Defined benefit pension schemes Contents

4Stressed schemes

81.A pension scheme is stressed when it is significantly underfunded and there is major doubt as to the employer’s ongoing ability to provide necessary financial support. A number of factors can compromise the viability of a pension scheme. Liabilities may grow, the performance of the scheme’s investments may disappoint, or adverse trading conditions can weaken the employer. Growing deficits necessitate deficit repair contributions from the employer that it may struggle to pay.

Binary outcomes – subsist or collapse

82.The current framework is almost entirely binary in its outcomes for stressed schemes, whereby the sponsor either:

83.The PLSA’s DB Taskforce said this binary structure can foster “regulatory misalignment and a lack of flexibility for solvent schemes”. The Taskforce described the UK’s regulatory approach as “inflexible and rigid” compared to OECD counterparts.138 The limited scope for compromise between members receiving their benefits in full or being restricted to PPF compensation was characterised as a “cliff edge” approach.139

84.The Pensions Institute argued that the binary outcomes framework operated to the detriment of the PPF, scheme members and the wider economy:

In some cases, insolvency might be preventable. In others, schemes will transfer to the PPF with far fewer assets than might otherwise have been the case, transferring the stress to the PPF in its role as the industry’s compensation scheme.140

85.The PLSA Taskforce found that “schemes have typically only sought to examine alternative means to structure their benefits when insolvency is inevitable”.141 By that stage compromise may be unachievable. The APL told us that “the current regime does not contain measures for addressing schemes” in situations where the sponsor is unable to commit to a recovery plan which TPR considers acceptable. They suggested that TPR could “provide more engaged and practical support (with realistic solutions) in these circumstances” but that its engagement, particularly with smaller schemes, is hindered by a lack of resources.142

Regulated Apportionment Arrangements

86.If a sponsoring company finds itself at serious risk of insolvency, and the sponsor and trustees are unable to agree to a modification of pension benefits to relieve the pressure, the sponsor may only have a viable future if it cedes responsibility for the pension scheme. A Regulated Apportionment Arrangement (RAA) is a statutory mechanism which allows a company to free itself from financial obligations to a pension scheme in order to avoid insolvency, provided that certain conditions are met and the RAA is approved by both the TPR and the PPF. An RAA was recently approved in the case of Halcrow, an engineering company. Under this arrangement, Halcrow pension scheme members were given the option of joining a new scheme which offers benefit levels lower than those provided by the original scheme but above those provided by the PPF. The scheme is backed by a guarantee from Halcrow’s parent company, CH2M, and received both a cash payment from CH2M and an equity stake in Halcrow. TPR concluded that pensions and jobs were protected by the agreement.143

87.RAAs are, however, extremely uncommon. TPR has approved RAAs in relation to only 26 schemes. TPR will only approve one if employer insolvency is inevitable, and the RAA provides a demonstrably better outcome than insolvency. As an RAA formally severs the link between the sponsoring employer and scheme, it may be an attractive solution to a company otherwise facing insolvency. Therefore TPR, in order to protect both the PPF and scheme members, “applies a stringent set of criteria to avoid RAAs being abused through employers’ responsibilities being inappropriately passed to the PPF”.144 TPR guidance says: “the regulator and the PPF will not agree to such arrangements lightly. It would not be right for levy payers to be compelled to fund the PPF if employers offload their schemes without providing appropriate value to the scheme or the PPF”.145

88.Chris Martin is Chair of the both the Halcrow scheme, in which an RAA was agreed, and the BHS schemes, in which a similar restructuring involving an RAA was explored with TPR prior to the sale of the company but never formally submitted.146 Mr Martin told us that the tools available for trustees of stressed schemes for working with sponsors and TPR were “very blunt”.147 He continued:

the process is just set up to take too long. It is too clunky; it has too many interventions. That is why unfortunately so many schemes fail and end up in the PPF.148

