New moral hazard powers

In April 2008 proposals for a number of changes to the ‘moral hazard’ provisions of the Pensions Act 2004 were announced. The changes had immediate effect notwithstanding that the substantive regulations had not (and still have not) been published.

The Pensions Act 2004 gave powers to the Pensions Regulator to impose financial sanctions on companies (and connected or associated parties) where events or activities have had a materially detrimental impact on the company’s ability to meet its obligations under a final salary pension scheme or where a scheme is lacking adequate financial support. These powers include the power of the Pensions Regulator to issue contribution notices and financial support directions (the so-called ‘moral hazard’ powers).

The key change announced in April is to remove the requirement for the Pensions Regulator to show an intention to avoid recovery of an employer debt or that the party acted to prevent a debt becoming due or to settle, compromise or reduce the debt “otherwise than in good faith” before being able to issue a contribution notice. The Pensions Regulator has also confirmed that it is possible for a contribution notice to be issued in respect of a series of acts rather than a single act aimed at avoiding an employer debt. This change has full retrospective effect, meaning that the Pensions Regulator can look back at a series of events as far as 27 April 2004. In relation to financial support directions, the Pensions Regulator is now also able to consider the resources of the whole group of companies rather than just a single company within the employer group when deciding whether a scheme is ‘insufficiently resourced’.

It is anticipated that these changes will lead to greater use of both the contribution notice and financial support sanctions. Transactions that may have occurred for good commercial reasons may now become vulnerable due to the ‘no fault’ element which has been introduced into the contribution notice regime.

Revised clearance guidance

Companies concerned about transactions impacting adversely on their final salary pension schemes may apply to the Pensions Regulator for a clearance statement to the effect that the Pensions Regulator will not its use moral hazard powers in relation to the transaction. Although a voluntary process, guidance was published by the Pensions Regulator in 2005 outlining the events where it may be advisable to obtain clearance.

This guidance was updated in March 2008 to reflect the experience of the Pensions Regulator since its first publication. In addition to changes to reflect the new employer debt provisions, the most notable change to the guidance is that there is no longer reference to Type B and C events; the Pensions Regulator only expects companies to consider seeking clearance in respect of Type A events (which was always the case, but the existence of Type B and C events in the original guidance led to a certain amount of confusion).

Type A events are described as events that are ‘materially detrimental’ to the ability of the scheme to meet its pension liabilities. These may be either employer-related events or scheme-related events, but whereas scheme-related events will always be Type A events requiring clearance, employer-related events will only be Type A events where there is a relevant deficit in the scheme. A materially detrimental event is one that weakens the employer covenant or one that has the effect of preventing the recovery of any employer debt owed to the scheme, compromising or reducing the debt. Any of these events (or a series of events which together may have such an effect) may lead to a contribution notice being issued. The guidance contains a non-exhaustive list of employer-related events, including a change in priority of creditors, a change in the employer group structure or change of control and business sales relating to the employer or employer group, particularly if the transaction is not at arm’s length or for a fair value. The other change to be aware of is that the relevant deficit is now the higher of the FRS 17 level, the PPF level of benefits, the scheme’s technical provisions if the scheme is subject to the new scheme specific funding regime or, if not, the scheme deficit calculated on an on-going basis. In certain circumstances, for example, if there are concerns about the employer or the scheme is in winding up, the deficit will be calculated on a buy-out basis.

The revised guidance makes it clear that, when employers and trustees have identified a possible Type A event, they need to consider possible mitigation, the level and type of which will depend on the nature and impact of the event and an assessment of the funding level of the scheme. Some indication of possible courses of action is set out in the guidance, including additional contributions of assets or cash, an improvement in the priority or security for the trustees, guarantees or insurance.

Whilst the application for clearance remains voluntary and, in the first instance, the responsibility of the employer, parties should consider the moral hazard risks they are exposed to in a Type A event where no clearance is obtained. It should also be remembered that past conduct may be a factor where the Pensions Regulator is considering using his powers in connection with a subsequent deterioration of the scheme, particularly now that a series of events can be taken into account in relation to contribution notices.