The Pensions Regulator, which on Monday publishes a consultation document on how it proposes to regulate the new funding regime for defined benefit company pension schemes, intends to take a pragmatic and commercially realistic approach.
We recognise there may be concerns among sponsoring employers that the regime will impose burdens on business. We would not expect trustees to take actions that would place a company in jeopardy unless this really would be the only way of securing members’ benefits – a viable employer will usually be the best way of providing such benefits.
However, a defined-benefit promise is indeed just that – and should be backed up by funding plans that are demonstrably capable of meeting this promise in most circumstances. We expect trustees to give the interests of the pension scheme their proper status: any shortfall must be recognised as a key material unsecured creditor of the business.
Regulations setting out details of the new arrangements, and the regulator’s code of practice, will be published in December. We intend to make it clear that trustees should act independently and be well prepared when negotiating with employers to ensure that schemes are sufficiently funded to pay the benefits their members have been promised.
There are two issues at the heart of the debate: what level of funding should trustees aim for and how rapidly can employers with underfunded schemes realistically be expected to get there? There is no simple answer – much will depend on circumstances facing individual schemes, not least of which is the strength of the sponsoring employer.
It will not necessarily make sense simply to focus regulatory effort on the largest deficits if, in some of these cases, there is no foreseeable risk of employer insolvency. Equally, to insist on a specific length of recovery plan would fail to take account of the wide range of employer covenants.
With about 10,000 defined-benefit pension schemes in the UK, subjecting the funding of each scheme to close scrutiny would involve huge expense – ultimately paid for by the schemes themselves through the general levy on pension schemes. This is not a sustainable option. However, the regulator has always been clear that it will be risk-based in its approach. The consultation document makes clear how and when we may wish to look more closely at schemes’ funding plans and consider intervening.
There are a number of mechanisms by which a pension scheme might come to the regulator’s attention – for example, through scheme return data. There is also a requirement that the regulator must be sent a copy of any recovery plan and be told if the trustees and employer fail to agree on the funding target or recovery plan.
The regulator’s emphasis will inevitably fall on schemes that appear to pose the greatest risk to their members’ benefits and to the Pension Protection Fund but it also takes account of the ability of sponsoring employers to eliminate funding shortfalls. We propose a system of filters, or triggers, to identify schemes that merit closer attention. These will focus on the funding target being set for each scheme (the “technical provisions”) and the time-scales over which the trustees and employer intend to correct any shortfall.
Given the regulator’s objective of reducing risks to the PPF, the range below which a scheme’s funding objective will trigger our attention relates to our current understanding of the typical level of funding required to secure PPF compensation benefits.
The range will also be informed by the typical value placed on a scheme’s liabilities under the accounting standard FRS17 appearing in company balance sheets. If the trustees have agreed a funding target of less than the range relevant to the scheme, this would attract the attention of the regulator. Where the funding objective lies within the range, the strength of the employer’s covenant and scheme’s maturity will determine whether it triggers our attention.
The regulator will also use triggers in relation to trustees’ recovery plans to correct any shortfall between the actual funding level and the funding target.
The new statutory funding regime will require trustees to correct any shortfall as quickly as the employer can reasonably afford, which means that we need to consider affordability in deciding whether to intervene. We will be more likely to consider intervention if the recovery period is longer than 10 years. We may also look at schemes where the recovery period is 10 years or less but where the employer’s strength suggests it could reasonably clear the shortfall more quickly.
We shall take into account the employer’s viability in considering whether its financial position would be inconsistent with a 10-year recovery period, or whether a shorter period would be reasonable. We are also, in principle, attracted to finding a mechanism to enable us to take into account contingent assets, such as a letter of credit, that generate a cash flow into the pension scheme in the event of the sponsoring employer’s insolvency. Where contingent security is in place, it may be appropriate for trustees to agree to a longer recovery period.
The triggers will be used to prompt closer inspection but not necessarily intervention. Our overall focus will be on schemes that present the greatest risks and we are more likely, therefore, to look at schemes with low technical provisions combined with long recovery plans. In such cases we shall wish to see more information, for instance on the employer’s financial circumstances, and seek to understand why the trustees believe they are effectively managing risk.
We aim to use our powers sparingly, assuming that trustees and employers will usually wish to comply voluntarily with the legal requirements. Consultation on the Pensions Regulator’s approach to regulating the funding of defined benefits will last for twelve weeks, ending on 26 January next year.
The writer is chief executive of the Pensions Regulator