Pensions Regulator's powers enhanced to ensure employers' support

The Pensions Act 2008 gave the Pensions Regulator a new power to issue contribution notices if it feels that some action is materially detrimental to a scheme's members. Its new code of practice sets out the circumstances in which it will exercise this power. We examine the new material detriment test together with further enhancements to the regulator's powers introduced by the act. 

On this page:
New powers for Pensions Regulator
Material detriment test
Code of practice
Guidance
Statutory defence
Financial supprt directions changes
Effective date
Our research
Box 1: Illustrative examples of the application of the material detriment test
Employer considerations in respect of the material detriment test.

Key points The Government has given the Pensions Regulator wider powers to deal with new business models that put the benefits of pension scheme members at risk.  The regulator is now able to issue a contribution notice if it believes that the action of a sponsoring employer is materially detrimental to a scheme's ability to pay current and future benefits, irrespective of the main purpose of the action.  A new statutory defence has been introduced to limit the application of the material detriment test.  It has published a code of practice setting out the circumstances in which it will use this power, together with short, high-level guidance and illustrative examples of how the power will be used.  The Pensions Regulator has been given extended powers in respect of financial support directions.

The Pensions Act 2004 gave the Pensions Regulator powers to ensure that sponsors of pension schemes do not avoid their statutory debts, for example by manipulating their corporate structure, and hence increase calls on the Pension Protection Fund. Its two key weapons are contribution notices (CNs) and financial support directions (FSDs).

The former are used when the regulator believes that the sponsoring employer is party to an act (a term that can include a failure to act) the main purpose of which is to reduce or avoid recovery of the scheme debt that it owes. CNs require the employer to pay all or part of the debt to the scheme trustees.

FSDs require companies connected with an employer causing concern to provide financial support to underfunded defined-benefit (DB) schemes. They can be issued in two types of circumstance. First, they can be made when the value of the employer's resources is less than 50% of the estimated scheme debt and the value of the connected company's resources, when added to those of the employer, are at least equal to 50% of the debt. Second, they can be imposed when most of an employer's turnover is generated by providing services to other companies within the group.

New powers for Pensions Regulator

The Pensions Regulator has achieved some success using its powers to issue CNs and FSDs, the first first FSDs imposed on Sea Containers Ltd. However, certain requirements have proved problematical. In particular, it is not always easy for the regulator to prove that the "main purpose" of an act is to reduce or avoid recovery of a statutory debt, which prevents it from issuing a CN. In relation to FSDs, the rule that the resources of only one connected company can be added to those of the sponsoring employer to meet the 50% test has sometimes proved to be a stumbling block.

The Department for Work and Pensions was also concerned about the rise of what it described as "new business models" that make it easier for employers to avoid their financial responsibilities under schemes. These arrangements may sever the link between the employer and the pension scheme in order to operate well-funded occupational pension schemes for profit but to the possible detriment of scheme members.

To tackle these problems, the Pensions Act 2008 introduces a number of new measures that widen the existing powers of the Pensions Regulator and should make it easier for the regulator to issue CNs and FSDs. The main changes made to the legislation have been to:

• introduce an alternative test in respect of CNs that enables the regulator to issue a CN if the effect of an employer's actions is "materially detrimental" to a scheme's ability to pay current and future benefits;
• remove the current defence to the existing CN test, that the parties involved acted in good faith, but to introduce a new statutory defence to the material detriment test;
• clarify that the Pensions Regulator has always had the power to issue CNs in response to a series of acts, not just a single act;
• introduce a group-wide test for issuing FSDs where the sponsoring employer is either a service company or insufficiently resourced; and
• extend the period of time within which the regulator can issue an FSD after an employer has severed its connection with the scheme, from 12 to 24 months.

Material detriment test

The government's rationale for the introduction of the material detriment test is the "rise of new business models" that may reduce the security of DB scheme members' benefits. The main circumstance the government seems to have in mind is where members' benefits are bought out by investment companies that are subject to the occupational pensions regulatory regime rather than the more stringent financial services regime. In 2008 it came to the conclusion that it is impossible to determine these business models meaningfully and decided to strengthen the regulator's anti-avoidance powers instead.

The material detriment test is an alternative to the existing test for issuing CNs. Under it, the Pensions Regulator may issue a CN if, in its opinion, the act or failure to act has affected in a "materially detrimental" way the likelihood of the scheme paying accrued benefits. The regulator is required to have regard to a number of factors when considering whether the material detriment test is met. These are set out in the legislation and include the value of the scheme's assets and liabilities and/or any effect on these; the scheme obligations of any person and/or any effect of the act on those; and the extent to which the act might affect the ability of any person to discharge scheme obligations in any circumstances, including on insolvency or bankruptcy.

