On 14 April 2008, the Department for Work and Pensions (DWP) announced broad proposals to make extensive changes to the powers of the Pensions Regulator (TPR) to issue contribution notices (CNs) and financial support directions (FSDs) (the moral hazard powers)1. The moral hazard powers allow TPR to issue CNs and FSDs making parties connected or associated with an employer liable for pension scheme funding if relevant conditions are met.

Following the DWP’s formal consultation on its proposals, which closed on 20 June 2008, the government has published details of the proposed changes. They are to be made through amendments to the Pensions Act 2004 (the Act) and are mostly expected to take retrospective effect on and from 14 April 2008. The DWP has also published a response to its consultation on the proposed changes2. This briefing is largely based on the proposed amendments to the Act as published in the Pensions Bill on 30 October 2008.

The government has suggested that the proposed amendments are being made as a response to its concern about the emergence of new business models for managing pension liabilities, which, among other features, may reduce the security provided by a pension scheme’s sponsoring employer. The government cites non-insured alternatives to the traditional insurance buy-out solution for defined benefit pension schemes as examples of such arrangements. As the government perceives them, such business models threaten to increase risks for pension scheme members while generating profits from those schemes for those businesses. However, the proposed amendments have the potential to have an effect on a much broader range of transactions than ones involving such arrangements.

The main changes being proposed by the government are to:

  • introduce a new ‘material detriment’ ?? test for issuing CNs, as an alternative to the current ‘main purpose’ test;
  • modify the conditions governing when TPR can issue CNs;
  • remove the current ‘good faith’ defence against CNs;
  • clarify that TPR can issue CNs in relation to a series of acts or failures;
  • make the test for issuing FSDs more flexible; and
  • introduce new powers to issue FSDs and CNs to schemes that receive bulk transfers.

This briefing is divided into the following parts: 

  • Part 1 – the new alternative material detriment test for issuing CNs;
  • Part 2 – the other key changes to TPR’s powers being proposed;
  • Part 3 – the proposed timing of the changes; and
  • Part 4 – other changes to the moral hazard powers that may be made in the future.

Part 1 – the new alternative material detriment test for issuing contribution notices

Broadly, under current law TPR may issue a CN to a person connected or associated with an employer sponsoring a defined benefit pension scheme only if it is of the opinion that the person was party to an act or failure to act that occurred on or after 27 April 2004 and that a main purpose of the act or failure to act was to prevent or reduce the recovery of or the amount of any debt payable by the employer to the scheme under section 75 of the Pensions Act 1995 (a section 75 debt).

The proposed amendments would give TPR a new, additional power to issue a CN when an act or failure to act has, in its opinion, detrimentally affected in a material way the likelihood of accrued scheme benefits being received.

The government has commented that this new material detriment test requires a before-and-after comparison of the effect of the act (or failure to act) based only on the circumstances prevailing at the time. There would be no requirement on TPR to show that the detrimental effect on scheme benefits was a main purpose of an act or failure to act.

Clearly, a test based on material detriment could potentially be satisfied in a very wide range of circumstances, putting persons at risk of liability under CNs despite the lack of any intention to avoid liabilities to pension schemes. For example, an employer could invest resources in a flawed business strategy or in a manner that loses money. Simply by weakening the financial position of the employer, this decision could be interpreted as satisfying the material detriment test. In response to this concern, the government proposes that:

  • TPR’s power to issue a CN on the basis of this test be constrained and guided by specific factors set out in the Act and others set out in a code of practice to be issued by TPR itself; and 
  • a new statutory defence to CNs be included in the Act.

Factors that the Pensions Regulator must consider before issuing a CN under the new material detriment test

The proposed amendments would include in the Act a non-exhaustive list of factors that TPR must consider (where relevant) when determining whether to issue a CN on the basis of the material detriment test. These factors include:

  • the value of the assets or liabilities of the scheme, or of any other scheme to which accrued benefits under the original scheme have been transferred; 
  • the effect of the act or failure to act on the value of those assets and liabilities; and
  • the effect of the act on any person’s obligations to provide funding to the scheme or on their ability to discharge those obligations.

