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Scheme abandonment

Reacting to considerable media coverage of innovative methods for reducing employer risks, the Regulator has followed its public pronouncements earlier this year by issuing a discussion paper on the subject. This invites comment on draft guidance to trustees on the factors to be taken into account when considering an employer’s proposal.

Regulator’s concern

The discussion paper outlines the background to employers’ interest in managing pension risks and details various methods of doing so, together with the Regulator’s perception of their prevalence. Whilst it confirms that the Regulator welcomes methods that reduce risk for both employer and scheme members, it also identifies those methods that cause the Regulator concern. The draft guidance expands upon this and, whilst stressing that it is for trustees to decide what is best for members of their scheme, sets out a formidable and extensive list of issues that the Regulator will expect trustees to consider, in addition to those contained within the Regulator’s Clearance Guidance. The Regulator’s prime concern is to ensure that the link between the scheme and ‘an employer of substance’ is not broken, and the scheme being abandoned.

The Regulator defines scheme abandonment as a transaction that has the following two characteristics:

• the covenant of the employer that ends up supporting the scheme is nominal when compared with that of the previous employer; and
• any financial support offered to the scheme is less than the amount required to ensure that it has sufficient funds to buy out its liabilities with an insurer.

It does not consider that the interests of the scheme members are best served by such transactions, and states that it believes the optimum position to be a scheme supported by a ‘viable employer which is capable of meeting the scheme liabilities’. Indeed, the draft guidance states that ‘the trustees’ starting point in considering any arrangement that results in abandonment of the scheme (or any part of the scheme) should be that it is not likely to be in the best interest of members’.

The discussion paper goes on to outline what the Regulator considers to be a suitable risk reduction strategy for pension schemes that is: relevant to both the scheme and the employer, proportionate and understandable. It suggests that trustees establish a risk control framework including robust and documented objectives within which the trustees and employer can manage the pension scheme risks. However, it states that a ‘vital element is that the risk management strategy does not break the link with an employer of substance’.

Regulator’s expectations

The Regulator believes that the primary benefit for these transactions accrues to the employer and its advisers, rather than the scheme members and that such transactions are contrary to the intention of recent pensions legislation. It strongly suggests that trustees think carefully before accepting the proposal if they could obtain the proposed benefit without losing the employer’s support.

The Regulator expects that all such transactions will be submitted to it for clearance, as it considers them to fall within the scope of its anti-avoidance powers. It states that it will examine such cases very carefully and will consider using its regulatory powers if action has been taken that jeopardises the members’ interests. It reminds employers that it has many methods of finding out about transactions even if they are not submitted for clearance.

The discussion paper recommends that trustees should subject the employer’s proposals to ‘an especially high level of scrutiny’ and carry out ‘an independent, comprehensive and rigorous review of the financial aspects of the employer and the arrangement’. The draft guidance states that trustees should examine at least the following factors and details how the Regulator expects trustees to assess each factor:

• What powers the trustees have under the scheme rules and whether the transaction triggers a statutory employer debt.
• The current employer covenant and the resources of the companies associated with it. (Analysis of this, and the following, factor should go deeper than merely obtaining a credit rating.)
• The covenant of the proposed employer following the transaction and the resources of the companies associated with it. (The draft guidance gives extensive detail in relation to the necessary considerations in this area.)
• The risk and potential benefit to parties to the transaction.
• The security and financial support being offered.
• The structure of the trustee board, appropriate level of technical provisions, implications for the scheme’s PPF levy and investment strategy before and after the transaction. (The discussion paper points out that the security of the UK funding regime relies upon a combination of technical provisions and employer covenant. If the latter worsens, then the former should be strengthened.)
• Alternatives to the transaction, such as winding up the scheme or using third-party insurances.

Guidance for trustees

The Regulator warns trustees that many proposals include a change of administrator or investment manager and list putative benefits to the scheme of agreeing to the transaction. It reminds them that they normally have the power to appoint service providers and advisers and that those put forward by the employer might not necessarily offer the best deal for members. This is yet another area in which the Regulator questions the bona fides of such transactions, as it postulates that any such investment manager might not act in accordance with the scheme’s investment principles and reminds trustees that they will not be indemnified unless it does.

The draft guidance lists advantages that the trustees should be able to obtain without breaking the link to the current employer and which therefore should not be treated as determining factors when assessing the proposals. These include:

• access to improved administration and investment management
• more knowledgeable advisers and
• increased or accelerated payment of employer contributions.

It makes the specific point that trustees should define new money as ‘additional funding to the scheme that can only be made available as a result of the proposed arrangement’.

Finally, the draft guidance states that trustees must assess ‘whether they have the necessary skills, training and ability to understand and judge any proposed arrangement and its consequences’. It recommends that they take independent advice and, where necessary, seek the agreement of the employer to meet the cost of such advice. It states that trustees should not agree to any proposal without taking advice and should not take advice without ensuring that the cost does not itself jeopardise the member’s interests. In this respect, it is encouraging that the guidance explicitly countenances mitigation of the cost of advice by sharing advisers in relation to work that is common to all parties, provided the advisers confirm that they are not conflicted.

Conclusion

Overall, the level of knowledge required to undertake assessments of proposed transactions will be daunting for many trustees and it is likely that the draft guidance will inhibit many trustees from engaging in discussions on arrangements to reduce the employer’s risk exposure from its pension scheme.

Responses should be sent to the coordinator, DB abandonment paper, at the Pensions Regulator. Deadline for responses to the discussion paper is 9 February 2007.

If you wish to discuss any of the matters contained in this publication, please feel free to contact your usual Watson Wyatt consultant or myself directly.

Ian Fairweather
+44 (0)1737 274561
Ian.Fairweather@watsonwyatt.com

For further information on any of the items included in Pensions News Flash, please contact your usual Watson Wyatt consultant.

The articles in Pensions News Flash are of general interest and guidance. Action should not be taken on any specific article without taking specific advice. Watson Wyatt is represented in the UK by Watson Wyatt Limited. Authorised and regulated by the Financial Services Authority.