Top of the agenda
- The Regulator’s revised guidance on the employer covenant
- Finance Bill 2015/16 laid before Parliament
Top of the agenda
1. The Regulator’s revised guidance on the employer covenant
The Pensions Regulator has replaced its 2010 guidance on the employer covenant. The revised guidance, “Assessing and monitoring the employer covenant”, has been prompted by:
- The Regulator’s revised Code of Practice on defined benefit (DB) funding of June 2014; and
- The Regulator’s latest objective to “minimise any adverse impact on sustainable growth of an employer”.
(To read our summary of the 2014 revised Code of Practice, click here)
On the whole, there are no surprises in the guidance. The guidance provides a useful “handbook” on assessing and monitoring the covenant and an important reference point in funding negotiations between trustees and the employer. The 23 examples, although simple, are particularly helpful in aiding understanding of the employer covenant in practical situations.
The employer covenant
The guidance identifies three key aspects of the employer covenant, the "legal obligation and financial ability" of the employer to support its DB scheme:
- Legal – the nature and enforceability of the obligations to support the scheme. The covenant assessment should focus on entities with a legal obligation to support the scheme. The guidance warns trustees against relying on the continued support of entities without a legal obligation although it may be reasonable to rely on informal support in the short term in certain circumstances.
- Scheme related – the funding needs of the scheme, now and in the future.
- Financial – the ability of the employer to contribute cash when required.
Monitoring the covenant
As a minimum, trustees are expected to undertake a full covenant review at each valuation; they should also monitor the covenant regularly between formal reviews.
Monitoring of the assessment must be proportionate, bearing in mind, scheme and employer circumstances such as:
- structure of the employer (simple or complex);
- size of the employer relative to the size of the scheme; and
- ability of the employer to generate cash flow relative to the scheme’s funding needs.
These factors will dictate how frequently the covenant should be monitored and in what depth.
Expert covenant advice
Guidance is also given on when expert covenant advice may be required. Thankfully, the guidance does not state that trustees should routinely seek the help of an expert covenant adviser. Expert advice may be necessary, however, where there is a lack of objectivity or expertise required to perform an appropriate assessment.
Employer’s sustainable plans for “growth”
The guidance reiterates the key message of the revised Code of practice on DB funding that trustees should put in place funding solutions that minimise any adverse impact on the employer’s sustainable growth plans. Trustees are reminded that an employer that is able to invest in the future growth of its business is better equipped to continue to fund the scheme.
Trustees must, however, take care in distinguishing between what are genuine investment costs and what are business expenses. For instance, replacing obsolete assets is likely to be a business expense and not an investment cost.
Trustees must assess the impact of the growth plans on the employer covenant.
Trustees should not accept lower deficit repair contributions from the employer where the investment is outside of the employer or the employer will not benefit from it unless appropriate mitigation for the pension scheme, such as a parent company guarantee, is provided.
Non-associated multi-employer schemes and not-for-profit organisations
Specific issues that might arise in relation to non-associated multi-employer schemes (NAMES) and not-for-profit organisations are covered in the appendices to the guidance. In relation to NAMES, the guidance covers:
- Key points to consider when assessing the employer covenant, such as the likelihood of an employer withdrawing from the scheme;
- Factors to take into account when assessing contribution affordability;
- How contribution liabilities should be shared between various employer(s);
- Downside of setting a deficit recovery plan that only reflects the weakest or strongest employer(s).
The main body of the guidance also considers specific issues around last man standing schemes and schemes that have partial wind-up rules.
The examples given provide useful focus on the issues that may arise in practice. They cover matters such as:
- When it might be appropriate to take external covenant advice.
- Impact of different types of guarantees (a section 75 or PPF compliant guarantee) or an undertaking from a “non-participating employer” to support the scheme that is not supported by a legal obligation.
- The impact of the capital structure of the employer i.e. the debt/equity ratio, on the covenant.
- A request from an employer to reduce deficit repair contributions when dividends are being paid – trustees are recommended to make a counter-proposal whereby all stakeholders contribute equitably to investment in sustainable growth and share in its benefits.
- The impact on the covenant of intra-group trading, intra-group receivable balances, group cash pooling and debt arrangements within the employer’s group.
The Pensions Regulator expects the trustee board “as a whole” to put in practice the principles outlined in the “At a glance” and the introduction sections of the guidance. Trustees who are assessing the covenant themselves are also expected to read and apply the principles in section 2 of the guidance, which explains how to assess the legal obligation and financial ability of the employer to support the funding needs and investment risks of the scheme.
