FUNDING IN DEFINED BENEFIT SCHEMES – THE NEW STATUTORY OBJECTIVE

With some exceptions, the current law requires an employer’s agreement to the contributions it has to pay under the valuation schedule. Some schemes may contain special funding obligations, but most give employers considerable freedom within the overall legal framework and the need to take actuarial advice. This is entirely logical. Most employers are keenly aware of the balance to be struck between the continuing health of their business and the prudent funding of the pension scheme. They are used to balancing diverse and sometimes competing interests: in fulfilling their legal duty to promote the success of the company in the interest of shareholders, directors must consider a wide range of stakeholders and interests. These include the interests of the company’s employees as a whole, not just the smaller number who are likely to be members of a legacy defined benefit scheme. Pension funding is important, but so are lots of other things.

The Pension Regulator’s emphasis on the employer’s covenant recognises this crucial and obvious point. Legal guarantees aren’t worth anything if the guarantor can’t meet them. It is in any event a well-established legal principle that scheme trustees owe a duty to the employer of a continuing scheme, whether or not benefits are still accruing. The point was succinctly put in Edge v Pensions Ombudsman. Trustees must “… always have in mind the main purpose of the scheme to provide retirement and other benefits for employees of the participating employers. They must consider the effect that any course which they are minded to take will have on the financial ability of the employers to make the contributions which that course will entail. They must be careful not to impose burdens which imperil the continuity and proper development of the employer’s business or the employment of the members who work in that business. The main purpose of the scheme is not served by putting an employer out of business.

A new statutory objective for the Pensions Regulator has been introduced. It requires the Regulator to ensure that when exercising its funding powers it minimises any adverse effect on an employer’s sustainable growth.

So why all the excitement about the new statutory objective? Will it make any difference? The Pensions Regulator should already take account of the employer’s position as an ‘affected person’ when exercising its powers. And earlier guidance has emphasised the need both for contributions to remain affordable and the maintenance of a healthy business as the best way of ensuring that an employer can meet its pension obligations.

In practice, the Regulator’s statutory duties to protect members’ benefits and to reduce the risk to the Pension Protection Fund have trumped everything else. On occasions, intentionally or not, its statements have set unnecessary hares running. It was, for example, perhaps unhelpful to appear to suggest that dividends should be curtailed while the pension scheme was in deficit. Clearly, shareholders should not be enriched by ignoring or avoiding proper corporate obligations, but robust companies are perfectly able to balance shareholder reward with their legal obligations to the pension scheme.

A revised funding code incorporating the new statutory objective has therefore been an opportunity to restate fundamentals. There is indeed much to welcome in the new code – the emphasis on an integrated funding strategy makes perfect sense. And one can’t complain that the new objective has been ignored; the code is littered with references to it. But all that said, the approach that underlies the code is one of greater prescription – the very reverse of the scheme-specific framework that the law envisages. The provisions setting out the Regulator’s segmentation of what it terms the ‘DB funding universe’ on the basis of the employer covenant are giving rise to particular concern. Although the Regulator may repeat the mantra that decisions are for the trustees to make, one can’t escape the feeling that the Regulator’s view of how funding decisions should conclude between employer and trustees will depend on its own view of covenant rather than the one the trustees may arrive at after having taken their own advice. The Regulator’s judgement will have been substituted for that of the trustees who are legally responsible to scheme members.

Of course, what the Regulator says isn’t necessarily the law, and robust and properly advised employers and trustees will make up their own minds about what is required for their own scheme. The new objective ought to provide appropriate balance to the Regulator’s other objectives and give trustees confidence as they approach valuation discussions. However, anecdotal evidence suggests the Regulator may be setting the bar so high in the way it intends to scrutinise an employer’s commercial plans that the objective will not have the impact originally envisaged. Few employers will be in a position to share and to justify plans of this sensitivity for their business and, even if they were, the rather clunky nature of the Regulator code (such as the expectation that additional contributions will be made if a particular investment doesn’t go ahead as planned) is unhelpful. So although the new objective ought to help companies with good covenants avoid tying up more resources than are needed for prudent funding – and facilitate a longer term approach to pensions risk – we shall have to see whether in fact that happens.

It will be necessary, as ever, to prepare thoroughly for any valuation or covenant discussions. A decision will be needed on what sustainable growth is – probably a combination of working capital, capital expenditure and dividends – and a careful consideration of the employer’s particular circumstances. Evidence, disclosure, confidentiality and fetters on corporate activity will all be key issues.

And the new funding code offers further food for thought. Conveniently, its more prescriptive approach chimes with the draft IORP 2 Directive, which would increase the scope for regulatory intervention…

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