On 16 June 2020, the Pensions Regulator (TPR) issued updated guidance to both employers and trustees on defined benefit (DB) scheme funding issues arising from the Covid-19 pandemic. The guidance focuses on the coming months, as the concessions it offered in March 2020 ended on 30 June.
The guidance adopts a "back to basics" approach. While TPR acknowledges the challenges faced by employers, the guidance emphasises the importance of legal compliance and good governance when employers make a proposal to defer, suspend or reduce deficit reduction contributions (DRCs) – or future service contributions – increase their secured debt or ask the trustees to release their security.
The guidance reflects TPR's views on what is good practice when dealing with a proposal but, importantly, does not supersede the employer or trustees' legal obligations under trust law and legislation, which remain paramount.
Here are five takeaways for employers and trustees to consider from TPR's updated guidance.
1. Is the employer's business case sound?
Employers are reminded that they have legal obligations (under pensions legislation) to give the trustees the information they reasonably need to administer the scheme in a timely fashion. Employers who make a proposal should, therefore, provide the trustees with financial and business information to justify it.
If the information supplied is limited, trustees are now warned that they should not agree the proposal unless they are confident they can demonstrate that it is in members' best interests and that they have considered the potential implications for the scheme if the employer were to become insolvent.
Trustees are expected to do their due diligence in all cases, request the information they need and probe the employer's business case to ensure the proposal is both appropriate and equitable when compared with how the employer is treating its other creditors and shareholders. Some proposals can expect a higher degree of scrutiny, such as any proposal to release security, which is described as being very unlikely to be in members' best interests.
Trustees should also consider the bigger picture. Now that employers have had time to evaluate their situation, does the information supplied suggest a temporary uncertainty and that it is in members' best interests to agree to the proposal on appropriate terms? Or does it suggest a material deterioration in the employer covenant? If the latter, TPR expects trustees to consider whether a new actuarial valuation or revised recovery plan is the way forward.
2. Take advice
Trustees should take targeted and proportionate advice when faced with a proposal. Advice is likely to include specialist covenant advice (to understand the scheme's position in refinancing, restructuring and insolvency scenarios), legal advice (to understand their powers and duties under the scheme rules and pensions legislation), and actuarial advice (to determine the impact of the proposal on the scheme's funding position).
Good advice should benefit the scheme and is an investment worth making. Telephone advice (with email confirmation) is likely to be more cost-effective than full written advice reports and, if cost is a concern, the trustees should assess (with advice) whether they are able to pay for the advice from scheme assets or amend the schedule of contributions and/or the scheme rules to permit this.
3. Negotiate equitable terms
The guidance encourages trustees to assess their leverage (with the help of legal advice) to secure a seat at the table with other creditors. Trustee friendly contribution rules or wind up powers might mean that the trustees' hand is stronger than they think.
The scheme's interests should be protected by a legally enforceable agreement between the trustees and employer, including terms to ensure continued equitable treatment of the scheme with shareholders and other creditors and the ongoing supply of financial information. TPR expects DRCs to be made good before shareholders see any distribution and that other creditors will not be treated more favourably. Repayment terms and financial triggers for earlier payment should also be agreed.
In our experience, such terms would generally feature in a side letter containing contractual commitments by the employer not to pay dividends, otherwise distribute value or repay or prefer other creditors before the DRCs have been paid in full, save perhaps with trustee consent (so that other protection could then be agreed). Where the scheme's recovery plan is to be reshaped, the revised plan agreed between with the employer will itself be enforceable by the trustees.
The guidance reminds trustees that they must report a revised recovery plan to TPR in the normal way, giving reasons for the change. Similarly, if contributions are missed, they must report these to TPR with reasons for the breach and how they intend to resolve it, as, the guidance states, that "it is likely to be of material significance in the exercise of [TPR's] functions".
When reporting, trustees are encouraged to explain the advice they took, whether they had sufficient information, the timescales for repayment, whether mitigation has been obtained and how equitable treatment has been ensured. The poorer the quality of information provided, the higher the likelihood of follow up questions from TPR.
4. Take good decisions
The guidance warns trustees to expect further questions, so strong governance is crucial. Any conflicts of interest should be appropriately managed and decisions should be taken in accordance with the procedures required by the scheme's trust deed and rules. This is to ensure a valid decision is made by the right number of decision makers considering the right information.
TPR expects trustees to ensure they have sufficient information and advice to understand how their decision will support the employer and the covenant supporting the scheme and balance this against the potential risks to the scheme.
As a matter of trust law, trustees should take into account all relevant factors (advice helps make sure these are tabled), disregard irrelevant ones (again advice can help to exclude matters outside of the trustees' remit) and reach a decision that a reasonable trustee board would make. The guidance adds that they should decide the matter in good faith. Having done this, if it transpires in hindsight that they have made the wrong call, the guidance notes that trustees should be able to defend their position against claims (by TPR or scheme members).
5. Keep records
TPR strongly recommends that employers document their position regarding treatment of their pension schemes, noting that this may help their engagement with TPR in due course. Trustees are also reminded of the need to keep full records of their decision-making and how they reached their conclusions.
In our view, the preferred approach is for employers to set out their proposal by letter, explaining and appending relevant financial information and business forecasts, and for trustees to respond in kind, setting out initial queries, thoughts, and requests for further information.
Further documentation is likely, at the very least, to include a trustee meeting minute, a side letter of terms and (where appropriate) a revised recovery plan. The minutes should set out the issues to decide, how any conflicts have been managed, the advice sought and from whom, key factors to consider and the resolution made (with how any steps needed to be take in consequence will be managed, for example authorised signatories).
Whereas under the earlier guidance quick decisions were tolerated where necessary, TPR's emphasis is now on good decisions. Given the ongoing uncertainty of the pandemic, the guidance accepts that not all circumstances, or decisions, will be perfect, but process is the one thing that trustees and employers can largely control.
Process may need to be swiftly managed, but shortcuts should be avoided. Not only do they risk the quality (and potentially validity) of the decision but they will generally be all too apparent in hindsight if TPR (or scheme members) have reason to take a closer look.