Scheme funding: how the Regulator will regulate defined benefit funding

New scheme funding requirements came into force with effect from 30 December 2005. These will apply retrospectively to any scheme valuation with an effective date of later than 22 September 2005 and signed off after 30 December 2005.

The Regulator's Code of Practice, 'Funding defined benefits', and the Scheme Funding Regulations have finally been published. However, the Regulator is still consulting on how it proposes to regulate the new funding requirements.

This briefing note outlines the details of the Regulator's proposals. These proposals are subject to change. A separate briefing note, 'Scheme funding: Code of Practice and Regulations' outlines the details of the new scheme funding requirements.

How the Regulator proposes to regulate defined benefit funding: general

The Regulator's proposals (set out in the draft statement) are to provide guidance for trustees, employers and advisers on how it will regulate the funding of defined benefit schemes.

The Regulator has two aims:

• To use scheme funding to assist it assess whether or not a scheme is at risk of falling into the Pension Protection Fund (PPF).
• To give an indication of when the Regulator will intervene if trustees and the employer cannot agree on how a scheme should be funded.

How will the Regulator identify the schemes at greatest risk?

The Regulator has developed triggers to enable it to identify schemes which are at risk. The Regulator will use separate triggers for technical provisions and recovery plans. However, it recognises that the triggers are not mutually exclusive. The draft statement makes it clear that the triggers are to aid the Regulator make a preliminary risk-based assessment of the scheme. They are not intended to be a target for scheme funding.

Triggers: technical provisions

The Regulator will be looking to assess the adequacy of a scheme's technical provisions. It will do this by considering whether a scheme's valuation is appropriate in comparison with typical schemes.

The draft statement states that for many schemes the valuation of PPF level of benefits and FRS17 is somewhere between 70-80 per cent of full buy-out. In most cases, the Regulator intends using this range as the trigger. However, different limits may be used where a scheme is significantly different from the average. For example, where it has a different maturity profile.

Even where a scheme falls within the usual range, the Regulator will consider the circumstances of the scheme to assess the appropriateness of the funding objective.

Appropriateness will depend on various factors, such as the strength of the employer covenant and scheme maturity.

The Regulator accepts that trustees may have a good reason for adopting technical provisions that are below the trigger level. The draft statement makes it clear that trustees should not assume that the absence of Regulator interest means they have set sufficiently robust technical provisions.

What can the Regulator do if it decides to investigate technical provisions?

The draft statement states that once the Regulator decides to investigate a scheme it may:

• Ask the trustees to demonstrate they have taken all relevant factors into consideration, for example the guidelines in the code of practice,
• Scrutinise the assumptions chosen as a result of actuarial advice,
• Consider the specific circumstances of the scheme and the employer, and
• Consider whether the trustees/employer have taken any other steps to mitigate the funding risk.

Triggers: recovery plans

Schemes with a deficit must prepare a recovery plan setting out how the shortfall is to be eliminated. The Regulator may intervene if:

• The recovery plan is 10 years or longer because of the risk of significant deterioration in the employer's financial position,
• The recovery plan is less than 10 years and the Regulator considers that the deficit should be made up in a shorter time because the employer's financial position is such that it could reasonably fund the deficit in a shorter time, or
• The recovery plan requires a higher level of contributions towards the end of the period.

Other relevant factors include whether the scheme has contingent security from the employer, other guarantees, agreements or pledges or insolvency insurance protection.

The draft statement makes it clear that there may be other circumstances where a recovery plan may influence the Regulator's actions. For example, in relation to clearance applications or where the trustees and employer fail to agree technical provisions.

The Regulator's focus will be on those schemes with lower technical provisions and longer recovery plans.

How will the Regulator identify schemes subject to the MFR which present the greatest risk?

Schemes have to comply with the new funding regime from the first valuation after 30 December 2005 with an effective date of after 22 September 2005. Until this valuation has occurred schemes will continue to comply with the minimum funding requirements (MFR).

