1. Regulator’s revised DB Code of Practice and annual funding statement
Following its consultation last year on a revised Code of Practice on defined benefit (DB) funding, the Pensions Regulator has issued the final version of the Code together with it response to the consultation. For our update on the consultation on the Code, click here.
The revised Code, Code of Practice No.3 is subject to Parliamentary approval and is expected to come into force in the coming months. Alongside it, the Regulator has also issued a number of other documents on DB funding, including its annual funding statement.
What has changed from the consultation stage?
The Code has been significantly shortened as it was considered by some respondents to have been too wordy. Accompanying the code now is a condensed “essential guide” aimed at new trustees.
Regulator’s new growth objective
The Code is part of the Regulator’s response to its new objective of “minimising any adverse impact on the sustainable growth of an employer” under the Pensions Act 2011, which received Royal Assent in May. The Regulator’s new objective is now more widely referred to throughout the Code to ensure that there cannot be any perception of a weakening of the Regulator’s policy intention.
That said, the Regulator has made it clear in the consultation response that the new objective is an objective for the Regulator, not for scheme trustees although trustees have a duty of complying with their fiduciary and legislative obligations of ensuring that the scheme benefits can be paid as they fall due; their ability to meet these obligations will be “greatly enhanced” if the employer supporting the scheme remains successful.
Deficit recovery plans to be “appropriately tailored”
The draft version had stated that scheme deficits be plugged as soon as it is “reasonably affordable” to do so; this has been replaced with a requirement that deficit recovery plans be “appropriately tailored” to both the scheme and the employer’s circumstances. A longer recovery plan period, for instance, may be appropriate where the technical provisions reflect the low risk approach; conversely, weak technical provisions could justify a proportionately shorter recovery plan period.
The emphasis on “reasonable” and “unreasonable” dividends has been done away with. Under the final version, trustees’ scrutiny of the employer’s dividend policy must be proportionate. Scrutiny is likely to be appropriate, for instance, where the covenant is constrained, the dividend payments are taking place at an unusual time or are exceptionally large.
Funding risk indicator – the bar for intervention
The balance funding outcome (BFO), the Regulator’s risk indicator for engaging with schemes, has been renamed the Funding Risk Indicator (FRI). The Regulator had said that it would publish the bar at which the BFO was to be set i.e. the level at which it would intervene with schemes. However, following concerns that such information when published could become the level at which schemes would fund, potentially creating a levelling down on scheme funding, the Regulator has decided not to publish in detail where it will set the level at which it would engage with schemes (beyond providing a high level description).
Engaging with small and medium schemes
As for concerns that the Regulator will not be focusing on small schemes when it comes to intervention, the Regulator’s response is that it is a risk-based Regulator; large schemes are of greater concern to it because they have the greatest impact on members and on risks to the system (90% of members and liabilities are concentrated in the 1,210 largest schemes). However, it will fully engage with small and medium schemes where it believes the circumstances warrant it.
The Annual Funding Statement
The Statement sets out the Regulator’s views on market conditions and their likely impact on schemes. It is aimed primarily at schemes undertaking valuations with effective dates in the period 22 September 2013 – 21 September 2014 (2014 Valuations). Key points of note are:
- Real yields on long-dated index-linked gilts are close to zero. As a result, many schemes may have lower real discount rates relative to RPI than 3 years ago.
- Future interest rates are expected to be lower for longer and there is therefore potential for yields to remain low for extended periods. Schemes which adopted risk management strategies such as hedging, are likely to have fared better in these market conditions, while others may face more challenging conditions.
- The Regulator’s analysis shows that many schemes carrying out 2014 Valuations are likely to have a larger funding deficit.
- For many employers, however, the generally improved economic conditions will mean they are in a stronger position to support the scheme going forwards.
- Flexibilities available in the funding regime may be used to set funding strategies that are appropriately tailored to the scheme’s and the employer's circumstances and which represent a balanced outcome. Open dialogue and collaborative working between trustees and employers is essential in this regard.
- The continuing low interest rate environment means that schemes may need to plan for a longer period of low yields than previously expected. In these circumstances, the Regulator expects schemes to adopt a prudent approach and keep their risk levels and funding strategies under review.