Under the proposed amendments, future regulations may prescribe additional factors that TPR must consider before issuing CNs and modify the current list of factors as contained in the proposed amendments.

TPR’s approach to its power to issue a CN under the new material detriment test – code of practice

The proposed changes would include in the Act a requirement for TPR to issue a statutory code of practice, outlining the circumstances in which it expects to issue CNs on the basis of the material detriment test.

TPR has published draft content for this code of practice. This briefly outlines the circumstances in which TPR expects to issue CNs under the new material detriment test as situations involving any of the following events:

  • the pension scheme transferring out of the UK jurisdictions;
  • the scheme’s sponsoring employer transferring out of the UK jurisdictions, if this results in a material reduction in the level of employer support or legal and regulatory protection for the scheme members;
  • the severing of the financial support provided to the scheme by the employer or any other person, so that such support is removed, substantially reduced or becomes nominal;
  • the transfer of liabilities of the scheme to another scheme or arrangement which does not have sufficient employer support or is not sufficiently well funded; and
  • a business model or the operation of the scheme in such a way that is designed to create a financial benefit for the employer or some other person from the scheme, but where inadequate account has been taken of the interests of the members of the scheme, including where risks to members are increased.

The TPR intends to issue a full draft of a code of practice in due course and to consult formally on this draft before it is finalised.

Proposed statutory defence to CNs issued under the new material detriment test

The proposed amendments to the Act would introduce a statutory defence to CNs issued on the basis of the material detriment test. The proposed defence would prevent TPR from issuing a CN against any person if TPR is satisfied that the person has shown that: 

  • before becoming a party to the relevant act or failure to act, the person (following reasonably diligent enquiries and other necessary steps) gave due consideration to the extent to which the act or failure might detrimentally affect in a material way the likelihood of accrued scheme benefits being received; and either 
  • in any case where, as a result of that consideration, the person considered that the act or failure might have such a detrimental effect, the person took all reasonable steps to eliminate or minimise the potentially detrimental effects of the act or failure; or 
  • having regard to all relevant circumstances prevailing at the relevant time, it was reasonable for the person to conclude that the act or failure would not detrimentally affect in a material way the likelihood of accrued scheme benefits being received.

Part 2 – other key changes proposed to TPR’s powers

Abolition of the existing good faith defence to CNs issued under the main purpose test As well as introducing the new material detriment test, the proposed amendments would make it easier for TPR to issue CNs under one limb of the existing main purpose test.

The Act currently allows a CN to be issued where a main purpose of an act or failure to act is to:

  • prevent the recovery of whole or a part of the employer’s section 75 debt to the scheme; or
  • prevent the employer’s section 75 debt from becoming due or to compromise, settle or reduce the section 75 debt.

However, TPR cannot issue a CN in respect of an act or failure coming within the second limb of this test unless it is done ‘otherwise than in good faith’. The proposed amendments would remove this requirement from the Act.

In its response to the consultation, the government has said that the ‘otherwise than in good faith’ requirement is difficult for TPR to satisfy, due to the difficulty in producing the necessary evidence. It comments that the defence ‘amounts to a prohibitively high hurdle for regulatory action, even where that intervention could be considered reasonable’.

However, the government proposes to meet the concerns raised by the abolition of the defence by introducing a requirement that TPR consider new factors when exercising the CN power (see below).

Additional factors that TPR must consider before issuing a CN under either the main purpose or the material detriment test

The Act already requires TPR, before it issues a CN, to satisfy itself that it would be ‘reasonable’ to do so. In reaching this view, TPR is required to have regard to a specific list of factors, as well as any other factors it considers relevant.

The proposed amendments to the Act would require TPR to consider additional factors when reaching its view as to reasonableness:

  • the extent to which, in all the circumstances of the case, it was reasonable for the person being issued the CN to act, or fail to act, in the way that the person did;
  • the value of any benefit which the person directly or indirectly receives, or is entitled to receive, under the scheme or from the sponsoring employer; and
  • the likelihood of creditors of the employer (or of any other person required to provide financial support to the scheme) being paid, and the extent to which they are likely to be paid.
  • These factors would have to be considered by TPR (to the extent that they are relevant) before it issues a CN under either the current main purpose test or the proposed new material detriment test.

