The Pension Regulator’s “moral hazard” regime for defined benefit schemes has been around for a while; its aim is to penalise employers (and associates) for behaviour which detrimentally affects the pension scheme. In October 2021, the moral hazard regime was extended to make it easier for the Pension Regulator to use its powers, and widened the possible corporate activity that could be at risk of prompting the Pension Regulator to use its moral hazard powers. At the same time new criminal sanctions were introduced. Nearly three years on and the Pension Regulator has yet to use these new powers. Despite this, employers, investors and buyers should be aware of them.

In this newsletter we will provide a recap on the Pension Regulator’s moral hazard powers, in particular Contribution Notices and criminal sanctions.

The Pension Regulator can issue a contribution notice, which imposes a requirement for a scheme employer or person(s) connected or associated with such an employer, to make a contribution to the pension scheme, if one of the following four tests is met. They are:

• material detriment – an act or failure to act that is materially detrimental to the scheme;
• main purpose – a deliberate act or failure to act aimed at preventing the recovery of the section 75 debt (the cost to insure benefits with an insurance company);
• employer insolvency – on a hypothetical insolvency of the employer there is a material reduction the amount the scheme can recover. This test takes no account of the actual likeliness of an insolvency occurring;
• employer resources – that the corporate activity will result in a material reduction of the employer’s resources compared to the section 75 debt. “Resources” is the value of the annual profit before the act and immediately after the transaction.

The newer employer insolvency and employer resources tests have yet to be tested, but both look at the position of the employer at a specific point in time and do not take into account the support the employer can offer to the pension scheme going forward after the corporate activity has completed. This makes it easier for the Pension Regulator to be able to use those powers on the employer or its associates, although it will need to act reasonably when exercising its powers.

Although the new Contribution Notice tests were not brought in retrospectively, Contribution Notices are by their nature backward looking and can relate to acts up to 6 years before the notice is issued.

October 2021 also saw two new criminal sanctions come into force in relation to an act or failure to act that:

• was intended to prevent, or reduces, the section 75 debt that would otherwise become due; and
• detrimentally affects, in a material way, the accrued benefits being received.

These are similar to contribution notice tests, are widely drafted, and each offence is punishable by an unlimited fine and/or seven years in prison, where the person was acting without a ‘reasonable excuse’. Any person is in scope, so would include banks, other entities conducting business with an employer with a defined benefit scheme or advisers (other than an appointed insolvency practitioner). It was originally thought that there may be as many as up to five fines being issued and two custodial sentences per year, but these powers have not been used and were not intended for normal business activity.

The variety of corporate activity that may be caught by moral hazard powers includes: sale of part of the business/group or assets that produces high income, payment of dividends, extension or refinancing introducing secured debt, restructuring, and acquisitions which are highly leveraged.

Employers, buyers, and investors should be aware of these wider powers when considering and structuring their corporate activity and trustees should be engaged at the earliest possible point in the transaction. Additional time may need to be factored in to allow for informed and constructive discussions with the trustees where there is material detriment for the pension scheme, especially if mitigation is required.

Key takeaway

Beware of the moral hazards and where there is likely to be material detriment, understand the funding implications, engage covenant advisers, and allow time to have open engagement with trustees as early as possible.