- Trustees should manage the risks to their scheme through a proportionate application of an integrated approach to risk management. Trustees are expected to be able to evidence how they have approached this for their 2014 valuations as well as how they have taken a proportionate approach to assessing the employer covenant, including their analysis of the employer’s affordability and plans for sustainable growth, given the employer's economic conditions.
Review of valuations and recovery plans
To give context to its Annual Funding Statement, the Regulator has also published:
- A review of valuations and recovery plans for scheme valuations with effective dates in the period September 2011 to September 2012
- A ‘look forward’ analysis of schemes with valuation dates between September 2013 and September 2014 - this reviews the expected position of schemes undertaking 2014 Valuations, highlighting the impact of changes in market conditions since the date of the previous valuations.
In terms of the Regulator’s role, the Regulator has published a revised funding policy, setting out in detail how it will look at risks, segment the landscape by covenant strength, assess schemes’ valuations and prioritise schemes for further engagement.
For the vast majority of schemes, the Regulator will continue to review valuations and recovery plans as they are submitted. The Regulator will evolve its suite of risk indicators which focus on the key areas of the covenant, funding and investment and scheme governance. A pragmatic approach will be taken as to the extent to which schemes have taken into account the new Code of Practice given where they were in the valuation cycle at the point that the Code came into force. The Regulator will also continue to select a number of schemes for proactive engagement by contacting them by the end of June 2014.
The suite of documentation on DB Funding demonstrate that the Regulator is taking into account its new employer growth objectively seriously - through measures such as the requirement in the funding statement that trustees be able to evidence that they have taken into account the employer’s affordability and plans for sustainable growth and a more direct emphasis on the objective in the final version of the Code itself.
The removal of the wording in the draft Code that scheme deficits should be plugged as soon as it is “reasonably affordable” and that a more “appropriately tailored” approach should be adopted are also to be welcomed.
It is unfortunate for schemes, however, that the Regulator will not be publishing in detail where it will set its risks indicators for intervention. This does leave schemes somewhat in the dark as to precisely the circumstances in which they can expect the Regulator to intervene.
2. PPF proposes significant changes to the Pension Protection Levy for the next three years
The PPF has issued proposals for significant changes to the Pension Protection Levy framework for the next three levy years (2015/16 to 2017/18), in particular to the way in which the insolvency risk of sponsors of schemes will be assessed.
The current model is based on “failure scores” assigned by Dun & Bradstreet. The PPF is proposing to replace it with a bespoke model that looks just at employers that have schemes eligible for the Pension Protection Fund i.e. a sponsor of a scheme that provides defined benefits, as opposed to the broader UK business universe on which the D&B failure scores are based.
The consultation gives details of the new model for assessing sponsor risk and its anticipated effect on pension schemes. It also floats proposals in other areas of the Levy, such as:
- Asset-backed contributions (‘ABCs’)
- Contingent assets
- Last-man standing schemes.
Measuring the insolvency risk
The PPF-specific model will be delivered by Experian and will be based on data relating to entities that have been DB sponsors in one or more years since 2005. These companies are typically much larger, more long-established and are more likely to be part of, or the parent company of, a group of companies than companies in the non-PPF universe. In sector terms, there is less of an emphasis in the PPF universe on business services and more on manufacturing. Most UK businesses currently in existence were set up from 2005 onwards compared to only 3% of PPF employers, half of whom were set up in the 1970s or before.
The model will be largely based on financial information (except in the case of non-profit organisations (NPOs)) captured by Experian from a range of sources, including Companies House and the Charity Commission.
A full explanation of the methodology to be used by Experian will be included in the “Experian Governance Document” which will be published shortly.
The PPF population will be divided into groups that are more homogenous depending on factors such as whether the entity is an NPO or whether it is a commercial entity, whether the entity is part of a group or is a stand-alone business, and the level of data available (some employers do not file full financial information, others will have full accounts).
After employers have been segmented in this way, a range of financial data will be used to determine which data are most predictive for each segment. Separate “score cards” will then be calculated for each segment. Data used for these purposes will be drawn from accounts filed at Companies House, the Companies House register of charges (and company age) and Experian’s trade payment system.
These PPF-specific score cards have around 5 to 7 components, far fewer than an off the shelf model and are very largely driven by financial data. Non-financial factors, the PPF has found, such as trade payments, number of directors etc. prove less predictive for the PPF universe than key financial factors and mortgage age.