In an extension of the existing rules, these conditions also apply to transferee schemes to prevent employers circumventing the regulator's CN powers by transferring benefits to another scheme. There is no requirement for the regulator to consider the motive behind the act.

When the new powers were announced, there was much concern that regular corporate transactions would come within the scope of the material detriment test. To overcome these concerns the government has introduced three limiting factors on the use of the test. It required the Pensions Regulator to publish a code setting out the circumstances in which the test would be applied; it has introduced a statutory defence to the issue of CNs under this test; and finally it requires the regulator to consider the reasonableness of imposing liability on the person receiving the CN to pay the sum specified in the notice.

Code of practice

Parliament has now approved the Pensions Regulator's 12th code of practice¹. This sets out the circumstances in which the test will be applied and the government intends that it will narrow the application of CNs in respect of the material detriment test in order to exclude normal corporate transactions.

The final version of the code is little changed from the draft. It is very brief and simply lists the circumstances in which the regulator would expect to issue a CN if it is of the opinion that the material detriment test has been met. These are:

• the transfer of the scheme outside UK jurisdiction;
• the transfer of the sponsoring employer out of the jurisdiction of the UK, or the introduction of a new sponsoring employer based outside this jurisdiction;
• the transfer of the liabilities of the scheme to another pension arrangement that leads to a significant reduction of sponsor support or funding to cover the liabilities; and
• the use of a business model or a method of scheme operation that is designed to create a financial benefit for the employer or some other person.

The report on the consultation on the draft code notes that several respondents felt that the purpose of the code is confusing. The code was originally entitled The Application of the Material Detriment Test, which implied that it would contain full details of how the regulator would operate the test. To reduce this confusion and to emphasise that the purpose of the code is limited it has been renamed Circumstances in Relation to the Material Detriment Test.

Guidance

To meet criticisms that the code does not really offer any help to schemes in respect of the application of the material detriment test, the Pensions Regulator has published what it describes as "high level" guidance² for employers that are considering corporate transactions, together with some examples³ that are intended to illustrate its approach to the test.

The guidance stresses the need to work with the scheme trustees to understand the outcome of the proposed transaction and decide whether any "mitigation" to the scheme needs to be made. It also highlights the possibility of using the clearance procedure if the employer is uncertain as to whether the proposed action comes within the ambit of the anti-avoidance powers. This involves obtaining a clearance statement from the regulator, which is intended to give assurance that, based on the information provided, it will not use its anti-avoidance powers to issue a CN or FSD in respect of the proposed event.

The new guidance on corporate transactions directs users to the Pensions Regulator's guidance on clearance, which has been updated to reflect the introduction of the material detriment test. The abandonment guidance has also been amended to refer to material detriment.

An extract from the illustrative examples of action that are not likely or that are likely to be considered materially detrimental to the likelihood of scheme benefits being received are set out in the accompanying box. As can be seen, they are not very detailed and do not explain how the regulator would exercise its powers. The regulator stresses that they are purely for illustrative purposes and should be regarded neither as precedents nor as exhaustive. It also points out that, even when it is pursuing a case where material detriment is alleged, it may still be possible to avoid the need to issue a CN and secure a positive outcome for the scheme.

Statutory defence

Where the Pensions Regulator has issued a warning notice that in its opinion the material detriment test is met, the 2008 Act provides that the party concerned may raise a defence to the notice. Neither the code nor the guidance provide any information about the defence: instead its details are included in the clearance guidance.

Establishing the defence is a three-step procedure. The recipients of notices have to show that:

• before becoming a party to the act in question, they gave due consideration to the extent to which there may be a resulting material detriment to the scheme;
• if they considered that, as a result of the first step, there was a potential detriment, they took all steps to eliminate or minimise the potential detrimental effects; and
• at the time of the act they could reasonably conclude, having regard to all the relevant circumstances prevailing at the time and having performed reasonably diligent investigation, that the act would not be detrimental in a material way.

Details of the defence are sent to all parties concerned with the warning notice.

At the same time as introducing this defence, the government removed the defence to the "main purpose" test for CNs that the parties had acted in good faith. The rationale behind this move is that it has proved difficult for the Pensions Regulator to prove that a party acted otherwise than in good faith. To meet concerns arising from the removal of the defence the legislation adds a number of factors to the list the regulator must consider when assessing the reasonableness of the actions of the parties involved. These include the reasonableness of the person's activities in the circumstances of the case and the likelihood that, and the extent to which, creditors will be paid.

