The death-knell for the MFR

"Unwept, unhonour'd, and unsung" ¹, it seems that the MFR is to be consigned to history. Paul Myners recommended its abolition in his interim report and, of the submissions subsequently made to the Government, the majority were not in favour of retaining the funding standard, even in a modified form.

The Government has acted surprisingly swiftly in response to the views expressed. In a paper ² issued just after the Chancellor's Budget speech, it sets out a plan to abolish the MFR and replace it with funding standards individually tailored to the circumstances of schemes and employers.

The paper makes no commitment as to when the new regime might be introduced. It will require primary legislation, and the Government intends to "develop proposals for legislation when Parliamentary time becomes available". In the meantime, it seems the MFR will continue in force. The interim changes recommended by the Faculty and Institute of Actuaries will not be introduced.

Highlights of the proposal are:

• a funding standard specific to each scheme, determined on a long-term ongoing basis

• possibly a change in the roles of employer and trustees when determining the contribution level – the paper is vague as to how this will operate

• a statutory duty of care imposed on scheme actuaries

• tight deadlines for remedying underfunding

• increased liabilities for solvent employers who discontinue schemes and also, possibly, for insolvent employers.

The new funding standard

Our submission on the MFR, in common with many others, stressed the problems inherent in a funding standard that takes a snapshot at an arbitrary point in time and assumes that the scheme is being notionally discontinued. The Government has paid heed to this, and is proposing that the MFR should be replaced by a funding standard designed to ensure that benefits can be paid as they fall due.

The Government has also agreed that it is impossible to have a single prescribed basis that will be appropriate to all schemes and will hold good in changing economic climates. Instead, each defined benefit scheme will be expected to have a funding standard determined by reference to its own liabilities and circumstances.

More controversially, trustees will be required to form a view of the strength of the employer's covenant to fund benefits. Exactly what this might entail has yet to be clarified. It is easy to imagine the difficulties that trustees might face in this respect if they are also senior employees of the sponsoring company and, as such, are privy to confidential information about its position.

Who will set the standard?

The problem with moving away from a prescribed funding standard, is that somebody has to set the standard for each scheme. It is here that the Government's proposals are rather worryingly vague. The paper stresses the importance of the employer being "fully involved in discussions about funding and investment plans, and in agreeing the contribution rates". However, it is not clear whether the trustees or the employer have the final say in cases where no agreement can be reached. If this power is given to either party in a manner that overrides the scheme's trust deed and rules, there could be a significant shift in the balance of power for some schemes.

The role of the actuary

When the actuary is advising the trustees on setting the funding standard, he or she will, in future, be subject to a new statutory duty of care towards the scheme members and other beneficiaries. The Government believes this will prevent actuaries from recommending a funding plan that will be "imprudent for members". The difficulty, of course, will be in defining what is prudent and what is not.

In addition, the actuary will be expected to take account of the strength of the employer's covenant to fund the scheme. There are practical difficulties with this requirement, because the actuary is unlikely to be close enough to the employer to form a view on this. It is likely that he or she will have to rely on the trustees' assessment. It is also not clear how frequently the actuary will be expected to review this factor or how it should be taken into account, as the financial position of even large and well-established companies can change quite dramatically in a short period of time.

Transparency?

Paul Myners has been a great advocate of greater transparency in disclosure to members, believing that better information will allow scheme members and trades unions to challenge trustees on their funding and investment strategy.

Accordingly, the Government now proposes that schemes should be required to distribute to members (and make available publicly) a Funding Statement, setting out:

• the scheme's funding objectives

• its investment policy and projected investment returns

• the assumptions used to determine future liabilities.

In addition, the Funding Statement should include a contribution schedule agreed by the trustees and the employer.

Improving the information provided to members is always desirable, but the Funding Statement may be a difficult document for a layman to understand, particularly as there will be no common benchmark for all schemes. As always, there will be the risk that, if the scheme is 100% funded on its chosen funding standard, employees will assume that they have 100% certainty of receiving the promised benefits, even if the scheme is wound-up.

Underfunding

If a scheme is not fully funded by reference to its funding standard, the Government proposes that contributions should be set with the aim of reaching adequate funding after a comparatively short period of time. In fact, the paper suggests that three years might be appropriate. Given the potential for contribution volatility, we believe that a longer period might be more suitable.