A total of 8 score cards have been constructed to build the PPF universe. Companies are assigned to one of these score cards. The probability of insolvency arising for an individual company is driven by a combination of financial and non-financial information held by Experian on its data base, as well as individual score cards to which a company is assigned.
Information about scores
A free web portal has been set up to provide information on scoring together with an e-mail alert service to indicate when a score changes. A "what if" analysis would also be possible under the portal, for example to understand what impact forthcoming accounts may have on the score. Schemes are encouraged to access the portal to monitor scores and data held on the portal and set up alerts.
Incorporation of the Experian insolvency scores into the Levy
As with D&B failure scores in the past, the scores will be grouped into ten insolvency bands and a levy rate will be assigned to each band. There will, however, be a significant redistribution of the levy across the bands. The consultation document sets out in table form the proposed bands and levy rates for 2015/16.
Transitional measures for schemes most affected
Given that the impact of this redistribution could be significant for some schemes, the PPF is seeking feedback on whether transitional measures should be introduced. The transitional option floated looks at the increase in the levy bill if the new model was applied to the 2014/15 bill. If the increase in the bill (compared in this way) is more than 200%, the PPF levy bill would be abated.
This would come at a cost, expected to be around £100 million, and will, if it goes ahead, be subsidised through an increase in the scheme based levy for the one year duration of the transitional protection measures.
Type A guarantees
The PPF has stated that there is a strengthening case for removing recognition of type A contingent assets altogether for future levy years. Whilst not removing them at the moment, the PPF considers that some changes are needed to the regime as follows:
- Trustees will be required to certify a fixed amount (the "Realisable Recovery") which they are confident the guarantor could pay if called upon. The approach is aimed at helping trustees focus on the amount the guarantor would be capable of meeting in circumstances where the employer is insolvent.
- From the 2015/16 levy year, a new form of wording would be introduced for certifying the guarantor strength taking into account the requirement to certify the Realisable Recovery. The new certification wording being proposed is:
"The trustees, having made reasonable enquiry into the financial position of each certified guarantor are reasonably satisfied that each certified guarantor, as at the date of the certificate, could meet in full the Realisable Recovery certified, having taken account of the likely impact of the immediate insolvency of all the relevant employers."
- The guarantor's insolvency scores would be adjusted by Experian to reflect the value of the guarantee they are potentially liable for.
Asset backed contributions
Changes also being proposed in relation to asset backed funding arrangements to ensure the recognition of such arrangements for the purpose of a reduction in the PPF levy is proportionate to the reduction in the risk of schemes entering the PPF because of the arrangement.
Currently ABCs are valued in line with the accounts valuation based upon an assessment of the net present value (NPV) of future cash flows from the arrangement to the scheme trustees. The values are rolled forward and stressed and smoothed for the purposes of calculating the levy. There is currently no requirement for the asset underlying the ABC to have a value equal to the NPV nor is any consideration given as to whether that value may reduce on an employer insolvency. Because of this, a scheme with an ABC arrangement in place may pay a substantially lower levy than is appropriate based on the risk it poses to the PPF.
To address these issues, the following proposals are being floated:
- The underfunding risk reduced by the ABC arrangement will be measured on the lower of the NPV of remaining contributions or the value of the underlying asset on an insolvency basis after stressing.
- Schemes will not be able to recognise certified payments made to set up an ABC as deficit reduction contributions.
- Schemes may submit a valid voluntary certificate in respect of an ABC arrangement to get full credit for the cash flow certified, with the cash flow information being updated annually and the NPV value being required every three years. The scheme submitting a valid voluntary certificate will get full credit for the cash flows certified.
The PPF is also consulting on whether an ABC should only be recognised in the levy in respect of the same underlying asset as for type B contingent assets, which in practical terms means recognition for UK property only. So, an ABC arrangement using other assets, such as branding, would not qualify for PPF levy reduction purposes.
Associated 'last man standing' schemes
A 'last man standing' scheme is, broadly, a scheme in which the last remaining employer is responsible for securing the liabilities; in such schemes the termination provisions will not require that a proportion of assets be segregated and the liabilities of a withdrawing employer be secured when that employer withdraws from the scheme.
A discount of 10% is currently applied to last man standing schemes, where the employers are 'associated', resulting in a reduction in the PPF Levy. This to reflect the fact that no claim on the PPF will arise until all employers had entered insolvency, leading to a potentially lower risk when compared to single employer schemes or those with an optional discretion to segregate assets and secure liabilities.
