Beware the Regulator’s extended Moral Hazard powers
The Pensions Regulator (Regulator) has a wide variety of powers within its arsenal including the ability to issue Contribution Notices under its ‘moral hazard’ or ‘anti-avoidance’ powers. These powers were originally intended to reduce the burden on the Pension Protection Fund by targeting and penalising certain behaviour by employers and/or their associates that had a detrimental effect on defined benefit (DB) pension schemes, but have been rarely used in practice. The Pension Schemes Act 2021 has introduced two new Contribution Notice tests designed to make it easier for the Regulator to use its powers, in turn making it more likely that more corporate activities will involve a ‘moral hazard’ risk for buyers and investors.
Historically, in order for the Regulator to issue a Contribution Notice there needed to be an intention to avoid pension scheme debt or an actual or potential detrimental impact on the scheme as a direct result of the employer’s behaviour. In practice this test has made it hard for the Regulator to meet the threshold to issue a Contribution Notice. The new ‘employer insolvency’ and ‘employer resources’ tests allow the Regulator to take a ‘snapshot’ of whether the corporate activity has a particular factual outcome on the employer – regardless of the immediate impact on the scheme.
As of the 1 October 2021 the Regulator will be able to issue a contribution notice and impose a liability where:
- on a hypothetical insolvency of the employer there is a material reduction in the amount the DB pension scheme can recover – the ‘employer insolvency’ test.
No account is taken of the likelihood of insolvency in practice, or of the alternatives to the corporate activity – if the theoretical estimated outcome on insolvency for the trustees is materially reduced, the test is met and the Regulator could issue a Contribution Notice.
- the ‘employer resources’ are materially reduced compared to the section 75 deficit (i.e., cost to buy-out benefits with an insurer) of the DB pension scheme – the ‘employer resources’ test.
The ‘employer resources’ is the value of the employer’s annual profit before tax, minus any non-recurring or exceptional items, stated in its accounts immediately prior to the act which is compared to the resources available after the act. No account is taken of whether the employer can continue to meet the contributions required by the trustee on an ongoing basis – if profits are materially reduced, the test is met and the Regulator could issue a Contribution Notice.
Although the Regulator still needs to act reasonably when using its powers, these new powers will make it easier for the Regulator to meet the threshold needed to issue a Contribution Notice and if the corporate activity affects the employer’s ability to support the DB pension scheme it should be easier for the Regulator to impose liability on the employer or its associates.
Although the legislative provisions for the new tests are not retrospective, contribution notices are retrospective in nature with the Regulator having a look back period of six years. It is still unclear whether and to what extent the Regulator will use that look back period for acts occurring before the 1 October 2021. There are statutory defences for both the new tests, but they are currently untested, so there are no precedents on how the requirements of the defence will be applied in practice.
The types of corporate activity that the new Contribution Notice tests are aimed at and likely to capture are:
- sale of part of the employer or its assets that produce a high income stream
- acquisitions which are highly leveraged
- corporate restructuring
- payment of dividends
- introduction or extension of debt of the employer
These are types of activity that would already have been on the radar for employers of a DB scheme and for purchasers of groups with such schemes. However, given the new tests are ‘snapshots’ and consider the position of the employer as opposed to the impact on the scheme there is more potential for the corporate activity to fall within the scope of the tests.
As these tests are still so new there is no real clarity or established practice on how the Regulator will view certain corporate activity – particularly that it will always be viewing the”snapshot” with the benefit of hindsight, typically where things have not turned out as expected or intended. We are expecting there to be an increase in number of clearance applications, a mechanism whereby the Regulator confirms it will not exercise its Contribution Notice powers in relation to specific corporate activity.
Practically, this means an employer and its advisers need to be conscious that having a DB pension scheme could impact timing of a potential transaction, as time to speak to the trustees and perhaps the Regulator, will need to be factored in. Employers should ideally involve the trustee at the earliest opportunity and should assess the impact of the corporate activity against the tests outlined above.