89.TPR expects RAA applications to be accompanied by an application for clearance. Clearance is an assurance that TPR will not use its anti-avoidance powers with respect to that transaction or restructuring.149 TPR accepts draft clearance applications.150 Chris Martin told us that the level of detail required, however, meant that highly complex proposals needed to be worked to near-completion before TPR would consider them:

Clearance is generally developed to the point where it is near-perfect before it is considered. I think it should be more of an iterative process, with the regulator being part of that discussion and developing the plan.151

90.Other witnesses argued that reducing timescales for RAAs would be desirable. RAAs currently involve a statutory 28 day period between TPR issuing a warning notice that it intends to approve an RAA and the final notice taking effect. The purpose of this interval is to give affected parties the opportunity to make representations about whether such approval should be given. However, this rationale has been questioned. The APL identified the hiatus as a “key failing” of the legislation which contrasts unfavourably with the clearance process, where TPR “can and does helpfully condense the process where appropriate so that the warning notice and final determination notice can be issued very close together (sometimes within hours)”. It argued that the 28-day RAA period serves no useful purpose and that it could “positively endanger the ability to rescue distressed companies”, particularly in cases where complex negotiations are continuing.152 Material changes in circumstance during the 28 day period could necessitate the reissuance of the warning notice, restarting the clock and “compounding the timing problem”.153

91.More radically, Chris Martin called for the removal of the requirement to demonstrate inevitable insolvency for an RAA to proceed:

One of the tests is that insolvency has to be inevitable in the next 12 months. By the time you have got to within 12 months of insolvency, it is self-fulfilling, so that test itself should be removed.154

Lowering the ‘inevitability’ threshold, such that RAAs could be used in cases where insolvency is merely very likely rather than inevitable, could be a means of delivering middle way outcomes that are better for all parties than the PPF. Any arrangement would need to have the support of scheme trustees, TPR and the PPF and the evidentiary threshold for insolvency risk would need to be placed on a firm statutory footing to avoid lengthy and costly legal disputes.

92.The Regulated Apportionment Arrangement (RAA) is a means of negotiating an outcome for scheme members that is better than the PPF in instances where a sponsoring employer is in mortal danger. When agreed, it can produce results that are better for pensioners, better for employers and better for the PPF than insolvency. It is, however, very rarely used, and the process includes potentially harmful delays. It is an emergency measure, but it does not operate at an emergency pace.

93.We recommend that in its forthcoming Green Paper the Government consult on:

We further recommend that TPR guidance be amended to encourage its involvement at an earlier stage in the formulation of RAA proposals in order to facilitate a more iterative approach.

Greater flexibility

The case for reform

94.The Pensions Institute argued that trustees do not have enough scope to consider middle-way options that fall short of the full promise initially made to members, but would be preferable to PPF compensation terms. The Pensions Institute asserted that the “worst-case scenario” of a scheme entering the PPF could be averted if the approach to managing pensions changed to one that was prepared for many more schemes to pay less than full benefits on a planned and co-ordinated basis. This could free an employer from the burden of its pension fund, whilst avoiding insolvency, thereby creating extra value which could be shared with the members.155

95.The pension investment manager Cardano argued in favour of trustees having flexibility to restructure unaffordable pension scheme benefits before the sponsor becomes insolvent:

Inevitably, many businesses will not be able to meet their pensions obligations. Therefore we need more flexibility to deal with these situations. Current law only provides one option to a business that cannot afford its pension promises – go bankrupt and pass the pension fund to the PPF. This is clearly a ‘lose-lose’ as the members take a heavy haircut to their pensions and shareholders suffer a complete loss of equity. It is not currently possible for trustees to renegotiate the pension contract before a bankruptcy in order to salvage value on behalf of their members. This must change. If permitted by law, ‘pension fund restructuring’ could provide members with a better pension outcome than the statutory PPF route and give additional breathing space for the company to find a solution that potentially could save thousands of jobs.156

Likewise, the pensions consultancy Mercer favoured greater flexibility. It was among several witnesses to argue that the reduction of pension benefits to increase the viability of employers was a means of addressing inter-generational fairness,157 an issue we considered in a recent report.158 Young people in private sector employment were effectively subsidising generous DB pensions to which they did not themselves have access.