The PPF is concerned that in some cases there is no genuine spreading of risks, especially where the smallest employer is the last man standing. To reflect the extent to which the arrangement generally spreads risk, the PPF is proposing that the 10% discount on the levy payable would be available where the scheme membership is widely dispersed, but where the membership is highly concentrated, with perhaps a handful of members in employers other than the largest, very little discount would be applied.
The consultation closes on 9 July. Further consultation on the final rules will be held in the Autumn. Schemes should consider how the proposed measures could affect them and respond to the consultation.
The consultation does not deal with the total levy for 2015/16, which will also be published in the Autumn. The total levy bill could well be higher as a result of certain benefits that were previously money purchase being re-categorised as defined benefits under section 29 of the Pensions Act 2011 and therefore being eligible for PPF compensation for the first time. For our update on the changes to the definition of money purchase benefits and their implications for schemes, click here.
The Pensions Act 2014 also contains provisions for an increase in the PPF compensation cap for those with pensionable service of 20 years or more (although the date on which these provisions will come into force is not yet known) – these will also increase liabilities of the PPF and may result in an increase in the PPF Levy.
3. High Court upholds Ombudsman’s determination that failures in an automated system can constitute maladministration.
In NHS Business Services Authority v Leeks , the High Court has upheld the Pensions Ombudsman's determination that failure to inform an NHS Pension Scheme member that she had accrued the maximum possible entitlement under the Scheme amounted to maladministration.
Mrs Leeks worked part time as a mental health nurse in the NHS and was a member of the NHS Pension Scheme, administered by the NHS Business Services Authority. When Mrs Leeks turned 60 in January 2007 she had reached the 45 year accrual limit under the Scheme, and was therefore entitled to retire with an unreduced pension.
Mrs Leek's role as a mental health nurse meant that she accrued benefits at a preferential rate, but this rate was then reduced by her part-time status. Also, Mrs Leeks had purchased an additional year of pensionable service, which was again reduced due to her part-time status.
The automated system used by the Authority failed to highlight that Mrs Leeks had reached the maximum accrual in 2007 and she continued to contribute to the Scheme until 2009. It was only when Mrs Leeks requested an estimate of her benefits that the Authority discovered its error and informed Mrs Leeks that she could have retired on a full pension two years earlier.
Mrs Leeks complained to the Ombudsman citing maladministration by the Authority and her employer, arguing that if she had been informed in 2007 of her right to retire, she would have taken a short break before returning to work whilst simultaneously receiving her pension.
The Ombudsman's decision
The Ombudsman upheld Mrs Leek's complaint, finding that inadequacies in an automated system could, if serious enough, amount to maladministration. The Authority was subsequently ordered to pay Mrs Leeks £110,000; the pension she would have received from January 2007 to the date of the determination.
Whilst the Ombudsman also found that the Employer's behaviour amounted to maladministration, he decided that only the Administrator should contribute towards Mrs Leek's loss. The Employer did not have to contribute in spite of the fact that the Authority had made it aware of the deficiencies in its automated system. In the view of the Ombudsman this was not sufficient to shift blame from the Authority to the employer.
It was the Authority that should have realised in 2007 that Mrs Leeks had reached the 45 year limit and, had it acted properly, her pension would have been paid out as it should have been.
The Authority subsequently appealed to the Court.
The Court's decision
The Court agreed with the Ombudsman's analysis confirming that limitations within an automated system can give rise to maladministration claims.
Whilst neither the Court nor the Ombudsman felt it was necessary to identify exact standards with which automated systems must comply, the Court did state that a system should be assessed against the reasonable expectations of members. In the present case, the complexity and size of the NHS Pension Scheme meant that it was reasonable to expect the Authority to have a sophisticated automated system in place.
Administrators and trustees should take note of this decision; it would appear that the Ombudsman and the Court will give little sympathy to suggestions that scheme complexity should mean a lower standard of administration will be acceptable. On the contrary; a larger and more complicated scheme will mean that an administrator is less likely to be able to justify simply being aware of inadequacies in their system.
Administrators and trustees should review the systems they have in place and identify any such limitations in those systems and consider what action should be taken to remedy them. Relatively simple suggestions from the Ombudsman, such as an automatic check on a member's status when they reach certain defined ages, should help to avoid maladministration claims.
