Green Paper: Security and Sustainability in Defined Benefit Pension Schemes

Outline

On 20 February 2017, the Department for Work and Pensions (DWP) published its much-anticipated Green Paper, "Security and Sustainability in Defined Benefit Pension Schemes". The paper calls for views from stakeholders on ways of improving confidence in the regulation of defined benefit (DB) pension schemes - whilst balancing the competing aims of (i) member protection (ii) sustainability and (iii) affordability. The consultation closes on 14 May 2017.

The DWP states that there is “not a significant structural problem with the regulatory and legislative framework” for DB pension schemes, but acknowledges that the framework “may not be operating for all and in all circumstances”.

The Green Paper therefore calls for evidence on four key areas of DB regulation:

• funding and investment
• employer contributions and affordability
• member protection, and
• DB pension scheme consolidation.

The Green Paper does not propose a fundamental redesign of any of these areas. Yet a number of the proposals out for consultation could have significant impacts on a number of DB pension schemes, their members and corporate sponsors.

Funding and investment

The DWP appears reasonably comfortable to maintain the broad shape of the regulatory regime, noting in particular that:

• there is insufficient evidence that triennial valuation cycles lead to short-termism and an overly conservative funding strategy for long-duration liabilities (noting it considers there is sufficient flexibility in the existing valuation cycle), and
• there are no strong indications of a systemic problem of discount rates being set on an overly cautious basis.

The Green Paper does call for further evidence, however, on whether:

• more could be done (by the DWP and the industry) to help members better understand valuation and deficit data and the risks to the scheme and members
• the quality of trustee decision making on funding and investments could be improved - eg by mandating further trustee training, qualifications or “professionalising” trustees; or indeed greater Pensions Regulator (tPR) intervention (eg giving tPR a more central role influencing or determining the level of risk a scheme should be taking), and
• existing barriers to using alternative asset classes could be mitigated - eg via pooling vehicles so that they are more easily accessed by smaller DB pension schemes.

Employer contributions and affordability

The DWP is not persuaded that there is a general “affordability problem” in relation to DB pension schemes and that “across the board action” is warranted.

The Green Paper states the DWP’s view that:

• DB pension schemes are not inherently unaffordable (in light of current levels of deficit) or unsustainable (in respect of future accrual of benefits).

The Green Paper notes that FTSE 350 companies pay as much as 11 times in dividends as they do in Deficit Repair Contributions (DRCs).

• DB pensions are "hard promises" and debts like any others and should be treated as such.

The DWP considers that any measures to reduce DB pension promises would risk discouraging pension saving and so would require compelling evidence.

The Green Paper does acknowledge, however, that there is a sub-set of distressed DB pension scheme sponsors in relation to which lightening the DB pension burden, coupled with corporate restructuring, could produce better outcomes for members and the Pension Protection Fund (PPF). (The DWP notes that some 20% of sponsors of some DB pension schemes are paying DRCs in excess of 100% of their profit before tax.)

The DWP recognises, however, the difficulties of separating “stronger” and “weaker” employers - and the inherent moral hazard risk of employer manipulation to access any new regulatory easements. The DWP therefore queries whether tPR could be given a role in judging which (if any) new easements are available to a particular employer.

“Stronger” employers

The Green Paper questions whether “stronger” employers should be encouraged to reduce deficits more quickly, perhaps by limiting extensions to recovery plans or setting hard limits on their length in certain circumstances - thereby reducing the exposure of members and the PPF to unnecessary levels of risk. The DWP does appear not to have fully considered the issue of “trapped surplus” - and how requiring stronger employers to “overfund” could present its own difficulties.

