UK: Pensions Green Paper - Issues For Employers

The Government has published its eagerly-awaited green paper on Security and Sustainability in Defined Benefit Pension Schemes, setting out its view of the current state of defined benefit (DB) pension schemes, and issues it wishes to discuss with providers of such schemes, including employers.

Key points

  1. The green paper starts from the premise that there is no crisis in defined benefit pensions - contrary to the views of some in politics and the media.
  2. It states that most members can expect to receive their benefits in full, and that few employers are going to be driven into insolvency by their pension schemes. It recognises that there are some who are struggling.
  3. There is little to suggest that radical change in law or regulation is on the way. The focus is on ensuring that the balance of risk between employer, member and the Pension Protection Fund (PPF) is adequate, and that the pensions industry operates with maximum efficiency.

This analysis summarises and comments on issues that are particularly of interest to employers with defined benefit pension schemes. A separate analysis of points of particular interest to trustees is available here.

Scheme funding

The Government notes that the scheme funding regime does not seek to eliminate all risk to members' benefits. It is designed to strike a balance between the sustainability and strength of the employer on the one hand, and the security of member benefits on the other, with the PPF providing a safety net where things go wrong.

The question to be addressed, therefore, is whether that balance is struck correctly at the moment.

There is certainly some truth in the argument that deficits are not widely understood and are often exaggerated. Consider for example the reporting of the BHS pension scheme deficit, which was generally by reference to the deficit against the costs of buying out benefits with an insurer. However, it is perfectly possible for a scheme with a deficit on the buy-out basis to pay all its benefits as they fall due (because the buy-out measure of liabilities includes an allowance for an insurer's reserving requirements and expected profit).

Historically low interest rates have led to deficits appearing to grow substantially, because most schemes discount their liabilities by reference to gilt yields. This is a controversial area at the moment and we often see employers and trustees further apart than ever on their understanding of how the liabilities should be valued.

The Government does not do much to address these concerns in the green paper, but it appears satisfied that there is no fundamental flaw in the way the legislation is designed. That is probably correct: it is inherent in the nature of scheme-specific funding that it should be flexible, to allow for scheme-specific experience to be taken into account.

What is needed, therefore, is for trustees and employers to be able to rely on high-quality professional advice, and for the Pensions Regulator to provide greater support when an impasse arises. Unfortunately the resource constraints to which the Regulator is subject means that experience of its ability to intervene can be mixed.

Investment

The green paper recognises the concerns of some employers that schemes are effectively crystallising their deficits by investing too conservatively. Against that, the Government notes that this is not necessarily a consequence of the market or of the regulatory regime: it is to be expected that, once schemes have closed to accrual, they will try to match their assets to their liabilities by moving away from growth assets into bonds and gilts. The same applies to schemes that are targeting buy-out with an insurer.

The Government accepts that some schemes are losing out on possible returns by investing more cautiously than they need to, in view of the strength of their employer covenants, but it does not propose a solution to that. On schemes where this is happening, it is not necessarily a consequence of the regulatory regime itself, so much as the prudence of trustees and their advisers when interpreting it, as encouraged by the Regulator.

The green paper acknowledges that employers have a role to play in determining the investment strategy: sometimes, indeed, the prudence is driven by the employer's desire to avoid a risk of higher contributions in a higher-risk investment strategy.

Employers who consider that the balance is currently tilted too far in favour of prudence will no doubt be glad of the opportunity to make those views known to the Government.

Liability management

The green paper notes that 'incentive exercises' are now fairly commonly used to enable employers to reduce their pension liabilities, and are governed by the voluntary code of practice developed by the pensions industry. It does not suggest any appetite for further regulation in this area. In our experience, these exercises, if properly run, are now seen as a reputable and mainstream way to give members the option to reshape their benefits in a manner which is less costly for the employer and trustees.

The paper also touches upon trivial commutation and raises the possibility of greater freedom to pay defined benefits as a one-off cash lump sum - employers are likely to welcome this as a way of removing risk from the scheme.

