The moral hazard provisions introduced by pensions legislation from 6 April 2005 give the Pensions Regulator broad powers to force companies, and in some cases individuals, to provide additional funding for defined benefit pension schemes.
The regulator has specific powers to deal with the scenario where deliberate action is taken to avoid triggering or meeting liability under legislation for a pension scheme deficit.
However, the regulator’s moral hazard powers are by no means limited to such situations. It is quite possible for corporate activity, which is in no way pensions-driven, to trigger the regulator’s attention.
Put very broadly, if a pension scheme has a deficit, the regulator will be concerned by actions that could weaken the employer’s (or employer group’s) covenant strength and/or weaken the position of the pension scheme as creditor in the event of the employer’s insolvency.
Applying for clearance
Because the Pensions Regulator’s powers are so broad, the legislation introduced a procedure whereby a person can apply to the regulator for clearance if they are concerned that a particular transaction or activity might result in an order from the regulator, hence receiving confirmation from the regulator that it will not exercise its powers in response to the act in respect of which clearance is sought.
In April, the Pensions Regulator issued guidance regarding its approach to clearance statements. The guidance states that an application for clearance should be considered if the following conditions are satisfied:
- The pension scheme has a deficit on the FRS17/IAS19 basis.
- The scheme employer, or another company within the group, is proposing to:
(a) alter the level of security given to creditors;
(b) make an “unusual distribution” to shareholders who are outside the group, outside the EU or outside the scope of the regulator’s moral hazard powers, including dividends, share buybacks and demergers; or
(c) change the structure of the group in a way that might impact on the pension scheme as a creditor of the employer.
- The action would have a material detrimental effect on the pension scheme.
Regarding an unusual distribution to shareholders, the regulator has signalled that a distribution would be “unusual” if:
- The employer would have negative distributable reserves after reflecting, on the relevant basis (normally FRS17 or IAS19), the pension deficit or after making the distribution.
- The cumulative annual amount distributed is more than two times the average of the amounts returned, paid or otherwise distributed to such shareholders in the last three years.
- The cumulative annual amount distributed will reduce dividend cover to less than 1.25 times (ie the ratio of retained after-tax profit for the period divided by the total amount returned, paid or otherwise distributed to such shareholders in the same period).
A literal application of the third point would prevent a company that has made no distributions in recent years from making any distribution while it has a pension deficit. A company that has made low distributions in recent years might find it difficult to raise them significantly, even to historic levels.
However, informal discussions with the regulator suggest that if the “unusual distribution” test would only be met because of a lack of dividend payments in previous years (or very low levels) and there is no risk of prejudice to the pension scheme, the regulator may be prepared to give a form of fast-track clearance or a comfort letter in respect of a proposed distribution.
What will warrant clearance?
The guidance does nothing, however, to indicate how the regulator will actually decide whether or not to give clearance. However, experience to date suggests that where, as part of the transaction for which clearance is sought, a party agrees to make an immediate cash payment into the scheme equal to the most recent FRS17 deficit, the regulator will generally be prepared to give clearance. Arrangements involving paying off the FRS17 deficit within three years or less will also generally receive clearance. However, it should be appreciated that there are no hard and fast rules in this area, as the regulator looks at each case on its merits.
Jade Murray is a partner and Madeleine Cox a professional support lawyer, both at Addleshaw Goddard