27th September 2016 Should I stay or should I go?
Anna Rogers suggests traffic light labelling to indicate the strength of the employer covenant for members considering a DB to DC transfer
In a nutshell:
- pensions regulation is not joined up on DB to DC transfers
- informed consent is the antidote to legal risk, but a major gap in transparency for DB scheme members is the lack of information about the covenant risk of the sponsor
- although presenting challenges for sponsors, a system of appropriately constructed and managed covenant assessment could provide de-risking benefits to them too.
One of the most delicate balances in pensions law is between defending the transfer rights of defined benefit (DB) members and protecting those members from making the wrong decision. DB to DC (defined contribution) transfers are a hot potato and, as transfer values increase rapidly, there are new calls to ban them. It is a common presumption that DB members are better off staying where they are. But as we have seen, the law struggles to deal with the situation when schemes want to obstruct transfers for fear of pension scams. Even if it is a legitimate transfer, DC exposes members to all kinds of financial risk that many people are not well placed to carry. Against this, we have Freedom and Choice, a popular policy (take back control of your own money!) and one that suits government (tax) and sponsors (de-risking) too.
Informed consent is the antidote to legal risk. In making a decision to transfer (or not to), health and family circumstances can quite rationally outweigh economic factors.
However, there is one factor relevant to the transfer decision which involves information that is known to the sponsor, and maybe the trustees, but is not shared with the member: namely, an informed view on employer covenant strength and therefore Pension Protection Fund (PPF) risk. Such information will not necessarily be easy to interpret, but can we expect members to make good decisions when potentially crucial knowledge is hidden from them? Is there a way to make this information more readily available than it is now? And could it be done without damaging the employer?
The DB “promise”
The statutory requirement for financial advice on DB to DC transfers seems predicated on the assumption that the risks in a DB scheme are necessarily less than those in a DC arrangement. In simplistic terms, the choice is often presented as foregoing the “certainty” and “guarantee” of the DB “promise” for the uncertainty and risk of the DC arrangement.
But how accurate is this DB picture in reality? What if the information available to members – or the lack of it – leads them to form an erroneously positive picture of the security of their DB benefit? Does not a decision to stay put have consequences that are potentially just as significant as a decision to transfer?
Without an objective assessment of the strength of the sponsor’s covenant, a proper risk assessment is impossible. The recent publicity around the BHS case, among others, reminds us of its importance. The Pensions Regulator recognises this in the emphasis it places on covenant for DB trustees.
Employers may be only too aware of the risks that their scheme members are running by continuing, in effect, to invest in the sponsor covenant. Yet they are unable (and perhaps unwilling) to convey the relevant information, because it might reduce the positive light in which they want to present their business prospects; and also so as not to seem to be pressuring members to transfer out.
At least we have the PPF safety net. But the degree to which members will be protected in the PPF can be hugely affected by timing issues. Broadly, the risks fall on those with pensions over the PPF cap, those who have not reached normal pension age (even if they have retired early) and those with benefits accrued mostly before 1997. In a bad case, the member may lose half the value of their benefit. Whether a member is running a greater or lesser PPF risk can depend on the precise point at which the employer fails. Yet without good quality covenant information, how can a member arrive at any sensible assessment of this risk and the possible timing of such an event? A highly paid member planning to retire early but working for a financially weak employer might well conclude, on a proper assessment of PPF risk, that a transfer into a DC environment would be preferable to the risk of suffering a significant shortfall in benefits should the employer collapse.
Clear covenant information
The strength of the sponsor’s covenant may often be apparent to the scheme trustees, their advisers and the Regulator when the covenant is particularly strong or weak. If weak, the trustees are unlikely to communicate to members what they know. Trustees will want to protect the interests of members, but their duties are to the members as a whole – not just to those who have an option to transfer out, or to those who would be most adversely affected by a move to the PPF. Case law suggests that trustees are not even supposed to take the existence of the PPF into account.
For individual members to protect their own interests, they require information that they mostly do not have; and were they to receive it in a conventional form, would be unlikely to understand without expert help.
There is therefore a strong case for making regular assessment of the sponsor’s covenant strength compulsory, and for it to be clearly communicated to members.
How could it be done?
No one benefits from undermining the sponsor’s business by divulging business sensitive information, or through information being misinterpreted. The risk is greater if the output from the assessment is in a simplified format, aimed at giving something that members with low levels of financial literacy can read and understand. However, if publication is universal, the likelihood of such damage occurring is less, simply because the market will become used to digesting similar information about a large number of businesses.
Also, if dividend payments and/or the share price are negatively impacted because the market has better understood the ability of the company to meet its pension liabilities over time, perhaps greater transparency was needed.
Anna Rogers: “Would it not help if we could find a way to give them relevant, consistent and comprehensible covenant information?”
If publication of the information tips the balance for members – especially those who face the greatest risk of reduction in the PPF – to transfer out into a properly regulated DC environment, it could speed the de-risking of the scheme, creating a positive outcome for all:
- members happy with their choices
- reduction in the funding cost and recovery period
- improvement in security for remaining members
- improved financial prospects for shareholders.
Avoiding unnecessary risk of damage to the sponsoring business would be crucial. One could envisage a system whereby a quite complex set of agreed criteria (mostly financial) would be used along with an agreed methodology to produce a “score”, similar to a credit score, which is then reported to members, possibly as an item in the scheme’s annual report.
The background assessment should be done on a standardised basis, devised to ensure that the output reflects a consistent approach across all businesses. This sounds a tall order, but the Regulator and the PPF do already categorise covenant risk in a broad brush way.
Many members transferring from DB to DC have to obtain advice from an independent financial adviser (IFA) – those IFAs would have to have access to the relevant covenant assessment.
Perhaps this could be supplemented by a system whereby the information were translated into a simple red/amber/green classification, influencing the requirement for financial advice. For example, a “red” covenant assessment could mean that a transfer, while not automatically authorised, would be made easier for the IFA to recommend.
In recent cases, such as Tata Steel, UK Coal and Kodak, we have seen the authorities demonstrate a willingness to find alternative solutions to the PPF when a DB scheme is struggling. The common thread in these processes is members being given the ability to make informed choices.
Going against the grain
Making DB to DC transfers easier may seem to go against the grain of the recent industry practice of `discouraging incentive exercises, but the incentives code (which I support) is itself an effort to ensure that members have the information they need, without distortion, in order to make a proper decision.
Would it not help if we could find a way to give them relevant, consistent and comprehensible covenant information? In a scheme where significant and undisclosed PPF risk is being run, the fact is that members who do not transfer are also making a decision, and one that may cost them dearly.
This article was also published in Pensions Expert and can be viewed here.
The views in this article are intended for general information purposes only and should not be used as a substitute for professional advice. ARC Pensions Law and the author(s) are not responsible for any direct or indirect result arising from any reliance placed on content, including any loss, and exclude liability to the full extent. Always seek appropriate legal advice from a suitably qualified lawyer before taking, or avoiding taking, any action. If you have any questions on the points raised in the above, please do not hesitate to get in touch.