Employers have shown a growing interest in liability management, but to what extent can they keep pension scheme costs under control? The Pensions Regulator has been flexing its moral hazard muscles while zoning in on the employer covenant and incentivised transfers. The Department for Work and Pensions has given consumer prices index the green light although European law has driven a squeeze on employer-related investments.

Meanwhile, the Pension Protection Fund has announced that it plans to structure its levy (from 2012/13 onwards) around certain factors over which employers may have some element of control. There is now also the potential for cheaper electronic member communications.

Is defined benefit pension provision hurtling towards more responsible affordability? Who's in the driving seat?

Employers on a collision course?

Moral hazard

The Pensions Regulator has been busy for some time,but the difference in the last few months can be found in moral hazard. With two financial support directions (FSDs) in respect of Nortel Networks and Lehman Brothers and the first ever contribution notice (CN) issued in respect of the Bonas scheme, it's clear that moral hazard is back on the map.

Are employers being driven into more hazardous territory? Or is this simply a case of the Regulator now doing what it has always had the power to do, because of the economic climate?

Some key themes emerge in the CN and FSDs. Is the parent company heavily involved in all major strategic decisions, including the setting of pension contributions? Was the enterprise run on a global basis, with activities benefitting others in the group, largely ignoring the distinction between corporate and legal entities?

One of the factors that the Regulator must take into account when deciding whether to issue a FSD, or indeed a CN, to a particular individual or body is "the value of any benefits received directly or indirectly by that person from the employer...". The fact that the Regulator paid particular attention to the Nortel group being run on business lines (where for example, one or two companies provide research and development services to the rest of the group) indicates that the Regulator assesses "the value of any benefits" widely, as opposed to focusing purely on, say, the flow of finance around the group.

Other points to watch out for are keeping trustees out of the loop, the absence of arms-length terms and an employer with a cavalier attitude to funding. Keeping trustees informed (and, by extension, not misleading them) is also common sense. However, the development of a subjective test in the Bonas decision appears to widen the circumstances in which a party's "purpose" could fall foul of the Regulator, resulting in a greater likelihood that a CN will be issued.

To date, there are press reports that Nortel and Lehman Brothers plan to challenge the FSDs issued in respect of their schemes. The central point of concern relates to the enforceability of FSDs, since insolvency laws mean that only contingent debts in existence by the time that the insolvency/administration was triggered will qualify for any payout.

For more detailed analysis, please see our alerts on Bonas and Nortel.

Employer covenant

When it comes to the employer covenant, both employers and trustees have become the focus of renewed pressure from the Regulator.

This is evidenced in its recent statement on this topic (Understanding employer support for DB schemes). Bill Galvin (the Regulator's acting chief executive) said "Most trustees will need to monitor the strength of their sponsor's covenant on an ongoing basis and all should have a very good idea of exactly how they might respond in different scenarios. This means they require a good knowledge of the sponsor's business, agreed trigger points for action, and clear options on how to act to increase scheme security."

Most schemes are unlikely to operate in all these ways at present. The Regulator wants trustees to ask their employers "probing questions", or obtain "professional help" to do so for them. The statement also says that "Trustees and employers should prepare plans for realising the employer support standing behind a scheme, should this become necessary. For example, this may encompass the provision of identified contingent assets, or the agreement of negative pledges such as not to grant new security."

In essence, the Regulator wants trustees to anticipate what they will do if x or y happens, rather than wait and see, in a more reactive way. While it will be hard for trustees to do this, since the surrounding circumstances at the time of any "trigger" will be key and can't be fully anticipated, it is an important point to address.

Following its statement, the Regulator has issued guidance which, among other things, expects trustees to "check that there are no company events over the period since the last meeting, or anticipated before the next meeting, that should give cause for a more detailed review or the seeking of immediate mitigation [and they] should also consider the ability of the employer to generate sufficient cash in the period until the next trustees' meeting to pay contributions due in that period".

How much of this information employers would be willing to pass to trustees remains to be seen. The Regulator wants trustees and employers to work openly together, taking a proportionate approach to assessing and monitoring the employer covenant and focusing on forecasts for the employer's future performance (although the Regulator acknowledges that the covenant can be assessed only for a limited time into the future).