Other forms of liability management, such as asset-backed funding arrangements, are not analysed in detail but we are seeing an increased level of interest in such structures as the market continues to adapt to provide employers with ways to manage their pensions liabilities.

Distress

Despite the general "crisis, what crisis?" tone, the green paper does recognise that there are some schemes that are unlikely ever to be able to pay their benefits in full, and some employers who are unlikely to survive while still responsible for their pension schemes.

At the moment, the regulatory system does not cope well with such situations.

The test for an employer to abandon its pension schemes (i.e. to drop it into the Pension Protection Fund) is difficult to satisfy. That is as it should be - there is clearly a moral hazard concern if it is too easy. However, we have experience of legitimate restructurings collapsing because they are unable to satisfy the test.

In a successful restructuring, the pain is shared between the employer, the members and the PPF. Typically, the PPF pays compensation to members (which is less than full scheme benefits), in return for a stake in the employer's business to protect from embarrassment in case the employer, freed of its pension scheme obligations, goes on to thrive.

If the difficulties of reaching an agreement with the Regulator and the PPF over a distressed scheme cause negotiations to break down, and the employer fails anyway, the consequence may well be a lose-lose scenario. The PPF does not get the stake in the employer, there is a failure of the employer's business which might have been saved, and members still lose their pensions and have to be compensated by the PPF.

Not only is the test arguably not right, it is too black-and-white. Currently, either an employer meets the test and can abandon its scheme altogether, or it does not and must struggle on as it is. There is greater scope for a middle ground, whereby certain benefits could be scaled back by an arrangement between the employer, the trustees and the Regulator, for an interim period to try to save the employer's business and to keep the scheme out of the PPF.

The legislation is also unnecessarily complex. For an employer to abandon its scheme, the statutory method goes by the somewhat euphemistic name of a "regulated apportionment arrangement". What this usually means is Regulator-approved scheme abandonment. However, the complex way it operates as an "apportionment arrangement" makes it fiddly for advisers to implement, and therefore can be expensive for a business and scheme that are already in distress. Some schemes avoid this mechanism altogether and simply go for a compromise agreement.

The green paper therefore invites comments on whether the requirements for separating struggling employers from their schemes can be relaxed without this leading to abuse, and on giving the Regulator greater power to intervene to assist such schemes.

It also floats the possibility of allowing such schemes to reduce their benefits, but argues that the problems across the industry are not sufficient to warrant this. That may or may not be a correct description of the global situation, but there nevertheless may be individual schemes and employers that would benefit from it.

Certainly, it would be in the interests of all parties to have better legislation giving an escape route for distressed schemes and employers.

Indexation

A particularly hot topic at the moment is the inflation-proofing of pension benefits, both in payment and in deferment. This is often a controversial topic between employers and trustees and there has been high-profile litigation about it ( most recently the Barnardo's case).

Indexation is a statutory requirement, but not for all periods of service. The statutory obligation is simply to provide inflation-proofing by reference to such measure of the general level of prices as the Department for Work and Pensions may select from time to time. Until 2010, the Department for Work & Pensions (DWP) used the retail prices index (RPI), but it has now switched to the consumer prices index (CPI).

Many schemes, however, provided indexation on a voluntary basis before it became a statutory requirement.

Because RPI was, at the time when most schemes were established, the only mainstream measure of inflation (albeit not the only available measure), and the measure which the Inland Revenue expected exempt-approved schemes to adopt, many schemes have a requirement to use RPI written into their rules. With the benefit of hindsight, employers now wish that their scheme rules conferred the same flexibility to switch indexes that the Government gave itself when the statutory framework was designed.

Even in schemes where such flexibility exists, it is often in the hands of the trustees, who legitimately question whether it is a proper use of their powers to switch from RPI to CPI, in the full knowledge that the latter, whatever its merits as a measure of inflation, will normally reduce the overall value of members' benefits, often to a large extent.

We are therefore left in a position that trustees may not be able to switch from RPI to CPI because of drafting which, with the benefit of hindsight, was too narrow, and even if they are able to switch, may be reluctant to do so because it is difficult to reconcile with their fiduciary duties to members.