“Weaker” employers

The Green Paper poses a number of areas in which regulation could be relaxed for “weaker” employers, which in many cases build on the previous consultation on the British Steel Pension Scheme (BSPS), including:

• Relaxing the rules on trivial commutation to make them simpler to operate in practice (and thus reduce the burden of administering small pensions).
• Setting interim funding targets and separate regulatory and reporting framework for stressed schemes requiring the sponsor to stay in close contact with tPR.
• Allowing deficits to be repaired over a longer period or deferred (back loaded) recovery plans perhaps coupled with allowing some other form of security to be offered by the sponsor.
• Allowing schemes to be separated from struggling sponsors more easily - eg by permitting Regulated Apportionment Arrangements to be used where the employer is not at imminent (but instead longer term) risk of insolvency, or allowing schemes more generally to “run on” without a sponsor).
• Providing more support from tPR to review the potential for restructuring and giving tPR powers to appoint professional trustees in wider circumstances, separate a scheme from a sponsor or wind up schemes.
• Possible changes to the indexation of pensions in payment or revaluation in deferment (including “conditional indexation” - where increases are only given if resources are available to fund them). The DWP recognises that the level of inflation protection offered varies from scheme to scheme and is “somewhat of a lottery” - but does not consider that there is strong evidence to suggest that indexation should be abandoned or reduced across the board.

Member protection

The DWP notes that DB scheme member protection is at “the heart of [its] policy” and considers it is functioning well for the most part, but acknowledges that additional safeguards could be achieved by strengthening the powers of tPR and the role of trustees. However, the DWP recognises that this must not be at the expense of competitiveness of the UK economy.

Accordingly the DWP is seeking views on the following:

• Corporate restructuring - the House of Commons Work and Pensions Committee’s calls for blanket clearance for corporate transactions appears to have been rejected - with the DWP noting that any mandatory clearance process would reduce the attractiveness of UK companies with DB pension schemes to investors. The DWP also seems unconvinced of the case for tPR powers to levy substantial fines (in addition to any required covenant support measures) - noting that this could lead to a rush for clearance and present a significant stretch on tPR’s limited resources.
• Scheme funding - the DWP seems unpersuaded by a move back to mandatory funding standards (such as the widely discredited Minimum Funding Regime), but queries whether clearer guidance from tPR in this area and a "comply or explain" regime may be appropriate.
• Exchange of information - this could involve:
  • duties for parties to cooperate with tPR to ensure tPR can be more proactive and be in a position to investigate schemes, coupled with a sanction for non-compliance
  • requiring sponsoring sponsors to engage with trustees (notably, to consult trustees before paying dividends if scheme is severely underfunded) and provide information that trustees might reasonably require in order to carry out their functions
  • requiring sponsors and trustees to publish a joint statement of scheme objectives, and
  • more tPR engagement with stressed schemes, more guidance from tPR during crucial periods and intensified data monitoring.
• Member disclosure - improving the transparency of communications to assist members with understanding the level and nature of risks faced by their scheme, particularly in the event of sponsor insolvency, although it is unclear what members can do with this information.

Scheme consolidation

Around one third of all UK DB schemes have memberships of under 100 individuals, but together only account for 1% of the total assets held by UK DB schemes in aggregate.

The DWP notes that consolidation could lead to significant economies of scale, including: reduced administration costs, improved governance, better investment performance and access to more sophisticated asset classes.

Various methods of consolidation are considered as follows:

• Full consolidation and ring-fenced consolidation: full consolidation, involving shared services and pooling of assets and liabilities, is thought to be more efficient than ring-fenced consolidation, where schemes share services and pool assets but liabilities are segregated
• Statutory v private consolidator: a statutory aggregator run by the PPF (and recommended by the Work and Pensions Select Committee) was “thought not appropriate”, but the DWP saw scope for the creation of private consolidation vehicles suitable for schemes unable to buy-out benefits but ineligible for PPF entry on the basis of their funding levels, and
• Voluntary or compulsory consolidation: the DWP saw a strong case for voluntary consolidation, but saw compulsory consolidation as potentially disproportionate (given the front-loaded costs) unless compelling evidence was available.

Separately, the DWP notes that it will consult further on a key current barrier to consolidation by non-associated employers: namely the way in which “orphan” section 75 liabilities can fall on entirely unconnected employers.