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Setting the scene for DB in 2012

Stephen Soper, NAPF trustee conference, January 2012

Good afternoon and welcome.

My role today is to set out the regulator’s expectations of you as trustees… in this increasingly complex and changing landscape.

I’ll set out what we expect from you in a number of key areas over the coming year, but I’ll also set out what you can expect from us as we go through 2012.

2012 has become synonymous with auto-enrolment and the shift to DC. This area of our work is very important. Our chief executive, Bill Galvin, spoke about our work to improve DC provision at the London NAPF conference in December last year.

This work is ongoing, as we focus our efforts on ensuring that the millions of individuals who will save more, or save for the first time, once automatic enrolment is introduced, will do so in an environment that is as safe as possible.

For very many of those individuals it will be a DC scheme they save into - so we are naturally focusing attention now on ensuring that DC schemes are designed and run to give members a good outcome from these savings.

You can expect to hear much more about our approach to DC in the coming year. And you will see us publish more information and practical guidance for pension providers, employers and trustees about our expectations of those involved with DC schemes.

As the executive director for DB it falls to me to focus on protecting members who have accrued savings in final salary or other types of DB scheme.

You, as trustees, are the first line of defence for these members and so we are looking to you to play an important role in this work in the coming year and beyond.

We recognise that these are difficult times to be a trustee, and over the coming months we will provide more support to help you play this important role.

This year we will provide greater clarity about our expectations of the trustees approaching valuations with effective dates in December 2011 and throughout this year; clarity about our case processes and procedures; and more information about our future approach to regulating DB schemes - all of which I will touch on today.

The economic climate and flexibility in pension scheme funding

One of the biggest challenges, if not the biggest, facing you all will be the economy.

Increasing life expectancy, shaky confidence in the UK’s economic recovery, uncertain investment returns, low interest rates and low gilt yields have all come together to increase liabilities and deficits.

We cannot predict with complete accuracy how the economy will change over the coming year, but this is clearly a difficult time for everyone involved with DB pension provision.

Over the past six years the scheme specific funding framework has proved robust and flexible enough to support trustees and employers in both benign and challenging economic conditions. During the past four years of economic turbulence, it has provided the flexibility necessary to support sponsoring employers and trustees to find appropriate funding arrangements that protect the scheme, whilst at the same time being affordable and reasonable for the employer.

In 2008 and 2009, when the UK economy last faced a severe economic shock, we published two statements setting out our position on scheme funding. These statements reiterated the flexibility in the framework and that we apply this flexibility pragmatically - recognising that the best support for a scheme generally comes from a healthy, going-concern employer.

These principles hold true however we also recognise the range of pressures, existing and emerging, that trustees to face. The economic conditions at each valuation date are unique and trustees will need to consider the impact of these on their valuation and recovery plan closely.

With this in mind, in April we will publish a statement that will set out our expectations of those trustees going through the valuation process in the coming months. We plan to make this an annual statement, helping trustees to understand our expectations within the prevailing economic conditions. By publishing a contemporaneous statement in this way, it is also our hope that when we start to receive recovery plans for this group of schemes, fewer will require in-depth scrutiny or challenge from us.

Later in the year, we also intend to set out our strategic view on how we will regulate the DB landscape in the future. We have already indicated a more segmented approach to regulation, where we would take a greater interest in schemes that fall into more risky segments - such as those schemes with a very weak employer covenant. In contrast we would expect to have less intensive interaction with those better funded schemes with stronger employer support.

Non-cash scheme support

Over the past couple of years we have seen trustees make increasing use of the flexibility in the funding framework.

The regulator’s view remains that the best support for a DB scheme comes in the form of direct cash contributions. However we understand that it is sometimes in the interests of both the sponsoring employer and the pension scheme, for example where cash flow is constrained, to look for alternative forms of support.

This support might come in the form of contingent assets – assets to which the scheme can only lay claim if there is a ‘contingent event’, such as a funding shortfall below a certain level or the deterioration of the employer’s covenant - or other forms of security, such as group or parental guarantees.

As set out in our ‘Monitoring employer support’ guidance, we expect trustees to be confident that any form of contingent asset, or other security, is legally enforceable, and that an appropriate value is placed on it.

We are also seeing the increasing popularity of incorporating asset-backed contributions (ABCs) and special purpose vehicles (SPVs) into recovery plans as another alternative.

Although many of the same issues arise as with contingent assets, these arrangements differ in whether the scheme directly owns the assets, or benefits from an income stream from the assets. If the SPV is within the employer group there will also be ‘employer-related investment’, or ‘ERI’ issues for the trustees to consider. The ERI risks are not only that the whole structure could prove to be illegal, and therefore potentially worthless, but also that the scheme could be imprudently concentrating risk - making the scheme even more dependent on the success or failure of the employer group.