Deferred pay

96.Professor David Blake of the Pensions Institute told us that over time increased regulations have changed pension promises originally made on a “best-efforts” basis into guarantees. A return to the original model, he said would create scope for greater flexibility.159 Steve Webb, however, told us that members of DB schemes have a legal claim to their pension:

in the UK these promises are regarded as an inalienable property right for as long as the pension scheme is in operation.160

Norma Cohen, a former journalist at the Financial Times, concurred, adding that any retrospective claw-back of the property of former employees would almost certainly bring a legal challenge.161

97.We repeatedly heard that pensions were “deferred pay”, remuneration for past work.162 Current and former employees clearly expected pension promises to be honoured and may well have planned accordingly.163 Samuel Pickford, an actuary working in the pensions industry, likened breaking or reducing past promises to asking an employee to refund to their employer part of the salary they received many years ago:

Clawing back salaries earned in the past would be inconceivable, and therefore so should the idea of reducing or scaling back the accrued pension that was earned by employees as deferred remuneration in the same period.164

Likewise, Professor Paul Sweeting, Professor of Actuarial Science at the University of Kent, said:

it would be unthinkable to ask former employees to pay back past salaries to a struggling former employer, but this is essentially what cutting accrued pensions amounts to.165

98.The Minister concurred with these sentiments:

to me a defined-benefit scheme is fundamentally not negotiable, inasmuch that it is an obligation of a company in the same way that salaries are.166

The trustees we heard from agreed that DB pensions were deferred pay. They also told us, however, that some flexibility in benefits would be justified where it was in the interests of scheme members.167


99.Overwhelmingly, the element of member benefits we heard most about in the context of adding flexibility was indexation. Indexation typically comprises an annual uprating of pension benefits, usually linked to a measure of inflation. As annual increases are compounded, small differences in the uprating measure used by different schemes could have a significant bearing on scheme liabilities.168 The Retail Price Index (RPI) used to be the main measure of inflation and the typical benchmark for pension indexation. It has, however, been superseded by the Consumer Price Index (CPI) as the Government’s measure of inflation in official statistics. The CPI is also used to uprate pensions in payment by the PPF.169

100.CPI inflation tends to be lower than RPI inflation. Historically, annual CPI growth has been around 0.7 percentage points lower than RPI, though the Office for Budget Responsibility expects the gap to widen to around 1.2 percentage points in future.170 DB schemes that have latitude within their rules to change the inflation benchmark have generally taken the opportunity to adopt CPI. Steve Webb told us:

Any pension scheme that says, ‘Uprate benefits in line with inflation or with the Government statutory measure’ or whatever, they are all using CPI.171

101.While many schemes are free to switch to CPI, others are bound by the wording in their rules to use RPI.172 Whether schemes now had the flexibility to use CPI indexation was tantamount to a “small print lottery”.173 Other indexation requirements placed even greater strain on the sponsor. Adnams PLC told us that its scheme increases pension rights accrued before 1999 by a minimum 4 per cent each year, double the Bank of England’s target rate of CPI inflation. Honouring that promise was consuming about 15% of the company’s profits.174

102.Switching to CPI indexation would improve the affordability of pension schemes for sponsors. Hymans Robertson, a pensions consultancy, told us that the UK’s combined DB deficit could be reduced by £175bn if all schemes could switch from RPI to CPI for pension increases and revaluation. This would, however, result in an irreversible reduction in value of benefits of an average DB scheme member by £20,000 over their retirement.175

Statutory employer override of scheme indexation rules

103.Employer representative bodies called for a statutory override of scheme rules to allow companies to switch to CPI indexation of DB pensions. The CBI argued that CPI should be used as the “modern” inflation benchmark and the one used by the Government as its official measure.176 EEF similarly noted that the “practice of using CPI as the main measure of inflation is now well embedded in other spheres”.177

104.Other witnesses, however, cautioned against giving employers such powers. Janice Turner said:

We know that there are pension schemes where companies are doing incredibly well and yet companies still want to close the pension schemes. If there was a power to reduce these liabilities, these promises, then to what degree are companies going to take advantage of that? That is a real worry.178

Similarly Broadstone, a pensions consultancy, suggested that allowing the unilateral amendment of past service benefits by the employer would be “the thin-end of the wedge and result in a longer term devaluing of member’s benefits and contingent benefits”.179 Unite, the trade union, argued that companies would exploit such a change to increase profits rather than improve pensions.180

105.Steve Webb told us that as Pensions Minister he considered whether to create a statutory override but, while he acknowledged that scheme indexation was “a bit of a lottery”, ultimately decided against it:

I think that has to be a last resort, to say, “We are a bit broke, guys. We are just going to break our promises”, because once you do it for RPI, you do it for everything else. It is a thin end of the wedge kind of thing.181

Empowering trustees to intervene in the interests of members

106.Broadstone expressed “sympathy” with employers disadvantaged by the drafting schemes rules but said the first concern should be for members “that have accrued benefits with a promise of RPI protection”.182 It is not clear, however, to what extent members would have accrued rights cognisant of the benefit of RPI indexation relative to CPI indexation. In arguing that enabling CPI indexation in private-sector DB schemes “should at least be on the table” as a means of addressing intergenerational unfairness, Paul Johnson, Director of the think tank the Institute of Fiscal Studies (IFS), noted that public service pension rights had been switched to CPI “entirely retrospectively”.183 He argued that “nothing is forever in public policy”:

We generally think it is reasonable for governments to change rates of income tax and VAT even if we have made our choices on the assumption they will stay much the same. State pension ages are rising, and nobody seriously thinks you can increase them only with 50 years’ notice to ensure nobody currently working will be affected.184

107.The Communication Workers Union (CWU) opposed a blanket change from RPI to CPI but accepted that in certain cases it may be allowable as the only option to stave off scheme failure:

where such a measure was deemed essential to keep a scheme open to future accrual having exhausted all other avenues, we accept that this would be preferable to scheme closure.185

Malcolm Booth, Chief Executive Officer of the National Federation of Occupational Pensioners, concurred:

in a situation where, ‘move to CPI or go to PPF’ is a straight choice, I do not think that is a choice. That is a case of go to CPI, and how that is managed is the key factor.186

108.Other witnesses suggested that conditional indexation would enhance the sustainability of some schemes.187 Struggling schemes could temporarily stop paying pension increases, or pay lower increases, to help them get back on track. These increases would be paid if and when scheme funding and sponsor performance improved. This approach has been used in the Netherlands in an attempt to encourage pension schemes to take on investment risk.188 The CWU opposed conditional indexation and noted that if a policy to allow it was introduced it would need to be “accompanied by special conditions to prevent employers from abusing the rules”.189 Hymans Robertson suggested that such conditions would need to align the interests of the business and scheme members. For example, the employer might be restricted in paying dividends in the interim period.190

109.Andrew Bradshaw told us that there should be more flexibility to allow trustees, companies and the regulator—possibly in consultation with members—to examine the means of reducing scheme liabilities outside the PPF. He said that this should only be as a last resort, after all alternative options had been thoroughly investigated.191 Chris Martin argued that trustees should be empowered to change member benefits if they thought it was in the best interests of the scheme members:

Some of these pensions were promised 40, 50, 60 years ago in a different time, but if the trustee forms the view that it is in the best interests of the generality of the members to change some of those benefits, then we ought to be able to do it and we should be empowered to do it in a way that is going to improve the outcome rather than just destroy value.192

110.Pension promises are just that. Any change to the terms of them should not be taken lightly. In circumstances where an adjustment to the scheme rules would make the scheme substantially more sustainable, however, a reduction in benefits could well be in the interests of members. Some schemes have more generous indexation rules than others more by accident than design, and indexation by CPI rather than RPI is certainly preferable to corporate insolvency and a pension scheme in the PPF. Trustees should be empowered to take decisions in the long term interests of scheme members.

