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The new regulatory regime for occupational pensions is being put to the test by the recession. David Pollard and Charles Magoffin look at what the future holds for this recently introduced legislation

The current economic crisis is providing a crunch test for the new regulatory structure for occupational pensions put in place from April 2005. The crunch issue for funded occupational pension schemes is how much they are going to cost, and how much advanced funding should be provided.

In the UK, having developed a system with no statutory funding requirements up to 1997, and then tried out a modified system based on a minimum funding requirement (the MFR, fixed at the same prescribed level for every relevant scheme) from 1997 to 2005, the Government (and Parliament) lurched forward in the Pensions Act 2004 to set up a new system.

The old MFR basis was criticised as too inflexible. And the Government could not resist, in a previous downturn, reducing the level required. So instead, a new regulatory regime was enacted. Ironically, this was at the same time that the European Union was producing a directive for the funding of occupational pension schemes which pointed more towards a minimum funding requirement basis.

The new regime has two limbs. First, political pressure required that a support fund be set up – this is the Pension Protection Fund (PPF). Ultimately, in employer insolvency situations, an underfunded defined benefit pension scheme can enter this fund and a minimum protected level of benefits should be provided to members. The PPF is funded by the assets received from the schemes entering it and by levies on all other defined benefit pension schemes, which increase the costs to employers of funding those schemes.

Secondly, a new funding regime was put in place. This recognises that individual situations are different. It does not set out a funding test applicable to every scheme (unlike the MFR). Instead, a new proactive and dynamic Pensions Regulator was set up with new powers. The aim of the Pensions Regulator is to be ‘risk based’ and generally to monitor pension schemes. Unlike the previous regulator (OPRA), the new Regulator was given increased powers and the mission statement of protecting occupational pension benefits and minimising claims on the PPF. Arguably, the Regulator was envisaged as being the ‘military wing’ of the PPF.

The existence of the PPF means that, for the first time, it is important for every pension scheme and its sponsoring employer to have some comfort on the funding position of every other pension scheme. Otherwise there could be an increasing number of underfunded schemes entering the PPF and so hitting all other schemes by increases in levies.

But, in practice, the Government realised that setting funding levels for each scheme centrally had its own problems. As a result, in time-honoured political fashion, instead of giving any guidance on this fairly fundamental issue, it booted the ball off to another player. The Pensions Regulator would be the one who would police levels of funding within occupational pension schemes.

The legislative framework gives fairly wide powers to the Regulator, which in turn back up increased powers given to trustees on funding, but tends to use words like ‘prudent’ when looking at funding levels. This vagueness is deliberate, as the framework envisages a ‘scheme specific’ funding basis – in effect, agreement must be reached between employers and trustees as to future funding rates, and a recovery plan if there is a deficit. If the trustees have a unilateral right to fix funding under the trust deed, then this seemingly remains unilateral (though there can be difficulties in interpreting precisely how the statutory wording interacts with the wording in the underlying scheme – another problem caused by the legislation).

If agreement cannot be reached between the employer and the trustees, then the Regulator is given power to fix the funding rates itself. The recent Pensions Act 2008 also gave further powers to the Regulator to intervene even if the funding rates have been agreed between the trustees and the employer. This would apply if the Regulator felt the amounts agreed were not prudent.

These points mean that the Regulator and, to a degree, trustees are faced with a quandary. Should they seek to protect benefits in occupational pension schemes (which the legislation says is the primary role for the Regulator)? Or do they have to take into account the ability of the employer to pay? Should funding of the pension scheme take priority over, say, business needs? To put it in context, should, for example, an airline be forced to pay money into the pension scheme rather then buy new aircraft?

All of this was readily foreseeable at the time the legislation was put in place, but these questions have now been brought into stark relief by the current economic circumstances. In effect, there has been a double whammy applied to pension schemes. Employers have become weaker, and often there has been a reduction of funding levels in the pension scheme through a combination of sharp falls in asset values (particularly equities) and a seemingly inexorable rise in liabilities (e.g. with increased longevity projections).

How should trustees and the Regulator deal with this situation? Should they ask for more funding, to be paid more quickly, on the basis that the weakening of the employer covenant means it is more likely that there could be insolvency leaving the scheme underfunded? Conversely, does the fact that the employer is weaker mean that the trustee should not be pushing for more money, on the grounds that the company cannot reasonably afford to pay?

Trustees in these situations will look to the views of the Regulator. After all, the Regulator has been given the new powers and can, in effect, override a funding decision in any event. So, the Regulator is faced with a need to give some guidance to trustees and to employers as to how it will assess funding plans in the future. But it is not staffed at a level that would allow it to do this on an individual basis for every scheme. And how will it decide what is appropriate in any specific case, given the Regulator’s main statutory purpose to protect pension benefits, rather than (noticeably) to protect jobs, enable businesses to continue, or even to encourage the future provision of pensions by employers?

Thrust by the legislation into this position, the Regulator stands to be criticised whatever it does. If it pushes for the increased funding into schemes then it runs the risk of deepening the severity of the recession for employers and increasing insolvencies and unemployment as a result. Conversely, if it allows trustees to reduce their demands for contributions, then it runs the risk of increased future levels of claims on the PPF, and hence sharply increased levy payments by other schemes and ultimately by the sponsoring employers, which could find the increased cost burden unsustainable.

Understandably, faced with this dilemma, the Regulator has acted cautiously. On the one hand, it has restated its previous position that trustees should not be aiming to drive employers into insolvency (this is the last resort). The best position for a pension scheme is a strong supporting employer.

So far, so easy. But short of a potential insolvency, how does the Regulator expect trustees to deal with requests by employers to reschedule contribution plans or deal with increased deficits? Statements from the Regulator point to a need for trustees to consider the position carefully. It would not expect employers to renegotiate extended recovery periods if, at the same time, they were still paying dividends. Otherwise, it has said that it may look favourably on proposals in which recovery plans were extended or back-end loaded in appropriate circumstances.

This demonstrates the difficulty of reconciling the merits of:

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