Over the past two years underfunded pension schemes have been waiting expectantly to see how the regulator might exercise its powers. After last week, schemes and members will be more confident that there will be circumstances when a financially exposed scheme will be protected by the regulator in the face of a significant weakening of the employer covenant. An FSD is an anti-avoidance measure introduced by the Pensions Act 2004 to oblige employers to adequately fund their schemes. Under a defined benefit pension scheme the employer agrees to fund members’ benefits, typically based on a certain proportion of final pensionable pay for each year of pensionable service. Another moral hazard provision is the regulator’s power to issue a contribution notice.
An FSD may be issued where the employer is either a service company or where it is sufficiently resourced and there is a connected or associated company against which it would be reasonable to issue an FSD. However, these statutory powers are complex and there is a balance to be struck in determining whether they should be used. A regulator is required to assess whether issuing an FSD is reasonable and must consider a number of factors, for instance the scheme deficit, members’ interests, and the interests of directly-affected parties.
In future, the exercise of the regulator’s powers and other potential scenarios for triggering moral hazard powers will be watched keenly by trustees, employers and financiers. It is a pertinent issue in respect of financial covenants and credit assumptions of finance arrangements involving group companies with under-funded defined benefit pension schemes. Where associated or connected companies within the group have resources at least equal to the actual value of a relevant employer’s assets and 50% of that employer’s estimated deficit under the scheme, an FSD can require the associated or connected companies to underpin (up to full buy-out) the scheme liabilities of the weak employer.
The regulator’s voluntary clearance process for employers and investors considering transactions where there is a defined benefit scheme may need to be considered in a different light. The recent spate of takeover bids, in particular highly-leveraged buy-outs by private equity investors, has sharply focused attention on the regulator’s powers. Where scheme funding is under threat due to limited employer backing or where a corporate deal will result in a significantly reduced covenant, trustees will seek the backing of the regulator. In May, the regulator stated that where there is a significant weakening of the employer covenant, clearance is appropriate regardless of the scheme’s funding position and that, in circumstances of a highly-leveraged transaction, trustees should seek an enhanced level of mitigation in excess of FRS17/IAS19. We have seen that the regulator is taking a proactive interest early on in the deal-making process and reassuring schemes that might have to joust with potential bidders. All of these recent developments are to be welcomed. They may usher in more clearance applications and a greater propensity for trustees, employers and investors to negotiate pension scheme funding issues realistically prior to corporate transactions.
Pensions Regulator chair David Norgrove has recently discussed with the Works and Pensions Select Committee the regulator’s work, including policing scheme governance. We must, against this backdrop, remember that the great majority of defined benefit schemes are well run and have sponsoring employers who support them properly. The difficulty is where a threat to members’ security looms large. Here, trustees need to act. Already major participants at the deal-making table, trustees are now taking a much firmer line and testing their boundaries.
The headline decision to issue an FSD will doubtless influence the advice pensions and corporate lawyers give to their clients (employers or trustees). We have interesting and challenging times ahead.
Jay Doraisamy is a pensions partner at