The draft statement makes it clear that the Regulator will identify schemes funded at less than 110 per cent on the MFR basis. In those cases the Regulator may investigate to see whether the trustees have either taken all appropriate actions to improve the scheme's funding position or have considered bringing forward the valuation in accordance with the new regime.

What will the Regulator do after there has been a trigger event?

When the Regulator investigates a scheme it will ask for readily available information and documents. It may request additional documentation where necessary from trustees or their advisers. The draft statement gives examples of the types of documents the Regulator may request.

We think that the Regulator is likely to use this information to consider whether or not to impose a contribution notice or a financial support direction.

What will the Regulator do if trustees and employer fail to agree?

The Regulator may intervene when it becomes aware that the trustees cannot agree with the employer on any of the following:

• Methods and assumptions for the calculation of technical provisions,
• Content of the statement of funding principles,
• Content of the recovery plan, or
• Content of the schedule of contributions.

The draft statement makes it clear that the Regulator will only intervene where it is absolutely necessary and where it understands why agreement has not been achieved. Trustees, therefore, will need to demonstrate that they have explored all reasonable avenues, including mediation, ADR or modification of future accrual.

Where the Regulator thinks differences can be resolved, it will indicate areas where agreement may be sought and give limited time for parties to reach agreement. It may also suggest that additional calculations are obtained or the parties use ADR. Where it is clear that agreement cannot be reached, the Regulator may:

• Require an expert's report based on the Regulator's parameters.
• Modify the future accrual of benefits.
• Issue a direction as to how technical provisions must be calculated.
• Direct how a recovery plan is to be drawn up, including its length.
• Impose a schedule of contributions.
• Issue a freezing order whilst considering whether to wind the scheme up.
• Order a scheme wind up.

Comment

The MFR prescribed the minimum funding standard schemes had to satisfy. In contrast, the aim of the new funding regime is that trustees can adopt funding targets specific to their scheme. While this message is contained in the draft statement, the Regulator has to reduce calls on the PPF, as one of its statutory objectives. The difficulty for the Regulator is not to impose a "son of MFR" funding standard by the backdoor.

The draft statement makes it clear that the Regulator intends to use a filtering mechanism to identify those schemes it may want to take a closer look at. Even though the filtering mechanism (or triggers) need to be adapted to suit the circumstances of the scheme in question, trustees and employers may look to set as their funding benchmark 70-80 per cent of full buy-out.

This way they can be more or less sure that they will not attract attention from the Regulator. If this is the case, will the main difference in truth between MFR and new scheme funding be that the new requirements set the funding threshold at a higher level?

The Regulator has wide and potentially draconian powers in respect of funding. Trustees (and employers) will be watching carefully to see how it exercises its powers. We expect the Regulator's practice will have an impact on the stance taken by trustees in their negotiations with employers.

If nothing else, one result of the new regime will be that trustees will be keener than ever to ensure both that they receive appropriate advice on funding issues and that they document the process adequately. This means that life is going to get tougher for trustees of schemes deemed to be at risk. They have to be ready to demonstrate competence in ever more areas because the Regulator will be closely monitoring the way in which the scheme is run.

The new scheme funding requirement replaces the MFR for defined benefits schemes. The MFR required schemes meet a minimum level of funding. In contrast, the SFR does not require schemes to achieve a particular level of funding. Instead, the trustees are responsible for decisions on funding. Trustees will, after actuarial advice and (usually) with the consent of the employer, set prudent actuarial assumptions to fund the scheme's liabilities (technical provisions). This will form the scheme's funding target, which must be set out in the statement of funding principles (SFP).

As now, a scheme must have a triennial actuarial valuation and the trustees and employer must agree a schedule of contributions. Where the funding target is not met, the trustees must put a recovery plan in place which sets out how and when the funding target will be achieved.

This note is based on the Regulator's consultation document dated October 2005 'How the Pensions Regulator will regulate the funding of defined benefits'. Consultation closes on 26 January 2006.