New scheme funding regime
I don’t know if you’ve already picked up on it or not, but The Pensions Regulator has recently published a consultation document on the way that it plans to regulate the new funding requirements for final-salary pension schemes. The new funding arrangements, as I’m sure you already know, will soon replace the old Minimum Funding Requirement (MFR) that came about as a result of the 1995 Pensions Act (that was the Maxwell one if you remember).
Now, without going into all the ins and outs of it, can I just start by saying that the old MFR basis of scheme funding wasn’t the best thing since sliced bread or anything like it. Final-salary pension schemes are based on promises made by employers to their employees. Employees in final-salary schemes are lucky – they know exactly what their eventual pensions will be in relation to their length of service and the level of their earnings at or near retirement. Employers promising such well-defined pensions are not so fortunate in a way – they cannot know for sure in advance what the true cost of making such strong promises will be. For a start, they can’t know in advance what rate of return they will make on the funds invested to pay for the promised benefits, nor can they be certain of how long people will live on after they have retired and, therefore, while the promised pension remains payable. These twin uncertainties of future investment returns and changes to the general levels of mortality and longevity mean that employers putting aside funds over the long term to meet such commitments need to keep reviewing the adequacy (or otherwise) of the amount of money being put into their pension funds. The Minimum Funding Requirement was supposed to help employers do that, but it is possible for a pension scheme based on benefit promises to be ‘fully funded’ on the MFR basis and yet have woefully inadequate funds to provide for the benefits promised to employees to date in the event of winding up. I'm lead to believe that some ‘fully funded’ schemes have as little as 50% of the money they would need to buy out the benefits scheme members have earned to date.
This thin ice that employers are skating on has been known about for some time and the change in the way schemes will be required to put funding aside in the future is the result. Basically employers running final-salary pension schemes will have to put more money aside in the future than the old basis would have required of them. That is even more necessary these days as the changes made by the Government in 2003 mean that final-salary pension schemes that are closed by solvent employers must be funded at the level necessary to buy-out all of the promised benefits. Before 2003 solvent employers could get out of their pension commitments by simply closing their pension schemes. Now they can’t.
Employers who become insolvent, however, are unable to make good underfunded schemes and it is for that reason that the 2004 Pensions Act gave birth to the Pensions Protection Fund (PPF).
The Pensions Regulator was also established as part of the 2004 Pensions Act and is responsible for not only protecting the rights of members of final-salary pension schemes, but also for protecting the Pensions Protection Fund itself. That’s a difficult juggling act. Getting employers to put aside more to meet the real costs of the benefits they have promised their employees is one thing, but doing it in such a way that would make companies insolvent would be kind of self-defeating really. This consultation is all about the fine line that the Regulator is proposing that employers should walk through this particular minefield.
I won’t go through the full details of the proposals as they are quite involved, but anyone who wants to can get hold of a copy of the consultation document by following the link at the end of this BeeLine. You might find it helpful in your discussions with clients if I summarise what I think the main thrust of it all is though, so here goes:
- The new funding requirements come into force on 30th December 2005.
- The Regulator’s code of practice will come in at the same time.
- Trustees will have to get advice from their scheme’s actuary about how they stand with regard to the new funding standard (which you will also hear referred to as ‘technical provisions’).
- Where there is a shortfall on funding trustees will be required to draw up a recovery plan aimed at eliminating the shortfall as quickly as the employer can afford to do so. (I can’t be the only one who’s gobsmacked at the concept of a ‘recovery plan’ being required to get employers out of the hole that the previous statutory requirements led them into can I?)
- Trustees will be required to tell the Regulator if they have a shortfall and to tell them about the recovery plan they have put in place to deal with it.
- When the Regulator gets all this information it won’t be scrutinising each in depth, but will rather be scanning the data to highlight those schemes where there is greater risk to the members’ benefits, or to the Pension Protection Fund (this is essentially the juggling act I referred to earlier).
- Certain triggers will be used to sort out the high-risk schemes and they may be monitored or even investigated by the Regulator who, at the extreme, can intervene and direct how a shortfall should be eliminated and even to impose a set schedule of contributions that the employer will be required to make.
They’re the main points I think, but overall the aim seems to be that employers will have to take steps to improve the level of funding against the promises they have made to their employees, but over a timescale of something like ten years. This is something that seems reasonable to me, indeed it’s exactly what Scottish Life suggested at an early stage of the consultation on the Pensions Act, it’s just a shame things have had to get so bad before anything could be done about it, but that’s something we can’t undo now…
11 November 2005
The information provided is based on Scottish Life’s understanding of current legislation and regulations and the consultation document "How the Pensions Regulator will regulate the funding of defined benefits" issued in October 2005 by The Pensions Regulator. This may change in the future.
Any research and analysis included has been provided by us for our own purposes and the results are being made available only incidentally.