditional assessment of the scheme's funding against the statutory funding objective (the scheme's technical provisions).

Where there is a deficit on this basis, a recovery plan and schedule of contributions will need to be put in place. Under the new regime there is now a legislative requirement for the deficit to be recovered "as soon as is reasonably affordable" by the employer.

The scheme's technical provisions will now also need to be calculated in a way which is consistent with the FIS.

Importance of covenant to the valuation process

Over the years the employer covenant has increasingly become an important part of the valuation process. Yet it is only now that covenant has been defined for the first time under legislation, with trustees now required to take into account the strength of the covenant in setting the FIS and preparing the accompanying SOS.

Trustees will need to consider the prospects and cash flows of the employer, together with any contingent assets, to form an assessment of the covenant reliability and longevity periods, the maximum supportable risk that can be taken by the scheme and ultimately the level of any recovery plan contributions to the scheme.

The change in law does, however, present an opportunity for sponsoring employers to proactively engage with trustees as part of the valuation process. In simple terms if the employer can demonstrate a more reliable covenant, this could:

• Support greater investment risk within the scheme's journey plan
• Be taken into account when setting the actuarial assumptions used to calculate the scheme's liabilities
• Ultimately reduce the contributons payable by the employer, and
• Reduce the time taken to reach the scheme's endgame solution (e.g. buying-out the scheme liabilities with an insurer).

In order to get the best outcome from the valuation process, employers should consider, with assistance from their covenant and legal advisers, how best to:

• Present focussed covenant information to assist the trustees in forming their assessment, and
• Engage with the trustees on potential covenant enhancing solutions, such as the use of contingent assets.

Understanding who is legally responsible for funding the scheme

The starting point when assessing the employer covenant is to establish which entities within a group are legally responsible for the funding of the scheme.

Those employers which meet the legislative requirements of a statutory employer are primary obligors to the scheme under the statutory funding regime, as well as being responsible for employer debts in certain scenarios. Care needs to be taken to ensure that all statutory employers are identified, including former employers who can remain on the hook as statutory employers even after they have ceased to employ active members under a scheme.

It is also important to understand from a legal perspective whether the scheme is a "last man standing scheme" in accordance with its rules, as this could influence whether or not the employer covenant should be viewed on an aggregated or consolidated basis across participating employers. 

Contingent assets

The statutory definition of employer covenant allows trustees to take account of contingent assets (such as guarantees, security over assets, escrow accounts and surety bonds) when assessing the strength of the covenant supporting the scheme.

When assessing the weight to attach to a particular contingent asset the trustees must consider whether it is legally enforceable and that they will be able to access the support at the time it is needed (e.g. in an insolvency situation).

The Pensions Regulator stresses that a proportionate approach can be taken when assessing the support offered by contingent assets, with a more thorough review needed where greater reliance is placed on the contingent asset.

Guarantees (in different shapes and sizes)

Many schemes will have parent company guarantees in place, but under the new funding regime the Pensions Regulator has taken a more prescriptive approach to the value that can be placed on certain types of guarantee.

The so called "look through" guarantee will allow trustees to take into account the financial strength of the guarantor as though it was a statutory employer to the scheme. This is, however, only possible if the prescribed criteria set out in the guidance is satisfied. Most existing guarantees will likely require amendment to meet the new more stringent requirements. Employers will need to consider whether the benefits of a "look through" guarantee outweigh the additional requirements from a commercial and practical perspective.

A guarantee which falls short of the "look through" guarantee standard may still have a value ascribed to it when assessing the employer covenant, provided it is legally enforceable and the trustees can demonstrate with reasonable certainty the level of support it will provide when it needs to be called upon.

Insolvency and structural subordination

When assessing the employer covenant consideration should be given as to where the scheme sits in the priority order on an insolvency and whether any structural subordination could impact the outcome for the scheme if an insolvency was to occur. As part of this advice may be required to understand the scheme's position and priority compared to other creditors in a group of employers.

Information sharing

One of the conditions for a "look through" guarantee is that an information sharing protocol should be in place to allow the trustees to monitor the financial strength of the guarantor.

Outside of this prescribed circumstance it may also be sensible for both employers and trustees to have in place a formal agreement which sets out the nature and extent of the covenant information to be shared. In practice this can streamline the process and provide the parties with clarity as to what needs to be supplied and by when.

Concluding comments

The new funding regime will take some time to bed in as schemes navigate their way through the detail of the new requirements.

We would recommend that sponsoring employers engage with trustees early in the valuation process and proactively look at covenant as a central pillar alongside actuarial and investment considerations. A positive dialogue with trustees around the reliance to be placed on any contingent assets is also encouraged.

A clear articulation from the employer as to the relative strength of its covenant (with supporting information) should help the trustees in forming their assessment of the level of supportable risk that can be taken in the scheme's journey plan. This, coupled with the use of contingent assets where appropriate, may ultimately reduce the contributions payable to the scheme and/or reduce the time taken to buy-out with an insurer. Conversely failure to engage may result in a weaker covenant assessment by the trustees (and potentially higher contributions to the scheme).

Please get in touch with your regular Pension team contact if you require any support in relation to these changes or if you wish to discuss your defined benefit pension scheme more generally.