Most well-run schemes generally would adopt the key principles of the guidance. For others, the guidance emphasises the level of involvement required from the trustees in assessing and monitoring the covenant.
The Regulator intends to produce further guidance to help trustees “navigate the DB Code”, including guides on integrated risk management and investment strategy.
The guidance emphasises the importance of covenant assessment in the context of employer-related events such as mergers and acquisitions, restructurings or share buy-backs. However, there is very little focus on such events in the guidance. Other guidance issued by the Regulator (such as its “Clearance” guidance of 2010) does contain guidance on the employer covenant in the context of commercial transactions and restructurings – it is hoped that the Regulator will update these in due course.
2. Finance Bill 2015/16 made before Parliament
The Finance Bill 2015/16 has been laid before Parliament. The Bill implements many of the changes announced in the Summer Budget 2015.
Reduction in the annual allowance for high earners
From 6 April 2016, high earners with income of over £150,000 (including the value of pension contributions) will have a smaller annual allowance. The reduction in the annual allowance will be applied on a tapered basis, so that the allowance will be reduced by £1 for every £2 that the income exceeds £150,000, up to a maximum reduction of £30,000. This will mean that those earning £210,000 and over can contribute only £10,000 to their pension tax-free.
The adding back of pensions contributions prevents individuals using salary sacrifice to ‘duck’ the 150k threshold. Employer contributions are also included and for defined benefit (DB) and cash balance schemes; these will be valued using the existing annual allowance methodology.
The taper will not be applied if income (excluding any pension savings) is under £110,000.
Those who are subject to the New Money Purchase annual allowance rules will also be subject to the tapering rules.
Carry forward relief will be available but will be based on the unused tapered allowance.
Provisions will be introduced to combat avoidance activity, where arrangements are deliberately made to reduce an employee’s income threshold in a particular tax year so as to duck the effects of the tapering rules.
Alignment of pension input periods for the tax year from April 2016
In order to facilitate the tapered reduction in the annual allowance, the pension input period (PIP) will be aligned with the tax year after 5 April 2016. In the run up to this change, all PIPs open on 8 July 2015 (the date of the Summer Budget) will be deemed to have ended on that date. Special annual allowance rules will apply (as shown in the diagram below).
The period from 6 April 2015 to 8 July 2015 is referred to as the “pre-alignment tax year”. The period from 9 July 20inance Bill 2015/16 ma15 to 5 April 2016 is referred to as the “post-alignment tax year”.
There will be a double annual allowance of £80k in the pre-alignment tax year (plus any carry forward from the previous tax year).
Annual allowance will be nil in the post-alignment tax year, although £40k of unused annual allowance may be carried forward from the pre-alignment period to this period plus any annual allowance available under the 3 year carry forward rule.
Click here to view image.
Money Purchase Allowance
Similar rules will apply in relation to the new Money Purchase Annual Allowance (i.e. for individuals who have taken their benefits flexibly under the Budget 2014 Flexibility Provisions). So, for the pre-alignment tax year, members who have taken their benefits flexibly, will get a double annual allowance of £20k (as opposed to the standard £10k) for any DC savings they make and a double adjusted allowance of £60k for any defined benefit savings they make.
Under the changes to the taxation of death benefits introduced under the Taxation of Pensions Act 2014, if a member dies after the age of 75, the beneficiary can take the whole pot as a lump sum, but this is taxed at 45%; if passed on as drawdown, the member is taxed at the marginal rate. (For our summary of the changes to death benefits, click here. The 45% charge will be removed for certain lump sum death benefits from 6 April 2016. Tax will be payable at the receipient's marginal rate instead.
Schemes may wish to consider amending their rules so as to place a cap on contributions or benefit accrual so that members are not caught by the tapered annual allowance rules. Schemes must consider communicating the above changes to members, where appropriate. Care, in particular, must be taken to ensure that the changes regarding the annual allowance in the transitional tax periods are explained clearly (given the complexity of the provisions). Schemes may also experience a high call on their scheme pays facility as potentially more members are caught by the new rules and are hit with the annual allowance charge.
3. Delay of almost a year in paying death benefits pending further enquiries was reasonable
The Pensions Ombudsman has rejected a complaint by a beneficiary that she had suffered significant financial loss because the trustee of the self-invested personal pension plan (SIPP) had delayed paying the death benefits to her by almost a year.