111.We recommend that in its forthcoming Green Paper the Government consult on means of permitting trustees to propose changes to scheme indexation rules in the interests of members. These proposals should be subject to regulatory approval but the presumption should be in favour of change. This measure should not only facilitate permanent changes to indexation rules; in many cases a conditional arrangement, whereby the scheme and employer have some breathing space to overcome difficulties, but then revert to more generous uprating when good times return, may be most appropriate.

Compulsory wind-up of schemes

112.If a stressed scheme’s trustees and sponsor are unable to put a funding solution in place to deliver full benefits, both parties may decide that the best available solution is to wind up the scheme. In such circumstances the scheme ceases to exist and its assets are either transferred to another scheme or used to buy annuities to provide member benefits.193 Where a scheme is in deficit at the point of wind-up, this triggers an enforceable debt under section 75 of the Pensions Act 1995 which obliges the sponsor to make good the shortfall.194

113.Andrew Bradshaw told us that some trust deeds give trustees the unilateral power to wind the scheme up. They may choose to use this power “if there is a change of ownership of the company or if the trustees are concerned about the level of funding”. This, he told us, gives trustees “significant leverage (and potentially a veto) over a proposed corporate transaction”.195 TPR also has the power, under section 11 of Pensions Act 1995, to force the wind up of a scheme if it is satisfied that such an outcome is “necessary in order to protect the interests of the generality of the members of the scheme” and cannot be achieved by other means.196 TPR has not tended to use this power.197

114.In severe cases of scheme stress—characterised by large and growing deficits, a weak sponsor and the lack of a sustainable plan to meet pension promises in full—it may be inevitable that a scheme will end up in the PPF. The insolvency event needed to trigger PPF entry may not yet, however, have occurred. A “zombie scheme” drifts on with no prospect of an improvement in the funding position but with a high likelihood of further deterioration. Steve Webb cautioned that schemes in a zombie state are incentivised to take risks that could make the situation worse:

One scenario is that trustees judge that their only chance of dealing with the deficit is to go for high-risk but potentially high-return investments (akin to ‘betting the fund on the 3.30 at Haydock’). Whilst this might have a small chance of success, the downside risk is that the deficit could balloon, making the eventual hit on the PPF that much greater.198

115.The Employer Covenant Working Group suggested that TPR’s wind-up power could be extended to be used in broader circumstances than just the interests of the generality of members. These might include circumstances where the PPF was being placed at greater risk by allowing a scheme to drift.199 The PPF suggested that TPR could have a new and broad power to require the wind-up of pension schemes, triggered at the request of either the trustees or PPF.200 Alan Rubenstein said the trustees or, in extremis, the PPF might approach TPR to say:

‘Look, we have been locked in negotiations with this employer for ages. They will not budge. We need your help, and in extremis, we need you to order the winding up of this pension scheme because we can’t see how, under these conditions, it can ever deliver the pensions it is promising to people’.201

116.Steve Webb said that a compulsory wind-up could be the least bad option in certain cases where an insolvency event has not yet occurred but there is no prospect of the funding position improving to deliver a better-than-PPF outcome:

Let’s say you have a scheme that everybody knows the day is going to come when it cannot meet its liabilities. Do you just let it run on, potentially letting the deficit get worse, so that the hit on the PPF is worse? Who pays for that, every other sponsoring employer paying the PPF levy, or do you end the pain now, force a wind-up of the scheme and say, “Look, we all know this is never going to get any better. We will put them in the PPF now before it gets any worse”?

He cautioned that “forcing the pace” on scheme resolution in this way would be contentious, as in the absence of a clear failure event such as insolvency there may still be those who argue that the situation could have eventually improved. He concluded, however, that “but it is probably in the public interest because otherwise you just take a bigger hit on the PPF.”202

117.We recommend the Government broaden TPR’s power under section 11 of the Pensions Act 1995 to order the wind-up of a pension scheme. TPR should be permitted to wind-up a scheme when it is satisfied that this would be in the best interests of the PPF and its levy payers, and that no alternative option is realistically available to deliver a better outcome for members.