The guidance says that monitoring should be done annually "in most cases". However, standardised reviews which don't add much value are discouraged. While the guidance appears to be encouraging a cautious approach in some areas (for instance, trustees are urged to be cautious about over-reliance on the wider employer group), the link between covenant strength and investment risk is made clearly (the guidance says that the stronger the covenant the better placed a scheme may be to accept a higher level of investment risk).

In another recent statement, the Regulator expressed concerns (in the context of employer related investments) about funding schemes through mechanisms not involving direct, unconditional cash payments (for example, special purpose vehicles). The Regulator doesn't want schemes to suffer a drop in funding should the mechanism in question fall foul of the statutory restrictions on employer related investments. Unfortunately, the statement is not as clearly worded as it could be. The Regulator says that it expects an underpin, providing alternative funding, if "this [employer related investment] risk could impact on the scheme". As a result, advice on such funding mechanisms will need to cover how best to interpret the Regulator's statement in relation to the mechanism in question.

Incentive exercises

One way in which employers have been seeking to control scheme liabilities has been through the use of incentive exercises, often involving a transfer out of the scheme on enhanced terms. However, this method of liability management is coming under fire. The Regulator recently issued a consultation paper on incentive exercises (to cover not just enhanced transfers but other incentive exercises too, such as pension increase conversions), to which we have submitted our response.

The draft guidance follows the trend for principles-based regulation, although there is quite a bit of detail behind each principle, especially around what the Regulator expects to see in member communications.

In a nutshell, the Regulator wants trustees to start from the presumption that transfer incentive exercises are not in the members' interests. Members should be free of pressure to accept the offer, having been given clear information that is not misleading, as well as impartial, independent advice. Trustees are expected to engage in the offer process, applying a high level of scrutiny covering, among other things, the implications of the cost of the incentive exercise for the employer covenant. They should be consulted and engaged from the start, with any concerns "alleviated before progressing".

The issue at the heart of the draft guidance appears to be the protection of members, but the tone of the document appears more negative than is warranted, in particular the presumption that these kinds of exercises are not in members' interests. An assessment of whether the exercise on offer would be in a particular member's interest can only be made in the context of that person's individual circumstances. A general presumption that all members' interests would not be served by an incentive exercise is highly unlikely to be borne out in respect of every member of any given scheme. In addition, the Regulator is pushing trustees into a role which is not always in existence under the law.

The forthcoming abolition of protected rights (scheduled for April 2012) has reached the stage of draft legislation, which has already been the subject of commentary (not least about whether the abolition would work where schemes have protected rights requirements hard-wired into the scheme rules). One (apparently unintended) consequence of the draft wording would have been the end of transfers from contracted-out defined benefit schemes to money purchase schemes. Thankfully, the DWP have confirmed that they will correct the wording so that such transfers will still be possible.

Squeeze on employer-related investments

Schemes will need to take on board the fact that collective investment schemes are no longer exempt from the five percent limit on employer-related investments. The exemption has been removed because a European directive[1] allowed Member States to maintain this exemption (along with others) only until 23 September 2010. We suspect that few schemes will be affected by this in practice. However, knowing whether the five percent limit has been breached will involve checking the collective investment scheme's underlying assets. Getting this wrong could result in trustees being found guilty of a criminal offence.

[1] Directive on the Activities and Supervision of Institutions for Occupational Retirement Provision (known as the IORP Directive) – 2003/41/EC

Employers free to navigate?

Consumer prices index: greater affordability or an unintentional underpin?

A great deal of press coverage has been devoted to the announcement that statutory revaluation and indexation will be calculated by reference to the consumer prices index (CPI), as opposed to the retail prices index (RPI). Usually, although not always, CPI has yielded a lower rate of increase than RPI and that has been used by the Government as the cost-saving backdrop to the announcement. However, the real impact of this shift will not nessarily mean greater affordability for employers.

As is usually the case in the world of pensions, the devil will be in the detail. For any particular member, the outcome will depend on how the scheme rules were drafted. In particular, do the rules set out how revaluation and indexation will be applied or do they simply cross-refer to the legislation? In many schemes, the rules that will apply to a member are those that were in place when he/she left service, so the position may be different for different groups of members.

