This briefing provides an update on recent TPR developments as well as a reminder of how the scheme funding cycle works, TPR’s powers concerning scheme funding and how TPR’s approach to funding negotiations has developed over recent years.
Agreeing appropriate funding and support for defined benefit pension schemes continues to be a challenge for trustees, sponsoring employers and any companies supporting group pension arrangements. The Pensions Regulator (TPR) has published two recent reports illustrating the standards it sets for employers and trustees in scheme funding negotiations and how it will intervene if those standards are not met.
In August, TPR issued new guidance on how trustees should assess the employer’s legal obligation and financial ability to support a pension scheme now and in the future (known as the “employer covenant”). This raised a number of areas where the interests of trustees and employers might diverge, such as how much information should be disclosed about the employer’s business, the extent to which employers should be able to prioritise the growth of their business and whether trustees should be assessing the ability of other group companies to support a pension scheme.
In September, TPR provided a case study showing its approach where trustees and the sponsoring employer were unable to agree how a pension scheme (in this instance, the Docklands Light Railway Pension Scheme) should be funded. It is a timely reminder of TPR’s ability to intervene in the scheme funding process and when it is most likely to do so.
This briefing provides an update on these latest developments as well as a reminder of how the scheme funding cycle works, TPR’s powers concerning scheme funding and how TPR’s approach to funding negotiations has developed over recent years.
What can we do to help?
We have extensive experience of working with trustees, employers and wider groups to agree a common approach to scheme funding. We can assist you both in preparing for, participating in and documenting scheme funding negotiations in a way that limits the risk that TPR will intervene.
If TPR does intervene in your scheme funding arrangements, we are well placed to help you develop and present your response to TPR and navigate the intervention process.
Our recent experience on this includes advising employers and trustees on the legal aspects of their employer covenant and helping them to respond where TPR has intervened at the outset of a funding negotiation or challenged agreed funding documents.
Defined benefit (DB) pension schemes are subject to a “statutory funding objective” (SFO): a pension scheme must have sufficient and appropriate assets to cover its “technical provisions”. Broadly speaking, this means that it must hold sufficient assets to pay their accrued benefits as they fall due in the future, as calculated on the basis of the actuarial methods and assumptions agreed with the trustees of the scheme in accordance with statutory requirements.
Trustees of DB schemes must prepare an actuarial valuation of their scheme at least every three years. Within 15 months of the actuarial valuation’s effective date, the trustees must put in place (usually in agreement with the employers):
- a recovery plan, if the valuation shows that the SFO is not met, setting out the period over which the deficit is to be remedied; and
- schedules of contributions for five-year periods (or the length of the recovery plan, if longer), setting out the contributions that are payable by the participating employers in the Scheme and scheme members.
A copy of each of these funding documents must be sent to TPR within a reasonable period of being prepared.1
If the trustees miss the 15 month deadline for putting funding documents in place, the trustees must notify TPR, which then has power to decide on the relevant documents. The trustees may be liable to a civil penalty (of up to £5,000 in the case of an individual and £50,000 in any other case) if they have not taken all reasonable steps to comply with this time limit.2
TPR has certain powers to intervene in scheme funding negotiations (see below, What action might TPR take when intervening). It can only exercise these powers if certain triggers are met (see below, When could TPR intervene in scheme funding negotiations). TPR is most likely to intervene after funding documents have been submitted (when it can assess whether they have met statutory requirements) or if no agreement has been reached. However, TPR may also request to be involved in a valuation process from the outset, particularly if it considers that a scheme faces unusual circumstances (eg a weak employer covenant or a risky investment strategy).
A recent example of how TPR has intervened in scheme funding negotiations
TPR recently published a report setting out its approach to a scheme funding negotiation where the employer and trustees were unable to agree a schedule of contributions.3
In this case, the trustees of the Docklands Light Railway Pension Scheme (the DLR Scheme) failed to agree a recovery plan or a schedule of contributions with Serco (the sponsoring employer) by the statutory deadline of 30 June 2010. TPR participated in negotiations between the employer and the trustees, before issuing a warning notice, with a view to exercising its statutory powers, on 31 August 2012. The notice requested that the trustees be directed to obtain (at a cost to the trustees and Serco) two skilled persons’ reports on the funding position of the DLR Scheme and the strength of Serco’s covenant. TPR intended that the reports would enable its Determinations Panel to make an informed decision as to how it should use its statutory scheme funding powers.
TPR suspended its regulatory proceedings when the parties considered that they could reach a consensual solution. Proceedings remained suspended when the trustees later issued court proceedings against Serco to seek clarity on (amongst other matters) whether the DLR Scheme’s contribution rule allowed them to impose a contribution rate unilaterally (see below, Who has the power to set contribution rates?).
The parties finally agreed the contribution rate (and use of a parent company guarantee to enhance covenant) in November 2014 and TPR decided not to use its statutory powers.
The case illustrates that TPR:
- may be more minded to exhibit a low tolerance for late actuarial valuations than it has in the past (especially if no adequate reason is provided for the delay or the parties involved do not provide a clear plan for finalising the valuation);
- is willing to intervene, and make its intervention publicly known, where scheme funding deadlines are breached, BUT;
- is likely to be reluctant to issue directions where a legal dispute is ongoing between the parties or where the parties appear likely to agree a contribution rate between themselves.
