On 20 February, the Department for Work and Pensions (the “DWP”) published a green paper on security and sustainability in DB pension schemes. Among other things, the paper aims to identify issues undermining confidence in the current DB pensions system in the UK and possible solutions. The paper looks at four areas – funding and investment, employer contributions and affordability, member protection, and consolidation of schemes.

Funding and investment

The DWP would like to explore whether there is rationale and scope to encourage some schemes to make different investment decisions and to mitigate any barriers to greater use of alternative asset classes. The DWP is also concerned that trustees are not always sufficiently skilled to make decisions about investment in an increasingly sophisticated investment market. Possible solutions identified include:

• improving trustee decision-making skills through training or better guidance;

• requiring the use of professional trustees; and

• giving the Pensions Regulator (the “Regulator”) a more central/proactive role in influencing or determining the level of risk that schemes should be taking.

However, the DWP is not convinced that there is sufficient evidence about the nature and quality of trustee decision-making, or about what the various influences are on investment decision-making. It therefore intends to commission further research into these areas.

Some industry commentators have suggested that the triennial valuation cycle leads trustees and sponsors to focus too much on managing funding levels at the valuation date, rather than taking an appropriate longer term approach. Although the DWP has not seen compelling evidence to suggest that the triennial valuation cycle is a significant problem for schemes, or that it is impacting on the funding and investment strategy chosen by trustees, the DWP recognises that schemes’ circumstances vary widely, and that a one size fits all approach may not be the best use of scheme or Regulator resources. Solutions suggested in this respect include:

• extending the scheme-specific approach to the valuation cycle to allow the Regulator to require more regular valuations from high risk schemes and a longer cycle from lower risk schemes;

• reducing the 15 month period for finalisation of a valuation to 9 months; and

• introducing risk-based reporting and monitoring requirements.

Employer contributions and affordability

The DWP does not believe that there is evidence of an affordability problem across the board, or a case for measures to reduce funding burdens for all employers. However, it is satisfied that some sponsors are stressed, which suggests that a targeted approach is required. Potential solutions considered include:

• imposing interim funding targets or a tougher funding regime for employers with significant available resources and severely underfunded schemes, or limits on recovery plan lengths in certain circumstances;

• making it easier to separate schemes from stressed employers – currently, the regulated apportionment arrangement route is only available where the sponsor’s insolvency is likely in the next 12 months;

• making it easier for schemes to “run on” without a sponsor where they have sufficient funding;

• allowing employers to cut or renegotiate benefits in some circumstances to allow the scheme to continue alongside its existing employer;

• more intensive support from the Regulator for challenged schemes and sponsors; and

• more use of existing flexibilities such as longer or deferred/back-loaded recovery plans, or relaxation of the trivial commutation rules.

A number of industry commentators have suggested that schemes should be given a power to change indexation measures or even to suspend or cease indexation. The DWP does not think that there is sufficient evidence to suggest that indexation should be abandoned or reduced across the board, but believes that there could be a case to allow some indexation changes in certain circumstances. Options discussed in this respect include:

• allowing schemes to make indexation conditional on the scheme and the employer having the resources to make the payments, providing the moral hazard risks can be managed appropriately; and

• introducing a statutory override to allow schemes to move from RPI to CPI where they are currently prevented from doing so by their scheme rules.

Member protection

The DWP believes that the funding framework and wider system for protecting members’ DB benefits is working broadly as intended. However, it thinks that the Regulator’s powers and the role of trustees could be further strengthened in certain areas to produce additional safeguards. Options identified include:

• additional scheme funding powers for the Regulator to set out, for example, what level of funding or risk-taking is appropriate – with either explicit legislative standards or detailed codes or guidance coupled with a “comply or explain” approach;

• a requirement for proactive compulsory clearance of certain corporate activities in limited circumstances;

• a power for the Regulator to levy substantial fines on companies for corporate transactions that have a detrimental impact on schemes without appropriate mitigation having been provided;

• a duty on parties to cooperate with the Regulator, backed by civil fines; and

• a more proactive approach by the Regulator whereby it would engage with a wider range of schemes on funding, risk and investment issues, using its existing powers but supported by additional resources.

While most employers work well with their scheme trustees, the DWP believes that there may be a case for strengthening trustees’ ability to require certain employer information or engagement. Options suggested in this respect include:

• requiring employers to engage constructively with trustees, and to provide information that trustees may reasonably require in a timely manner;

• requiring employers and trustees to agree and publish a joint statement of objectives for the pension scheme; and

• requiring employers to formally consult with trustees before paying dividends if the scheme is severely underfunded.

Consolidation of schemes

The DWP believes that consolidation of DB schemes offers a range of potential benefits, including improved efficiency and governance, better investment performance, a more cost-effective form of buy-out, and an enhanced solution for stressed schemes/sponsors. However, there are a number of issues and risks to be dealt with before the DWP would be prepared to take action to facilitate such consolidation.

In terms of voluntary versus compulsory consolidation, the DWP believes that there is a strong case for voluntary consolidation. Suggested methods of incentivising consolidation include:

• making it easier to simplify and re-shape benefits;

• removing regulatory and other barriers to consolidation and setting standards for consolidation; and

• requiring schemes to report and potentially publish their administration costs and the charges paid for investment and other advice/services.

The DWP is not convinced that compulsory consolidation is a proportionate approach and, if adopted, would need to think very carefully about the criteria that would need to be met for compulsory consolidation to apply. Possible options in this respect include:

• setting a standard for governance and costs with schemes that are unable to meet the standards being required to move into a consolidation vehicle; and

• focusing compulsory consolidation on small or stressed schemes by setting asset and funding thresholds with schemes with assets and/or funding below the thresholds being required to consolidate.

The DWP is not convinced that it should interfere in the market by designing new consolidation vehicles, but does think that creation of consolidating superfunds targeted at delivering an alternative to buy-out for small schemes that cannot access the buy-out market, or at consolidating stressed schemes would be helpful. The paper therefore suggests that the DWP could provide a suitable legislative framework for such superfunds and allow the industry to innovate to create new vehicles.

The DWP notes that consolidation is already possible through multi-employer schemes and that a number of problems arise for such schemes, particularly in relation to orphan liabilities. The DWP would therefore like to explore the possibility of making changes to the employer debt regime for multi-employer schemes to relieve the pressure placed on some employers by orphan liabilities, while ensuring that orphan members receive their full benefits. The DWP also intends to consult on a new option for employers in non-associated multi-employer schemes for managing employer debt following an employment cessation event.

Comment

The green paper is extremely lengthy and discusses a wide range of issues in relation to the current DB pension system in the UK – both issues identified by the DWP, and issues identified by industry commentators. The paper also suggests numerous options for change to tackle these issues, some of which (such as the indexation proposals) would represent a fundamental alteration of the system. However, the DWP makes no commitment that it will in fact adopt any of the suggested changes – indeed, in a number of areas, the DWP remains unconvinced that change is required. The paper also explains that any changes must be proportionate and workable, and must not be detrimental to the effective functioning of the economy. While the green paper therefore raises a number of interesting points, it remains to be seen whether it leads to any significant reform of the DB pensions system. The DWP is accepting responses to the green paper until 14 May.