March 6, 2017

Government consults on changes to defined benefit pension schemes

The Government has issued its consultation paper, Security and Sustainability in Defined Benefit Pension Schemes. It contains a comprehensive overview of the current defined benefit regime, including analysis of the funding position of schemes and affordability for employers and options for change. The Government is seeking views on possible changes that can be made to the defined benefit regime, although the Government's main conclusion is "that there is not a significant structural problem with the regulatory and legislative framework".

The Government's modelling suggests that, although most schemes are currently in deficit, that funding levels will have improved so that by 2030 schemes will, in aggregate, be in surplus on a technical provisions basis.  However, it is accepted that modelling will only ever be a guide based on assumptions and that whilst the aggregate position may be positive, individual schemes within the modelling could be significantly worse off.

The Pensions Regulator's analysis is also that defined benefit schemes remain affordable when comparing profit before tax (PBT) against deficit repair contributions (DRC).  However, there is a significant minority of employers for whom DRCs may become unsustainable in the near future.  The Government's conclusion is that it "is hard to find evidence that deficits are driving companies into insolvency, [but] there are clearly employers for whom their pension scheme deficit is a significant call on their resources".  With some signs that the ratio of PBT to DRC may be higher for smaller companies, the Government concedes that "there is a mixed picture and a need to explore [affordability] further."

Against this background, the consultation focuses on four key issues and the options available.  The intention is "encourage an informed debate on what if anything Government may need to do".

Funding and investment

There has been some suggestion that schemes have been overly cautious, shifting the balance of funding from investment returns to sponsor contributions.  The Government believes that whilst there has been a shift away from return seeking assets, this has been driven by a number of considerations such as a desire to reduce volatility.  However, the consultation paper concludes that there is more work to be done on collecting information and insights into the nature and quality of trustee decision making, and this may throw more light on the issues and present further options to change.

A further issue raised is the triennial valuation cycle, with some commentators suggesting that the focus has shifted too much to managing the position as at the triennial pension valuation date, rather than taking a longer term approach to funding.  However, the Government seems lukewarm on the suggestions for more frequent valuations for higher risk schemes, as it might be counter-productive in that it would increase costs.  The Government does suggest the introduction of risk reporting and monitoring, which might reduce the regulatory burden for lower risk schemes, with a proportionate monitoring regime for higher risk schemes.

Employer contributions and affordability

Given the evidence on affordability, it is not surprising that the Government rejects the idea for changes across the board to reduce defined pension benefits in order to relieve the pressure on employers.

However, there may be a case for increasing flexibility for stressed schemes and sponsors, which will help preserve value and jobs in the economy, while also delivering a good deal for members. There are a number of options put forward here:

  • allowing businesses to separate from their scheme more easily.However, this brings a number of difficult issues.For example, the moral hazard risk of the unscrupulous employer deliberately abandoning a scheme and members losing out if the scheme is separated and benefits are cut if the business might otherwise have recovered without separation.If a scheme is separated from the employer there is the issue of who bears the investment risk: the scheme members or the Pension Protection Fund (“PPF”).The PPF has recently embarked on a consultation addressing the levy to be charged for schemes which have separated from their employer, recognising that the nature of the risk to the PPF changes with the separation.
  • allowing cuts or renegotiation of benefits. This could include changes to make it easier to switch from using RPI to CPI as the measure of inflation which, at present, is "something of a lottery" depending on how the rules were originally drafted.In aggregate this could save up to £90billion, but the changes would impact schemes differently.
  • widening the Pension Regulator's powers to wind up a scheme.Although there is a power for the Regulator to wind up schemes, it could be widened to recognise the Regulator's objectives under the Pensions Act 2004, which include reducing the risks to the PPF.However, this runs the risk of the Regulator intervening and forcing a winding up in circumstances where the scheme might otherwise have been fine.
  • provide more intensive support from the Regulator, including possibly mandatory appointment of professional trustees, who have the skills and experience of stressed schemes and employers.

Member protection

The focus of this section is on corporate activity and the need for Pensions Regulator approval.  The Work and a Pensions Select Committee raised the question of whether the Regulator should have power to prevent certain corporate activities taking place, rather than deploying their anti-avoidance powers after the event.  The Government has adopted a very cautious approach to such suggestions, concerned that nothing should be done which could affect competitiveness or inhibit legitimate business activity.  The Government has said that any such powers should be "very narrowly limited" and with a "high threshold" to avoid "significant disadvantages to business" - so it seems unlikely that the Government will be willing to agree to such changes to the Regulator's powers. 

The power for the Regulator to issue a fine, if an activity is detrimental without appropriate clearance (which was also recommended by the Work and Pensions Select Committee) is also discussed.  But the Government seems equally concerned that the fear of regulatory action might drive sponsors to seek clearance when it would otherwise be unnecessary or disproportionate.

However, the Government does seem more amenable to changes to give the Regulator more information gathering powers, such as an overall duty to co-operate and power to interview parties.

Consolidation of schemes

There are around 6,000 schemes with approximately 11 million members, but around 10% of members are spread over 81% of schemes.  Regulator analysis suggests that, in general, smaller schemes tend to have less effective governance and trusteeship.  This has led to the suggestion that smaller schemes should consolidate.

The Government's approach is that it should not interfere in the market, but does consider that aggregator schemes might be a helpful development.  In particular, it has suggested that it might be appropriate for the smaller end of the market which might struggle to buy-out even if well funded.  However, this would require careful consideration of the extent to which the employers are discharged and the PPF remains as a safety net for the scheme (and which would require changes to the PPF legislation).

The consultation document also considers whether consolidation should be voluntary or compulsory. The Government's preference is towards soft measures and facilitation of consolidation, and believes there is a strong case for voluntary consolidation, due to the benefits of scale and access to better investment opportunities.

Clyde & Co Comment

The Green Paper is a timely initiative, although we wait to see what responses are made and the Government's reaction.  The Government's current position is that the regulatory framework generally works well, so any amendments will be tinkering around the edges.  But even then the impression is that Government is not convinced that there is much need for tinkering either.  We may see the introduction of more flexibility to deal with stressed schemes and stressed employers  but a difficulty will be adequately defining what counts as sufficient stressed to bring the changes into play.  Increased flexibility allowing schemes to switch to using CPI for increases would be a sensible measure, even if the benefit will not be felt across all schemes.  We are also likely to see increased powers for the Regulator for obtaining information, but the idea of a veto over M&A activity – which the Regulator suggested in evidence to the Work and Pensions Select Committee - seems unlikely to go ahead.

The consultation paper is available here.