Scheme discontinuance

The Government believes that solvent employers should be required to stand behind their pension promises, even if the scheme is discontinued. Where the scheme is to run on, the employer must continue to fund the benefits. If it is wound-up, it appears the employer may be required to meet the cost of securing the benefits by buy-out policies.

Employer insolvency

The Government seems far less sure about what should happen in cases where the employer is insolvent. It makes two highly contentious suggestions and then says that these will be subject to further consideration.

The first suggestion is that the employer debt requirement should be extended to cover "the cost of paying all benefits accrued to date". This would presumably mean the cost of securing buy-out policies if the scheme is to be wound-up.

Secondly, the Government plans to look again at the question of making the employer debt a priority liability. There are obvious difficulties with this, which is why a previous Government backed away from the proposal. It could make it difficult for companies to obtain new finance. In addition, existing corporate bonds (many of which are held as assets by pension schemes) may suffer price and/or credit downgrading if pension plan members are suddenly promoted above them in the list of secured creditors.

Compensation scheme

A welcome piece of news is the Government plan to improve the benefits provided by the Pension Compensation Scheme in cases of fraud or misappropriation of assets. In future, the scheme will provide the cost of securing the members' benefits, or the amount of the loss (whichever is the lesser).

Still to be tackled

Not surprisingly, given the speed with which the Government has reached its decision, there are some issues that have had to be left for further consideration. The paper explicitly mentions two that must be dealt with if the MFR is abolished:

• the basis for calculating transfer values

• the statutory priorities on winding-up.

Our view

There is much to welcome in the Government's plans. In particular, we are pleased that the MFR is to be replaced by a scheme-specific standard. We advocated this change, but warned that careful thought needed to be given to the balance of power between employer and trustees. A responsible and solvent employer should not have its cash flow or the future of the scheme taken out of its control.

The new regime is a step in the right direction and could provide a sensible framework for long-term funding. However, a great deal of work needs to be done to determine how it will operate in practice. The most important points to be clarified are:

• the roles of the employer and the trustees

• the liabilities to be imposed on an insolvent employer and on one who is solvent, but chooses to wind up the pension scheme

• the practical implications of the new duty of care to be imposed on the scheme actuary.

We hope that the Government will consult the pensions community on these issues, because if they are not satisfactorily resolved, the new regime could cause as many difficulties as the current MFR. In particular, there is the risk that the trustees and the actuary, bound by their duties to the beneficiaries, will favour investment strategies and funding levels that the employer considers to be unduly cautious.

It would be ironic if the new regime does result in an inherent bias towards conservative investment strategies, given the Treasury's aim of freeing up institutional investment. It could also be extremely damaging to the health of the economy, distorting investment markets yet further and imposing higher contribution levels on employers than would otherwise have been required.

It is also important to recognise that, although the Government paper is entitled Security for Occupational Pensions, the proposals do not tackle the underlying issues concerning security for members. The Government has not resolved the fundamental tension arising from the fact that, in general, the cost of funding a scheme on an ongoing basis is likely to be lower than the cost of securing benefits by means of buy-out policies. It will remain the case that a scheme that is fully-funded on an ongoing basis may not have enough money to secure the benefits on discontinuance.

If anything, this anomaly may be brought further to the foreground by the new regime, because it will increase the employer's liabilities on discontinuance. In addition, the requirement to take account of the employer's covenant may lead to some difficult choices. If an employer falls into financial difficulties, and the trustees, together with their actuary, become doubtful about its ability to survive, they may be under an obligation to review the funding basis. Should they, at the point when the employer can least afford it, move the funding closer to a buy-out basis?

It is disappointing, in some respects, that the Government has set its face against a wider review of security. We would have liked to see more consideration of a pooling option on discontinuance, because this might have offered a cost-effective alternative to annuity purchase. The NAPF proposal to convert benefits to a money purchase basis where the employer ceases to exist had also, we believe, much to commend it.

As a short-term measure, we would urge the Government to review the operation of the MFR during this transition period. While we are waiting for primary legislation to abolish it, there are some steps that the Government could take immediately to suspend one or two of the MFR procedural requirements. Employers, trustees and their advisers would welcome any relief from the grinding of the MFR machinery at this point.