138 Pensions and Lifetime Savings Association, DB Taskforce Interim Report, October 2016

139 Employer Covenant Working Group (PPF0038)

141 Pensions and Lifetime Savings Association, DB Taskforce: interim report, October 2016

142 Association of Pension Lawyers (PPF0071)

144 The Pensions Regulator (PPF0091)

146 Work and Pensions and Business, Innovation and Skills Committees, First Report of the Work and Pensions Committee and Fourth Report of the Business, Innovation and Skills Committee of Session 2016–17, BHS, HC 54; The Pensions Regulator, Regulatory intervention report issued under s89 of the Pensions Act 2004 in relation to Halcrow Pension Scheme, July 2016

147 Q3322 [Chris Martin]

148 Q3322 [Chris Martin]

149 TPR guidance, March 2010

151 Q3319 [Chris Martin]

152 Association of Pension Lawyers (PPF0071)

153 Association of Pension Lawyers (PPF0071)

154 Q3322 [Chris Martin]. The 12 month requirement is set out in section 7A of the Occupational Pension Schemes (Employer Debt) Regulations 2005.

156 Cardano (PPF0061)

157 Mercer Ltd (PPF0064). See also Association of Consulting Actuaries (PPF0039)

158 Work and Pensions Committee, Third Report of Session 2016–17, Intergenerational Fairness, HC 59

159 Q3189 [Professor David Blake]

160 Steve Webb (PPF0002)

161 Norma Cohen (PPF0112)

162 Samuel Pickford (PPF0049); Qq3322–3323 [Janice Turner and Andrew Bradshaw]

163 Qq3322–3324 [Janice Turner and Andrew Bradshaw]

164 Samuel Pickford (PPF0049)

165 Professor Paul Sweeting (PPF0111)

166 Q3475 [Richard Harrington MP]

167 Qq3322–3324 [Chris Martin, Janice Turner and Andrew Bradshaw]

168 Q3476 [Richard Harrington MP]

169 PPF payments relating to pensionable service from 5 April 1997 rise in line CPI with inflation each year, subject to a maximum of 2.5 per cent a year. Payments relating to service before that date do not increase.

170 Office for Budget Responsibility, Working paper No. 2: The long-run difference between RPI and CPI inflation, Ruth Miller, November 2011.

171 Q3149 [Steve Webb]

172 Hymans Robertson (PPF0084)

173 EEF (PPF0072). See also Willis Towers Watson (PPF0102).

174 Qq3259–3260 [Stephen Pugh]; Adnams PLC (PPF0031)

175 Hymans Robertson (PPF0084)

177 EEF (PPF0072)

178 Qq3322–3323 [Janice Turner]

179 Broadstone (PPF0076)

180 Unite (PPF0093)

181 Q3149 [Steve Webb]

182 Broadstone (PPF0076)

183 Paul Johnson, “Time to break promises to pensioners?”, BBC News, 4 October 2016

184 Paul Johnson, “Time to break promises to pensioners?”, BBC News, 4 October 2016

185 Communication Workers Union (PPF0075)

186 Q3352 [Malcolm Booth]

187 Aon (PPF0062); Hymans Robertson (PPF0084)

188 Professor Paul Sweeting (PPF0111)

189 Communication Workers Union (PPF0075)

190 Hymans Robertson (PPF0084)

191 Qq3323–3324 [Andrew Bradshaw]

192 Q3322 [Chris Martin]

195 Association of Professional Pension Trustees (PPF0128)

197 Q3210 [Rosalind Connor]. The Employer Covenant Work Group (PPF0038) did not think TPR had ever used the power.

198 Steve Webb (PPF0002)

199 Employer Covenant Working Group (PPF0038)

200 Pension Protection Fund (PPF0088)

201 Q3391 [Alan Rubenstein]

202 Q3172 [Steve Webb]

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20 December 2016