A new scheme funding framework for defined benefit schemes is now in effect. John Ashcroft, head of strategy at the Pensions Regulator, discusses the regulatory approach.

One of the biggest issues facing the Pensions Regulator is the underfunding of defined benefit pension schemes. This posed a significant problem in the past when employers became insolvent leaving insufficient assets in the pension scheme to pay the promised benefits. While the impact on scheme members of such an event has been lessened by the creation of the Pension Protection Fund, all defined benefit schemes are required to pay into the fund, so the greater the frequency of such events the higher the cost to all schemes.

Tackling the deficit

The 2004 Pensions Act has set out a new framework for scheme funding which replaces the old Minimum Funding Requirement and requires schemes and employers to take action to tackle their deficits. The challenge for the regulator is to see that this new framework is effective at reducing the risks to members’ benefits and the risk exposure (and hence cost) of the Pension Protection Fund.

All schemes with defined benefit liabilities must implement the new framework, starting from their first valuation on or after 22 September 2005. Under the new ‘scheme-specific’ funding requirements, trustees must assume, broadly speaking, two important responsibilities:

• They must establish their scheme’s technical provisions – an assessment, based on prudent actuarial assumptions, of how much is currently needed to provide for the benefits promised to members. This will require careful consultation with the scheme actuary.
• Where a comparison of the technical provisions with current assets reveals a shortfall – as in the majority of cases it probably will – trustees must produce an appropriate realistic, workable recovery plan, backed up by a schedule of contributions, with the aim of eliminating the shortfall as quickly as is reasonably affordable.

The legislation does not prescribe targets or standards for these items; trustees must take into account the nature and circumstances of their particular scheme. They are, of course, expected to make every effort to agree the details of their funding strategy with the sponsoring employer.

Regulating scheme funding

The Pensions Regulator’s statutory objectives include the protection of scheme members’ benefits and the reduction of risks to the Pension Protection Fund, as well as the promotion of high standards of scheme administration in general.

In the area of scheme funding, we have issued a code of practice and other guidance, as well as talking directly to many of those affected by the new requirements through workshops and other events. Furthermore, we have developed a free e-learning resource for trustees and others (www.trusteetoolkit.com) and the most recent module provides in-depth training on the funding of defined benefits. We have also developed examples of some of the documents involved in the new funding framework such as the statement of funding principles and recovery plan.

In May 2006, we issued a statement, following extensive consultation with the industry, explaining how we will approach the task of regulating the funding of defined benefits. This statement was issued in the interests of transparency, and to help trustees and others to make informed choices; it does not prescribe funding targets or the structure of recovery plans.

In this statement, we explain the ‘triggers’ that we intend to use as a means of filtering out those schemes that pose the greatest risks to their members.

Risk-based approach

There are some 10,000 pension schemes with defined benefit liabilities in the UK. For the majority of these, the calculation of technical provisions is likely to show a shortfall, resulting in the need for a recovery plan.

Attempting to analyse all funding decisions in detail would not be an effective use of our resources. We propose instead to take a risk-based approach, using two types of trigger to alert us to schemes that may be at risk

The first and most important trigger relates to the technical provisions. What we shall do initially is compare the figure established by the trustees with a range between two values:

• the ‘section 179’ valuation (the funding required to secure the level of benefits provided by the Pension Protection Fund in the event of employer insolvency used for levy purposes); and,
• the scheme’s liabilities as calculated using the FRS17 accounting standard (or IAS19 where used) as given on the sponsor company’s balance sheet.

If the technical provisions fall below this range, we will want to look more closely at how the target figure has been arrived at. If they lie within the range, whether the scheme triggers or not will depend on our assessment of the maturity of the membership and the strength of the employer’s covenant.

Recovery plan

The second set of triggers relates to the recovery plan. Generally speaking, schemes will trigger if this is longer than 10 years or has a significantly higher level of contributions towards the end of the period. And while we recognise that assumptions on likely investment returns may allow a degree of equity outperformance, a further trigger will apply if the recovery plan appears to be based on unrealistic investment assumptions.

Our prime concern is that the technical provisions have been set at a prudent level so that, in the longer term, members’ benefits will be more secure when full funding on a scheme-specific basis is achieved. We will be prepared to be more flexible when considering the recovery plan. In deciding what action to take (if any) where a recovery plan has triggered, we will take into account the impact any alteration to the plan might have on the employer’s viability, including its ongoing ability to fund the scheme and its long-term health. Our position is that the best means of delivering members’ benefits is, in the great majority of cases, for the scheme to have the continued support of a viable employer.

The fact that a scheme triggers our attention in any of the ways described above does not mean that regulatory action will follow. In all cases, we will carry out a further assessment of the scheme’s circumstances before taking any decision about contacting the scheme or intervening further.

Equally, we may decide to investigate a scheme that has not triggered but that has come to our attention through other channels such as the notifiable events framework, ‘whistleblowing’ reports or other sources of intelligence. The triggers described in our statement are essentially a regulatory tool, and are only one way in which we may identify schemes at risk. Whilst trustees will wish to be aware of how the regulator operates, they must base their funding strategy on prudent consideration of their scheme’s circumstances, not on the regulatory triggers.

Regulatory action

The regulator’s initial task is to gather information and monitor the plans that schemes are drawing up to address their deficits. Recovery plans, where required, must be submitted to the regulator; in addition, we must be told if, for example, trustees and sponsors fail to reach agreement, or if the scheme actuary is unable to certify the calculation of the technical provisions or the adequacy of the schedule of contributions.

If trustees fail to produce appropriate funding plans, or fail to reach agreement with employers, we have powers to intervene and impose a funding solution – for example, by specifying how the technical provisions are to be calculated, or imposing a schedule of contributions. However, these powers will be used proportionately and only as a last resort.

Our aim is that trustees, employers and advisers should work together to develop appropriate solutions to eliminate their deficits, wherever possible, in as short a time as is reasonably affordable for the employer. We recognise that many employers will find the process of eliminating pension deficits very challenging, and that there will be difficult negotiations, possibly involving members as well, if a workable solution is to be established. Some schemes, for example, may need to resort to modifying the future accrual of benefits in order to reduce liabilities.

Use of contingent assets

Ideally, all employers would be able to eliminate their scheme’s deficits within a reasonable period by a series of cash injections. We accept, however, that some employers will have good reason to make use of ‘contingent’ assets such as property, letters of credit, or cash set aside in a separate account and charged to the fund. Typically, the ‘contingent event’ resulting in the release of the asset to the scheme would be employer default or failure to achieve a specified investment return.

Depending on their nature, such assets could be used, for example, to support the recovery plan by providing security until the deficit has been substantially reduced or eliminated.

The regulator has issued guidance setting out the principles that trustees should consider when the use of contingent assets in a scheme’s funding strategy is proposed.

To view or download the regulator’s code of practice on funding defined benefits, example documents, our statement on how we intend to regulate funding, and guidance on the use of contingent assets, visit www.thepensionsregulator.gov.uk.