New guidance on assessing the employer covenant: issues for group companies
One of the most significant factors in agreeing appropriate scheme funding is how the parties rate the employer covenant. TPR’s latest guidance on this issue flagged several areas where trustees and employers might disagree in scheme funding negotiations.4
For instance, TPR suggests that trustees could conclude that the employer’s covenant is weaker in the following cases:
- Inadequate Disclosure: The employer resists requests for information (eg citing confidentiality) about its business.
- Unwillingness: The employer appears “unwilling” to provide contributions to the scheme.
- Investing more resources in the business: The employer’s plans for growth restrict support for the scheme and the employer fails to justify how this will benefit the scheme.
- Other stakeholders: The scheme is not being treated equitably with other stakeholders (eg shareholders and lenders), or other stakeholders are not contributing appropriately to the employer’s growth plans.
TPR notes that trustees need to monitor the covenant provided by third parties (eg group companies) where they have provided support to DB schemes eg by way of a guarantee. TPR further advises that when assessing the impact of a guarantee on the strength of the covenant, trustees need to consider the extent to which the support of the guarantor improves the affordability of the required deficit repair contributions. This approach could discourage group companies from providing covenant support, if it means that the benefit of an improved employer covenant (which should normally reduce the short to medium term funding cost) is offset by demands for increased contributions based on the financial strength of such group entities, rather than the employer itself.
Trustees may find it particularly challenging to determine the extent to which they can rely on or take account of the support offered to an employer by its wider group as a matter of normal practice, where this is not backed up by enforceable legal obligations.
Who has the power to set contribution rates?
Most trustees of defined benefit pension schemes will need to agree with the employer how the scheme’s the technical provisions will be calculated, and the terms of the recovery plan and the schedule of contributions.5
If the trustees fail to agree these matters with the sponsoring employer, the matter must be referred to TPR, which has the power to give directions, including imposing a schedule of contributions for the scheme.6
However, this requirement for employer consent does not apply if the scheme trust deed gives the trustees unilateral power to determine the employer contribution rate and does not give the employer power to suspend contributions. In those cases, the trustees must instead consult the employer about each of these matters.
The requirement for agreement with the employer still applies if, for example, it is the scheme actuary who fixes the employer contribution rate under the rules, or if employers have the power to suspend their contribution obligation under the deed.
How does TPR expect employers to comply with their funding obligations?
TPR has several, potentially competing, objectives relevant to scheme funding. It must:
- protect benefits under pension schemes and the Pension Protection Fund (PPF) against the risk of increased liabilities; and
- (since 14 July 2014) minimise any adverse impact on the sustainable growth of an employer when carrying out its functions under the scheme funding regime.
TPR’s sustainable growth objective has been reflected in its latest Code of Practice on defined benefit scheme funding.7 This encourages scheme trustees to be mindful of their sponsors’ needs as regards the sustainable growth of their businesses, and is likely to make an integrated approach to actuarial assumptions, investment strategy and employer covenant the norm in valuation discussions. We expect this to have some effect on future scheme funding negotiations, potentially enabling longer recovery plans to be agreed or a greater appetite for sponsors to challenge TPR’s approach in some cases.
TPR has described its role in scheme funding negotiations as a “referee” rather than a “player”, stating that it will not interfere where trustees and employers have discharged their responsibilities properly.
When could TPR intervene in scheme funding negotiations?
Ensuring that pension schemes are funded effectively is key to two of TPR’s statutory objectives, namely protecting the benefits of members of occupational schemes and reducing the risk of calls on the PPF. TPR has adopted a risk-based approach, and the triggers for intervention are intended to identify those schemes which pose the greatest threat to the security of members’ benefits and the PPF.
TPR has statutory powers to intervene where:
- an employer fails to pay the contributions required under its schedule of contributions;
- the trustees have been unable to reach agreement with the employer in scheme funding negotiations within the statutory time limits;
- where a scheme’s technical provisions have been calculated using imprudent methods and assumptions;
- if trustees have not met the requirements for preparing a recovery plan, statement of funding principles or schedule of contributions; and
- the trustee has failed to obtain an actuarial valuation, or the scheme actuary is unable to certify the schedule of contributions or the calculation of the technical provisions.
Even if none of the statutory tests have been triggered, TPR may seek to engage with trustees informally, where it considers that a scheme faces a particular funding risk (eg a weak employer covenant or a risky investment strategy).
What action might TPR take when intervening?
In most cases, TPR will initially respond to these triggers by investigating the relevant funding arrangements (eg requesting information or meetings with the trustee to discuss its approach to valuations at the outset) rather than a formal exercise of its powers. This stage of the intervention process can be protracted and cause considerable uncertainty for both sponsoring employers and trustees. TPR will rarely be upfront about either the timeframe or the specific goals it intends to achieve. Public disclosure by TPR of the mere existence of an ongoing investigation can have a significant effect on the share price of a sponsoring employer.
If TPR decides to act, there are a number of funding specific powers at its disposal, including the power to:
- require that sponsoring employers and trustees to revisit previously agreed valuations;
- modify the scheme as regards future accrual of benefits;
- give directions as to:
- the manner in which the scheme’s technical provisions are to be calculated (including the methods and assumptions to be used in calculating the scheme’s technical provisions); or
- impose a new recovery plan; and
- impose a schedule of contributions, specifying the rates of contributions payable by the employer, the active members and their due dates.
In addition TPR has various general powers which it could consider using (although they would not directly change the funding arrangements):
- to appoint a new trustee (who can be given special powers); or
- to require the trustee to commission (and pay for) independent expert reports (eg a new valuation or covenant review); and
- to issue financial support directions or contribution notices under its “moral hazard” powers.