We recognise that there will be times where a well put-together structure may be of benefit to the scheme and this is something we could be support. But we know that these structures are being promoted heavily and that there is speculation that the regulator has encouraged or approved many of these types of arrangements – this is not the case. Trustees should not assume that an ABC or SPV will always be in the scheme’s interests. It is important they have a firm grasp of the risks and that they carry out proper due diligence. We would not expect trustees to allow a structure to be put in place that increases the time it takes for the scheme to actually reach its funding target.

You should take professional advice, and should also be prepared to challenge that advice and to use common sense to decide whether the structure really does provide better scheme security than the alternative – a standard recovery plan.

Above all, as for any type of asset, we expect trustees to ascertain the genuine value of the assets, and to be comfortable with how this value could be realised for the scheme in the future. It can be particularly difficult to value some asset classes such as brands. Should it prove necessary to realise assets that are closely related to the employer, this will often be against a background of difficult trading conditions or even the employer’s insolvency. In such a scenario, the value of the asset to the scheme may quickly fall, and, ultimately, could prove worthless.

We have also noted that putting in place ABCs and SPVs can involve a significant investment of time and money. It’s important that the scheme receives the highest possible benefit from this investment, and that trustees carefully consider whether such resources would be better deployed as direct contributions to the scheme. We also encourage trustees to request at the outset that employers refund the scheme's adviser costs.

As I have said, we recognise that such arrangements could benefit schemes, but we also encourage trustees to tell us where they have concerns about what is proposed. We can provide further specific guidance for trustees about what steps they should take to assess them.

De-risking & corporate transactions

We recognise and appreciate the importance of corporate transactions in stimulating growth, and in creating and preserving jobs. Adaptable, flexible, and financially stable businesses will play an important part in the UK’s economic recovery. However corporate transactions, where pension schemes are involved, should not happen at the expense of promises made to scheme members. In appropriate circumstances, we are fully committed to investigating and taking action to ensure that members are protected.

Our expectation of trustees faced with any corporate transaction is that you will maintain a dialogue with your employer and that you will fully represent the interests of your members, working hard to ensure that adequate security is in place to secure their benefits. We also expect employers to engage with trustees and have an open and honest dialogue with them. If an employer is concerned about the potential impact of a corporate transaction on the scheme, they should talk to the trustees and, if necessary, consider applying for clearance. Clearance is and will remain voluntary - however we do expect both parties to be able to recognise the types of situation that give rise to risks to members, and to contact us if they have concerns.

We are currently concerned about the potential for pre-pack insolvencies to be used as a vehicle to offload the pension liabilities quickly and cheaply.

All parties must remember that any employer insolvency crystallises members' benefits and that if schemes are underfunded members will potentially receive a lesser pension payout than promised. This will also be a greater burden on other PPF levy payers - who pick up the bill via increases in the levy.

Where we become aware of this type of arrangement, we stand ready to investigate and will carefully consider the impact on the pension scheme and how the situation has come about.

Transparency

To finish I’d like to mention a couple more things you can expect from us in the coming year, both of which relate to the use of our powers, and both of which aim to increase clarity around our actions and our decisions.

Over the past year, as well as continuing to publish the determination notices issued by the Determinations Panel, we have also published reports covering other aspects of our regulatory casework.

These ‘s89 reports’ help us to open up to the industry what we have done in key cases, including where we have used our powers - colloquially speaking, setting out some 'rules of the game'.

Over time we expect trustees to learn from the reports we publish and to use this knowledge to inform the difficult situations and decisions we know that you face.

As well as aiming to provide information about our decisions in specific cases, we will also increase the clarity and transparency of our processes.

The Pensions Act 2011 has amended the statutory time limits for reaching decisions on the use of our anti-avoidance powers. In certain cases this may allow parties a greater window of opportunity to make representations.

We plan to consult with the industry in April on the procedures that our case teams follow as they bring a case to the regulator’s Determinations Panel.

Alongside this the Determinations Panel will also consult on an updated version of the procedures it follows for making a determination on a case.

We hope that each of these moves will help both trustees and employers to better understand how we work.

Summary

We recognise the demands on you and the level of understanding you need are extensive. Current economic conditions are adding to those pressures. You are the first line of defence for 12 million DB memberships – a huge part of the overall landscape. The regulator is sensitive to these difficulties, but we also have a duty to make sure that high standards are met. In that regard, we are committed to providing as much support and information as we can, and always welcome your thoughts on what more we can do.

© The Pensions Regulator