If a shift to CPI would require changes to the scheme rules then any restrictions on amendments could block that shift. The way in which the legislation is amended will be key. For instance, will there be some kind of override and, if so, would the override apply automatically or (as we think more likely) at the trustees' discretion? Another concern is the risk of revised legislation inadvertently imposing a CPI underpin where the scheme rules provide for RPI. Avoiding such an underpin for schemes that provide for RPI would require very careful drafting.

The most recent development has been the Consumer Prices Advisory Committee report to the Office for National Statistics, covering how best to include owner-occupied housing in CPI. Views differ on the extent to which this may reduce the gap between CPI and RPI and, potentially therefore, the impact of the RPI to CPI switch in respect of pensioners. While this is described in the report as "a top priority for HM Treasury and the Bank of England", there is no clear introduction date. There is a reference, however, to the required research work taking 30 months "plus a few months for engaging users". If this change does go ahead, therefore, we may well be looking at another three years before we know the outcome. It is also possible that the Government simply creates a new CPI+ index and retains the current CPI for pension purposes.

Please see our alert on the move to CPI when it was first announced, for more detailed analysis on these issues.

A levy looking below the surface

The Pension Protection Fund (PPF) is consulting (until 20 December) on a new formula for its levy from 2012/13 onwards (a policy statement is planned for next Spring). The proposals are digging below the surface. The PPF hope that one outcome of their proposal will be that funding will become as significant as insolvency risk in the levy calculation. One aspect lies in an area which, while a trustee responsibility, can involve some measure of employer involvement: investment risk.

The PPF want the levy funding measure to include an adjustment based on how responsive a scheme's funding level would be to a range of investment risks. The consultation paper is clearly indicating that a liability matching strategy posing little risk to the PPF would see that reflected in a reduced risk-based levy. The PPF have put together an indicative set of asset value "stresses" in the consultation document, with the final version expected "as at a date somewhat before 31 March 2012 (e.g. 31 December 2011)".

The "stresses" are based on the asset allocation data already collected on Exchange. Schemes with assets worth over £1.5 billion would have to carry out their own analysis of this "stress", although other schemes would be allowed to do the same if they wanted to (for example, schemes using hedging strategies or products not identifiable through the data captured on the Exchange system).

The consultation document does recognise some of the limitations apparent in the proposals. For instance, liabilities would be assessed as at the section 179 valuation date whereas assets would be measured by reference to the annual accounts date. In other words the two dates may differ, resulting in a disjointed picture of investment risk.

The PPF says that other proposed changes should mean that levy bills will be more predictable and stable. Fixing the levy rules for three years at a time (subject to review in exceptional circumstances) should go some way towards achieving this. To avoid temporary changes, the PPF propose using average measures for both underfunding (with market movements averaged over five years for their roll-forward calculations) and insolvency risk (with the measurement averaged over one year, as opposed to a snapshot figure at the end of March). In theory at least, controlling costs should be easier to achieve where those costs are kept stable. Employers will therefore probably take some comfort from these changes if they go ahead.

Member Communications

While the savings are unlikely to be significant in the short-term, one measure that should facilitate lower administration costs is the new (since 1 December 2010) opportunity for trustees to comply with their obligations under the disclosure regulations electronically. Members will be able to insist on any paper communications, however, so a move to electronic disclosure would mean telling the membership in writing first.

The ability of schemes benefit from this (and the extent to which they may do so) is likely to vary from industry to industry and be dependent on the mix of active, deferred and pensioner members. Consequently, those schemes considering this change may decide to hold off until their next scheme-wide communication. Shorter annual benefit statements for money purchase schemes are also allowed now (again, with certain electronic disclosures permitted).

A clear road ahead?

There are signs that the Government wants pension schemes to remain affordable, if only to minimise the resulting burden on the State if that were not the case. Employers and trustees, engaging in ever more inventive ways of addressing scheme funding, may find themselves paying lower PPF levies (depending of course on the risk posed by any given alternative investment).

However, the Regulator is keen to bring the focus back to the employer covenant and that means, together with the tightened restrictions on employer-related investments, treading carefully. While still possible, incentive exercises will need to be conducted with the utmost scruple. This should always have been the case but the Regulator's spotlight serves to heighten the need for a squeaky-clean approach. As for how the shift to CPI will play out, only time (and a good legal satnav) will tell!