Some employers want the Government to resolve this problem by granting a statutory power that would override scheme rules to allow CPI to be used in place of RPI. Others oppose this on the grounds that it would amount to Government endorsement of employers avoiding promises that were voluntarily entered into.

The Government has so far stopped short of recommending an override. However, it does recognise that the approach that was taken to drafting scheme rules has assumed perhaps excessive importance, referring to this as a 'lottery'. Whatever one's views on that, it is undeniably the case that trying to understand what indexation index members are entitled to in any particular scheme has led to much time and adviser costs being spent.

The status quo may please nobody, but there is no change that would please everybody, either. This is, however, an opportunity to provide further information and views to the Government.

Corporate transactions

High-profile cases where the sponsoring employer of a pension scheme has been sold to a buyer without the financial means to pay off the deficit has called into question whether members are given enough protection on corporate transactions, and has led to suggestions that clearance by the Regulator might become a mandatory part of the process.

Currently, clearance is a voluntary procedure and works primarily to protect the participants in such transactions, not the members of pension schemes. It reassures employers that provided that the transaction does in fact match the way they described it to the Regulator, they are safe from the Regulator subsequently using its powers in respect of it.

Because the Regulator will only clear transactions that would not have caused it to use those powers anyway, most employers have concluded that it is not worth the time and expense, and prefer simply to rely on professional advice that the transaction either will not damage the covenant support offered to the scheme, or that any such damage has been appropriately mitigated.

The Regulator has no power to intervene before a transaction takes place and cannot block a transaction. Its powers are reactive: if a transaction harms a pension scheme, it can order financial support to be put in place, or a direct contribution to be made, subject in both cases to detailed statutory conditions.

Hence the calls for regulatory clearance to be mandatory and to focus on protecting the interests of scheme members. Against that, however, and in particular given the limited resources of the Regulator, there is a valid concern that mandatory clearance would be an unreasonable and disproportionate barrier to legitimate corporate activity.

The green paper recognises both points of view, and it is a point that will be explored further by the Government as its thinking develops.

Moral hazard

The green paper recognises throughout that there is a moral hazard danger in allowing struggling employers to avoid their pension obligations, the concern being that employers who are not genuinely struggling will nevertheless find ways to engineer their affairs to take advantage.

The most high-profile recommendation from the Work and Pensions Select Committee, the so-called 'nuclear deterrent' of punitive fines, does not appear to be under serious consideration.

In fact there is not much about increasing the powers of the Regulator at all. The paper recognises that whilst pensions should be protected, this should not necessarily be at the expense of a competitive economy, and that protecting jobs and viable businesses is at least as important. The Government invites views on that proposition, and employers who welcome it would no doubt be grateful for the opportunity to express those views.

Consolidation

The difficulties of funding and running a defined benefit pension scheme tend to be more acute for employers with small schemes. Such schemes can be disproportionately expensive as they do not have access to economies of scale when appointing advisers or entering into investments.

The green paper recognises the difficulty of a full merger of defined benefit schemes, but even a consolidation of so-called back office functions, i.e. a collective approach to administration and the appointment of advisers, has the potential both to reduce costs substantially whilst increasing the prospect of a good outcome for members.

Proposals to encourage such consolidation on a voluntary basis are to be encouraged, in our view.

Concluding comments

The point of a green paper is to consult, and promote debate, rather than to be a definitive statement of the Government's views, and this paper is no exception. It does not suggest that radical change is on the way.

Allowing for that, it is nevertheless interesting as a statement of the Government's preliminary thinking in response to the high-profile problems in some defined benefit pension schemes, and the opportunity to comment on the areas outlined above is one which many employers will welcome.

We have already provided comments to the Work and Pensions Select Committee in response to its call for evidence, and we will be commenting on behalf of our clients on the green paper also. If there are any comments you would like to be made on your behalf, please contact Christopher Stiles on the contact details below.

Please also see our analysis which focuses on trustee issues.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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