In December 2005 the Pensions Regulator (TPR) issued a significant code of practice entitled “Funding Defined Benefits” (the Code) and our briefing note of June 2006 looked at the Code in detail. This briefing updates and replaces our June 2006 briefing. Although the Code was not, and is not, binding, it is taken into account in ascertaining whether the underlying legal requirements have been met. Trustees, therefore, should pay strong regard to the Code.
The Code must be read in conjunction with the Pensions Act 2004 (2004 Act) and the regulations made under it.
Summary of the scheme funding regime
The Code relates to the scheme specific funding regime introduced by the 2004 Act. The new regime replaced the much-criticised Minimum Funding Requirement and came into effect on 30 December 2005. The requirements apply to final salary (defined benefit) schemes, save those which are exempted. Under this regime, trustees must:
- prepare a statement of funding principles, setting out how the statutory funding objective will be met, within 15 months of the valuation;
- prepare a schedule of contributions;
- obtain actuarial valuations and reports;
- put in place a recovery plan where the statutory funding objective has not been met; and
- provide copies of all funding documents to TPR within a “reasonable period” (broadly 10 business days).
The valuation process
The legislation requires a scheme to be funded to at least the level of its “technical provisions”. The technical provisions are an actuarial estimate of the assets required at a particular time to make provision for benefits accrued under the scheme. Trustees must obtain regular valuations to check that the statutory funding objective is being met. On receipt of a valuation, and, having taken actuarial advice, the trustees must:
- decide on their funding policy and establish a statement of funding principles;
- draw up a recovery plan if the valuation indicates a shortfall; and
- prepare a schedule of contributions.
Trustees have an overall deadline of 15 months from the valuation date to complete the cycle, by requesting the actuary to certify the schedule of contributions. The Code suggests that the trustees should draw up and monitor an action plan to manage the valuation process and keep records of steps taken to comply with it.
The position of the actuary
The Code anticipates that employers will also require advice on scheme funding, and may wish to minimise costs by taking advice from the scheme actuary. The Code does not, perhaps surprisingly, prohibit the scheme actuary from advising both the trustees and the employer. It merely requires an understanding as to what would happen were a conflict to arise. Many trustees are uncomfortable about the risk of conflict, and have required their actuary to work for them alone.
The position of the employer
The 2004 Act does not give the trustees carte blanche to deal with scheme funding. Broadly:
- if the trustees have unconstrained powers under the scheme rules to determine the employer contribution rate, they must consult with the employer but must seek agreement if the employer has the power to reduce or suspend contributions; and
- if the rate is determined by a person other than the employer or trustees, such as the actuary, they must obtain the agreement of the employer to the rate.
For some schemes, this may represent a significant change in the balance of powers. However, even where trustees are merely required to consult, the Code recommends that employer consent should be obtained.
The Code states that:
“It is essential for the trustees to form an objective assessment of the employer’s financial position and prospects as well as his willingness to continue to fund the scheme’s benefits (the employer’s covenant).”
Employers are obliged to provide trustees with such information as they reasonably require in order to carry out their duties. Trustees should encourage employers to share the information at an early stage, and should understand that some of the information may be confidential. Trustees should also consider using other sources of information to assess the employer’s covenant, such as specialist credit advice, and should be alert to information which is in the public domain.
The Code also considers how trustees with conflicts of interest should act. The most common conflict will arise where a trustee’s duties as a trustee conflict with his duties as a director of the employer company. The Code does not require a trustee with a conflict to stand down, but states that conflicts should be recognised and, where appropriate, legal advice should be taken on how to manage them. Subsequent codes from TPR have provided more detail on how to manage conflicts including keeping a conflicts register (see our October 2008 client stop press and our December 2008 briefing for more details).
If the trustees and employer are unable to reach agreement, the Code suggests that alternative dispute resolution procedures, such as mediation and arbitration, should be considered. TPR should also be informed within 10 business days. If the trustees are unable to agree one or more scheme funding matters with the employer, the 2004 Act enables the trustees, with the consent of the employer, to modify benefits for future service.
Meeting the statutory funding objective
Trustees are required under the 2004 Act to take actuarial advice and to obtain the employer’s agreement to the funding method for calculating the scheme’s technical provisions and to the actuarial assumptions which will apply. The assumptions can be changed at subsequent valuations, provided this can be justified. The Code requires the trustees to discuss different potential funding methods with the actuary. Trustees are required to be “prudent”, although this is not defined in the legislation. The Code contains detailed guidance as to the assumptions to be used and issues to be taken into account when selecting assumptions. Prudence will be assessed by looking at the assumptions as a whole.
However, the Code provides little guidance as to what funding level the statutory funding requirement is seeking to achieve. It notes that legislation does not require the technical provisions to be set at buy-out level, and that the additional valuation which will be carried out to assess the Pension Protection Fund funding level will provide “further useful points of reference”. TPR’s consultation document suggested that TPR would investigate schemes which are funded below 70-80 per cent of buy-out level, or where the period agreed for eliminating deficits is in excess of 10 years. In practice this has proved to be the case for many schemes subject to the statements on scheme funding issued by TPR in late 2008 and during 2009, and as collated in our October 2009 briefing.
The 2004 Act requires the trustees to aim to achieve full funding in relation to the technical provisions where the valuation reveals a shortfall. The plan to eliminate the shortfall must be included in the statement of funding principles. The shortfall should be eliminated “as quickly as the employer can reasonably afford” and the Code contains issues which the trustees should take into account, such as the employer’s business plan and any difficulties the trustees may have in recovering a debt for example, if the employer is overseas.
Trustees should also consider whether contingent security, such as a guarantee from another group company or a letter of credit, can form part of the recovery plan.
The schedule of contributions
The Code contains detailed guidance as to the contents of the schedule of contributions. The schedule must cover a period of five years or, if longer, the recovery plan period, and the trustees must ensure that the receipt of contributions is monitored robustly. They must investigate failures to pay and, where necessary, report them to TPR.
Reports between valuations
The 2004 Act imposes requirements on trustees to obtain annual actuarial reports, in years where a full valuation is not commissioned. The purpose of a report is to provide an approximate update on the funding position. It should reflect any changes which would have a significant impact on the liabilities. However, if events take place which would make it unsafe to rely on a prior full valuation, a further full valuation should be prepared. The 2004 Act requires trustees to issue a summary funding statement to scheme members within a reasonable time (generally 3 months) of receipt of a valuation or report.
As previously noted, TPR issued statements on scheme funding at the end of 2008 and during 2009. These statements have been summarised in our October 2009 briefing. The purpose of these statements was to provide trustees with additional guidance in dealing with scheme funding during a period of economic uncertainty. All of the statements issued stressed the flexibility that the scheme funding framework provided. TPR confirmed that the best security for a pension scheme is a viable employer “and that trustees and employers should work together to identify what was reasonably affordable. However, pension scheme funding should not suffer,” in order to enable companies to continue to pay dividends to shareholders.
The latest statement, issued in June 2009, provides the most detail for trustees and employers. Essentially, the trustees need to continue to decide upon the level of technical provisions, based on prudent assumptions, and these should not be compromised to make a recovery plan appear affordable. Flexibility is provided by the option to extend the length of the recovery plan, where appropriate.
The 2004 Act sets out a prescriptive regime for dealing with scheme funding, and trustees must familiarise themselves with the terms of the Code given TPR’s high expectations. Trustees should also ensure that they take into consideration the periodic statements issued by TPR on scheme funding, especially in times of financial turbulence.