4. Ombudsman’s determination emphasises that key information about benefits should be set out in the main member communication and not in FAQs
In Gregory (PO-623), the Pensions Ombudsman has upheld a complaint by a member of a defined contribution (DC) plan that information about how his transfer payment from the plan to a Group Personal Pension Plan (GPP) would be invested in the GPP was not clear.
At the time of transferring his benefits from the main plan to the GPP, Mr Gregory received an information pack produced by Friends Life, who managed the main plan and the GPP, which stated that that the "transfer value must be invested in exactly the same funds and investment proportions as your existing contribution".
Mr Gregory took this to mean that his transfer value would be invested in the GPP in the same way as it had been invested in the main plan (which had been invested 80% in UK equities and 20% in cash).
As it turned out, the statement actually meant that the transfer value would be invested in the GPP in the same way as the member's ongoing contributions to the GPP – as the ongoing contributions were invested in cash, the transfer value was also invested in cash.
The FAQs, however, in the transfer pack given to Mr Gregory, had stated the position accurately. These stated that the "transfer payment" would be invested in the same funds as [the Member's] regular GPP contribution". When the member found out some 10 months later that his funds had been invested in cash, he instructed Friends Life that his funds be invested 50% in equities and 50% in cash, and complained to the ombudsman.
Friends Life acknowledged that had the transfer payment been invested from the transfer date, as under the main scheme the value of the GPP fund would have been £15,786 higher.
The Ombudsman held Friends Life to be guilty of maladministration in not making the position clear in the transfer information pack. Whilst he acknowledged that the FAQs did state the position accurately, he said that FAQs might not necessarily be read by members. "FAQs are there in case of questions that a reader may have, not be read in detail as a way of finding information for the first time" the Ombudsman held." Mr Gregory had not in fact read the FAQs and the Ombudsman held that Friends Life could not rely on this in their defence.
The determination highlights the importance for administrators, trustees and employers to ensure that any key information about members' benefits are clearly set out in the main communication and not in the FAQs. The challenge, of course, in any given situation is being able to gauge what is key information and should therefore be in the main communication and what might be suitable to include in FAQs.
5. Government publishes its review of survivors’ benefits in pension schemes
The Marriage (Same Sex Couples) Act 2013 requires the Government to conduct a review of survivor benefits in occupational pension schemes. HM treasury and the DWP have now produced a report of their review of survivor benefits.
The review investigates differences in occupational pension schemes between:
- same sex survivor benefits and opposite sex survivor benefits provided to widows;
- same sex survivor benefits and opposite sex survivor benefits provided to widowers; and
- opposite sex survivor benefits provided to widows and opposite sex survivor benefits provided to widowers (i.e. in relation to contracted-out benefits).
The report tracks the historical development of survivor benefits as well as the legal requirements and how survivor benefits are provided in the private and public sector pension schemes. It notes that:
- Most public service schemes exceed the statutory minimum requirement by providing benefits to survivors in respect of the member's service from 1988.
- On the other hand, of the 27 % of private pension schemes that were found to have a difference in the way survivor benefits between surviving opposite sex spouses and surviving civil partners were calculated, around two-thirds provided the statutory minimum i.e. provided benefits for accrual after December 2005. That said, some private sector schemes, the report notes, such as those covering the privatised railway industry, already provide full equality.
The review looks at the cost to schemes if the government were to legislate to eliminate various elements of discrimination in survivor benefits. Eliminating all difference in treatment, for instance, would cost the private sector £0.4 billion and the public sector £2.9 billion (of which around £1 billion would be an immediate liability)
It also identifies non-monitory concerns such as that aligning some differences in survivor benefits could in themselves create new elements of discrimination between groups. Some schemes offer members the option of buying additional survivor benefits; any change in the law to remove discrimination in survivor benefits would need to look at the position of such members who may have paid more member contributions or accepted a reduced pension.
The review does not float any specific ideas for reform, concluding that given the complexity of issues and the potential costs, the Government must consider any proposals carefully. The appeal inInnospec v Walker case is expected to be heard this year. It may be that the government will wait until judgment in that case is delivered before issuing proposals (if any). If, however, that decision itself gets appealed to the Supreme Court, then it may be even longer before the government issues any proposals for change.