Financial supprt directions changes

The government has also introduced changes to the FSD regime. Previously the Pensions Regulator was restricted to identifying a single entity with sufficient resources (when added to the resources of the sponsoring employer) to support the FSD. Now the 2008 Act provides that, when the Pensions Regulator wishes to issue an FSD, it can take into account the resources of the entire corporate group to check if it can meet the requirement that the value of the connected entities' resources, together with the sponsoring employer's resources, are at least equal to 50% of the debt. This change makes evasion much more difficult.

Regulations⁴ have also been laid that gradually extend the period within which the regulator must issue an FSD from 12 to 24 months of the date on which an employer severs its connection with the scheme. This change is in response to concerns that the 12-month period did not allow enough time for investigation by the regulator and for the employer to prepare a response to the regulator's notice that it wishes to issue an FSD.

Effective date

The regulator's new powers under the 2008 Act commenced on 29 June 2009 but are backdated to actions occurring on or after 14 April 2008.

Commenting on the wide-ranging effects of the CN changes, solicitors Lovells questions whether "an alternative, more proportionate, approach could not be found that could achieve the government's objectives while interfering less with genuine corporate activity carried out in good faith". However, Tony Hobman, chief executive of the Pensions Regulator, believes that "we're not expecting any undue impact upon routine business".

The 2008 Act requires the operation of these new powers to be reviewed during the four years from the date on which they take effect and a report back to parliament within a further 12 months. 

Our research

This feature is based on s.126 and Sch. 9 of the Pensions Act 2008, which insert new ss.38A, 38B, 39A, 39B and 43A into the Pensions Act 2004, together with the Pensions Regulator's Code of Practice No.12 and associated documents. We also referred to a large number of briefing papers issued by solicitors and benefit consultants, particularly those produced by Freshfields Bruckhaus Deringer, Lovells and Mercer.

1 Pensions Regulator's Code of Practice No.12: "Circumstances in Relation to the Material Detriment Test" (PDF format, 302K) (external website).

2 Corporate Transactions (external website).

3 Illustrative Examples: Material Detriment Test (external website).

4 Pensions Regulator (Miscellaneous Amendment) Regulations 2009 (SI 2009/617) (PDF format, 42K) (external website).

Box 1: Illustrative examples of the application of the material detriment test Examples of actions that would not normally be considered materially detrimental Payment of dividends to parent company. Company A is trading profitably and the associated pension scheme has a deficit which is being addressed by an appropriate recovery plan. As part of the recovery plan directors make a routine annual dividend payment to shareholders in the normal course of business. Buyouts and annuities. The trustees of scheme B have chosen to buy out pensioner liabilities by annuities. The trustees discharge the scheme liabilities through the purchase of annuities from a regulated insurer, so that the insurer assumes responsibility for making payments of members' benefits. The trustees took proper account of members' interests in deciding to insure the scheme liabilities. They reconciled the respective interests of different classes of member to ensure all are fairly treated, and conducted due diligence when selecting a product and insurer. General poor trading. Employer C has experienced poor trading as a result of market conditions, and consequently has lost a major customer to its competitors. Granting of security. Employer D grants security in the form of a first charge over some of its assets to renegotiate its borrowings with the bank. In so doing, the employer engages with the scheme trustees and provides appropriate mitigation to the scheme for the reduction in covenant. Investment strategy. The trustees of scheme E and representatives of the sponsoring employer agree an investment strategy in light of the employer's ability to cover any shortfall. This ensures a properly chosen, compliant investment strategy with prudent assumptions taking into account the employer's ability to cope with adverse experience. Example of an action that would normally be considered materially detrimental Removal of covenant. Company P is moderately profitable, and is a sponsor of a scheme with a large deficit. The parent company, which has no legal link to the scheme, substitutes it with company Q, which is a shell company with a materially weaker covenant than company P, as sponsoring employer. Company P is sold off and the proceeds from the transfer pass directly to the parent company and its shareholders. Risking members' benefits. Sponsoring employer R is a company with a very weak covenant and is not able to fund the scheme beyond ongoing expenses. The employer and trustees decide to take an inappropriate investment strategy which will provide profit for the employer and shareholders if a surplus is generated. However, if a deficit is created, any call on the employer for payments will force the company's insolvency. This will in turn cause the scheme and its members to enter the Pension Protection Fund and therefore receive reduced benefits. Restructure and transfer - weakened covenant. Company S has transferred its employees and their respective pension liabilities to company T. Company T is highly leveraged and offers a much weaker supporting covenant to the scheme than company S. No mitigation has been provided to the scheme or its membership for the weakening position. Source: The Pensions Regulator's guidance, "Illustrative Examples: Material Detriment Test".

Employer considerations in respect of the material detriment test

Source: "Corporate Transactions", Pensions REgulator (TPR) (accompanying commentary and notes omitted).