The Complainant, Mrs Barnicoat had been nominated by her partner to receive death benefits from the SIPP under an "expression of wish" form. On the death of her partner, the trustee sought to make the payment also to her. However, the deceased's two children, who were the executors of the estate, wrote to the trustee that Mrs Barnicoat's relationship with the deceased had broken down before his death; they asked the trustee for more time to investigate their father's financial affairs and the circumstances following his death and to defer making any final decision on the payment of the death benefits until they had had the opportunity to submit more evidence. The trustee gave the deceased's children more time to submit any relevant information and wrote to Mrs Barnicoat of their decision to do so.
Although it received further correspondence from the children, the trustee was of the opinion that none of the additional information provided was enough for it to go against the deceased's expression of wish to pay the death benefits to Mrs Barnicoat. The executors asked for further time in order to obtain probate and access further documents pertinent to their queries. Meanwhile, Mrs Barnicoat appointed solicitors to contact the trustee about the delay and to ask for further information about the nature of the challenge by the deceased's children. Not receiving sufficient information from the children, the trustee eventually paid the death benefit to Mrs Barnicoat almost a year after the death of her partner.
The Ombudsman held that it was not unreasonable for the trustee to delay paying the death benefits to Mrs Barincoat and allowing time for the deceased's children to make more enquiries into the father's financial affairs and the circumstances of his death. He also held that it was not unreasonable for the trustee not to disclose the full reasons behind the investigation to Mrs Barnicoat.
He made the following points:
- In reaching the decision as to who a death benefit should be paid to, the trustee must consider all relevant facts and ignore anything which is irrelevant.
- The nomination form was a factor to be considered in reaching a decision. The trustee has to check in these circumstances when the nomination form had been completed by the deceased and whether there had been any change in his domestic or financial circumstances which may cast doubt on the validity of the wishes expressed.
- The trustee had to ask itself if there were any reasons why they should not award the death benefit to Mrs Barnicoat and to determine whether there were other potential beneficiaries.
Regarding Mrs Barincoat's complaint that she had suffered a financial loss, the Ombudsman held that she had a duty to mitigate that loss. The trustee had offered twice to assist Mrs Barincoat financially by making an interim payment from the SIPP to her (this was on the basis that she would not have to repay the amount whatever the decision); by refusing that offer, Mrs Barnicoat had not mitigated her loss. Moreover, she had recouped that loss when the death benefit had been paid to her. The Ombudsman did, however, agree that the £500 in compensation that the trustee had awarded to her for distress and inconvenience was reasonable.
4. The Regulator's FAQs on the new governance standards and caps on charges requirements
The Pensions Regulator has produced FAQs on the requirements introduced in April this year in relation to governance and administration of occupational DC schemes and caps on charges. Broadly under the new duties:
- With some exceptions, charges and default arrangements in money purchase schemes used for auto-enrolment purposes must be capped.
- DC occupational pension schemes must have an appointed Chair who signs the scheme's annual report and accounts.
- There will be further governance standards for occupational money purchase schemes to comply with. Trustees must:
- explain how their combined knowledge and understanding enables them to properly exercise their functions and how the current knowledge and understanding requirements under the Pensions Act 2004 have been met;
- assure themselves that the core scheme financial transactions (such as transfers and investment of contributions) are processed promptly and accurately;
- consider whether costs and charges borne by members represent "good value";
- Trustees must prepare a statement of investment principles for the default arrangement and to ensure that the investment strategy and performance are reviewed at least every three years.
For more on these requirements, click here
The FAQs contain a reminder that for many schemes there will already be a Chair that will have particular responsibility for the effectiveness of the trustee board. The new legislation does not affect this. The Chair's only additional responsibility under the new legislation will be to formally sign the Chair's statement.
Regarding the chargees controls, the FAQs contain a reminder that a scheme can make use of the 'adjustment measures' provisions in the legislation if it is unlikely to be able to comply with the charge cap for a particular default arrangement. The measure may, however, only be used before 6 October 2015, except in exceptional circumstances. Trustees must additionally notify the employer, scheme members and the Pensions Regulator at least one month before relying on the adjustment measure.
The FAQs provide an important reminder for trustees to ensure that they are compliant with the new duties in relation to governance and administration and caps on charges. Compliance with the requirements needs to be confirmed, in most cases, in the scheme return. Penalties, including fines, apply where schemes are non-compliant.