In its response to the consultation, the government comments that these new factors would be particularly relevant for companies in distress and that the requirement on TPR to consider them should allay fears that the proposed changes would make pension schemes a ‘super creditor’ with priority over other unsecured creditors of the employer.

Issue of CNs in response to a series of acts or failures

Currently the Act appears only to allow TPR to issue a CN in response to an isolated ‘act or failure to act’. The proposed amendments would allow TPR to issue CNs in response to a ‘series of acts or failures to act’. This will apply to both CNs issued under the current main purpose test and those issued under the new material detriment test.

In its response to the consultation the government comments that it believes that TPR already has the power to look at a series of acts or failures to act, but that it wished to clarify the Act to put this beyond doubt. Because the government does not believe that it would be broadening TPR’s powers by making this change, it is proposed that this clarification be given backdated effect from 27 April 2004, the date the moral hazard powers first took effect under the Act.

New group-wide test for issuing FSDs

The Act currently allows TPR to issue an FSD to one or more persons connected or associated with an employer sponsoring a pension scheme where that employer is either a pure service company or is ‘insufficiently resourced’. Regulations currently define ‘insufficiently resourced’ as the employer having net assets less than 50 per cent of the section 75 debt it would pay to the scheme. However, TPR may only issue the FSD on the insufficiently resourced ground if it can also identify a single connected or associated person with resources that, when added those of the employer, would exceed this 50 per cent threshold. This means that TPR could not issue an FSD if a number of companies in a group, but not one of them alone, have sufficient assets between them to pass the threshold. To remove this anomaly, the proposed changes would allow TPR to issue an FSD where two or more connected or associated persons have in aggregate sufficient assets to pass the 50 per cent threshold.

New powers to issue FSDs and CNs in relation to schemes that receive bulk transfers

If the requirements for issuing CNs or FSDs are satisfied in relation to a pension scheme (the initial scheme) and the accrued rights of at least two persons who were members of the initial scheme are transferred to another pension scheme (the transferee scheme), the proposed amendments would allow TPR to issue CNs or FSDs in relation to the transferee scheme. In its response to the consultation, the government comments that this additional power is intended to close a ‘loophole’ under which the current moral hazard powers may be avoided.

Part 3 – when do the proposed changes come into effect?

The proposed amendments to the Act (as discussed in Parts 1 and 2 of this briefing) are mostly expected to be brought into force by the Pensions Bill receiving royal assent. This is currently anticipated to take place some time in November. However, these changes are mostly expected to have retrospective effect on and from 14 April 2008 (eg TPR will not have to satisfy the good faith requirement for issuing CNs if the act or failure to act occurred on or after 14 April 2008).

TPR has said that it will not be able to issue CNs based on the new material detriment test until the Pensions Bill receives royal assent and TPR publishes its finalised accompanying code of practice1.

Part 4 – further potential changes to the moral hazard powers

Currently, the Act allows TPR to ‘look back’ up to 12 months when issuing an FSD. This means that a person can become subject to an FSD up to 12 months after the time that person ceased to be connected or associated with a sponsoring employer.

The government has said in its response to the consultation that it is considering gradually increasing the look-back period from 12 months to 24 months and that it intends as soon as possible to consult formally on draft regulations that would do this. The reason given for this proposal is that the process for issuing FSDs can be ‘complex and involved’ and that a longer period may be needed to allow sufficient time for this process to unfold.

Sources of more information

  • Clause 124 and schedule 9 of the Pensions Bill 2008 as published on 30 October 2008. 
  • DWP press release and response to consultation in The powers of the Pensions Regulator: amendments to the anti-avoidance measures in the Pensions Act 2004 – 20 October 2008. 
  • TPR draft list of circumstances for TPR’s proposed material detriment test code of practice – 20 October 2008. 
  • DWP’s consultation on The powers of the Pensions Regulator: amendments to the anti- avoidance measures in the Pensions Act 2004 – 25 April 2008. ?
  • TPR statement and press release on use of amendment powers – 25 April 2008. ?? Freshfields Bruckhaus Deringer LLP ‘Pensions transaction manual’.