UK: The Pensions Act 2004: Pension Protection Fund

The Pensions Act 2004 (the "Act") received Royal Assent on 19 November 2004. Most of its provisions are expected to come into force in April 2005. The Act includes the establishment of a new Pension Protection Fund ("PPF") which will administer schemes of which the sponsoring employer has become insolvent. The PPF is modelled, in part, on the Pension Benefit Guaranty Corporation, which performs a similar function in the United States. This article summarises the main provisions relating to the PPF and draws some conclusions from the US experience.

The PPF is established by a new Board of the Pension Protection Fund (the "Board"). The Board will collect a levy from all "eligible schemes". Eligible schemes are final salary schemes which have not commenced wind up before this provision comes into force.

If the Board assumes responsibility for an eligible scheme, it will administer the scheme and wind it up or continue it as a closed scheme as it sees fit. It will use the assets held from all the schemes that it has taken over and the levy to pay benefits to members under the schemes. The Board will stand as an unsecured creditor of the sponsoring employer in place of the trustees.

The Board will consider assuming responsibility for a scheme if:

• an insolvency event of the sponsoring employer is notified to the Board by an insolvency practitioner; or

• the trustees or sponsors of the scheme notify the Board that the employer is unlikely to continue as a going concern.

The insolvency practitioner (or in the absence of an insolvency practitioner, the Board) will then assess whether a "scheme rescue" is possible. Although there are presently no details of what will constitute a scheme rescue, it is believed that this will be a change in the principal employer to a more financially sound entity.

The Board will assume responsibility if:

• a scheme rescue is not possible; and

• the scheme has a deficit.

During the period in which the Board is assessing whether to assume responsibility for a scheme, no new members may join the scheme and the scheme may not go into wind up, unless the wind up is directed by the Pensions Regulator. Contributions to the scheme and payment of benefits at this time are subject to restrictions.

The PPF will be financed by the funds of the schemes transferred to it, payments by the employers of those schemes and, also, by a levy on all defined benefit schemes. The level of that levy has caused much concern as there are likely to be larger levies at times of financial stress when more employers are becoming insolvent.

The levy will be based on:

• the size of the scheme; and

• the solvency of the scheme.

The levy will be set by the Board but the levy for the first year will be set by the Secretary of State under regulations. The government has confirmed that the first year levy is intended to be based only on the size of the scheme, so as not to further penalise schemes which already have a solvency problem.

As well as the PPF, a new Fraud Compensation Fund will be established under the Act ("FCF"). The Board of the FCF will take over the funds and duties of the Pensions Compensation Board, which makes awards to schemes which have suffered a reduction in assets due to the fraud of some party. An application must be made to the Board of the FCF to receive the benefit of an award. Applications will only be considered if:

• an insolvency event has occurred in relation to the sponsoring employer and a scheme rescue is not possible; or

• an application has been made to the PPF by the trustees of the scheme and a scheme rescue is not possible; or

• the scheme is not a final salary scheme and the employer is unlikely to continue as a going concern.

As with the Pensions Compensation Board, there is no requirement for the Board of the FCF to repay the whole loss suffered by the scheme. The FCF is to be financed by a fraud compensation levy which will be charged on all or a proportion of schemes at a rate decided by the Board of the FCF.

The Pension Benefit Guaranty Corporation ("PBGC") was established in the mid-1970s. As with the PPF, its purpose is to take control of the assets of the schemes where the sponsoring employer is insolvent and to pay the benefits for those employees.

The PBGC has usually run at a deficit (although it did enjoy a surplus between 1996 and 2001) and its deficit by the end of fiscal year of 2004 was over US$23 billion. A major concern for the PPF is the deficits suffered by the PBGC and the view of some commentators in the US that its long term viability is far from assured.

One of the major problems for the PBGC has been the large number of companies entering some insolvency event and surrendering their schemes to the PBGC, thus aiding the recovery of the employers involved. The PBGC’s substantial deficit reflects the large number of schemes for which it has assumed responsibility (over 32,000 by the end of 2003 covering 44 million employees and retirees).

The Act attempts to prevent the same experience with the PPF, in particular by allowing the Pensions Regulator to extend the pensions liability to group companies of the sponsoring employer, should the sponsoring employer seem financially weak. However, this concept in the US has failed to stem the flow of scheme into the PBGC.

The PBGC has a number of advantages that the PPF does not enjoy, including:

• the large deficits habitually run by the PBGC are unlikely to be so politically acceptable within the UK and the government has indicated that it would expect the PPF to break even in the medium term;

• insolvency legislation in the US results in many more companies whose schemes are put into the PBGC’s hands being reorganised and becoming financially viable in the long run than would be the case in the UK. Therefore, the assets of the sponsoring employer are a much more substantial source of income for the PBGC than is likely to be the case for the PPF;

• insolvency events in the US will often result in the company’s debts being forgiven, in return for equity. The PBGC has therefore benefited from equity in the recovering company, whereas the PPF will stand as an unsecured creditor, as would the trustees of UK pension schemes and, therefore, is unlikely to obtain a substantial payment in the case of liquidation.

• the PBGC guarantees benefits up to a monetary limit per individual, whereas the PPF intends to fund 100% of benefits for pensioners and 90% for deferred members, whatever the total cost.

As a result of these differences, it is likely that the levy on schemes in the UK will be substantially higher than those charged by the PBGC. The PBGC levy is charged to the sponsoring employers rather than on the schemes themselves. The PPF by contrast will be required to make substantial levies on schemes whose funding is already precarious, further reducing the security of benefits to members.

In conclusion, the US experience shows that it has been possible to run a protection fund of this kind although the US must now address the long term funding issues of the PBGC, or face a taxpayer bailout. Furthermore, the financing of a fund in the UK may result in an increased number of schemes in very substantial deficit.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.