UK: The Pensions Act 2004: Moral Hazard Clauses

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. Some of the most controversial provisions of the Act are the clauses known as the "moral hazard provisions", which aim to spread the liability for defined benefit pension scheme funding to companies outside those which are employers under a pension scheme. This article summarises the details of those clauses.

When a defined benefit pension scheme starts to wind up, its assets and liabilities are calculated, and any deficit becomes an unsecured debt of the scheme’s employer (the "Debt"). The way the Debt is calculated depends on the status of the employer:

• Since 11 June 2003, where the employer is solvent at the time of wind up, the Debt is calculated on the basis that all liabilities will be met by the purchase of annuities. This is by far the most expensive method of calculating pension scheme liabilities and has effectively brought to a halt the rush by employers to wind up pension schemes.

• Where the company is insolvent, the Debt is much lower, presently on the minimum funding requirement basis, although this will change to the scheme specific funding basis required for ongoing schemes under the Act.

Under certain circumstances, the liability for the Debt will lie with the Pension Protection Fund, and the Act attempts to limit the calls on this fund by making other parties liable for the Debt.

Under UK law, it has always been the case that the only parties liable for pension scheme underfunding are those which are or have been adhered to that pension scheme as principal employer or as an associated employer. The effect of the moral hazard provisions is to extend the liability in certain circumstances to any company which is associated or connected with the scheme employers.

This includes:

• holding companies (including non-UK companies) with at least one-third of the voting power at general meetings of the employer or where the directors of the employer act in accordance with the holding company’s instructions; and

• any subsidiary of such a holding company.

• The Act, and the regulations to be made under it, will exclude individuals who control the employer or are directors from personal liability, but it is not clear whether a company which provides one of its employees to be a director of the employer will be similarly excluded.

The new Pensions Regulator established by the Act (the "Regulator") will be able to issue directions to require an associated or connected party to the pension scheme employer to provide financial support. The level of financial support required will depend on the circumstances but may include making other group companies jointly and severally liable for the ongoing liabilities of the employer in the pension scheme. If a party does not comply with a financial support direction, the Regulator may require that party to make a contribution to the pension scheme or provide asset security equal to the present Debt in the pension scheme.

The Regulator may impose a financial support direction if the employer under the pension scheme is:

• a service company, that is, its principal business is the provision of staff to other group companies; or

• insufficiently resourced, that is, it does not have sufficient assets to meet a specified portion of the Debt should the scheme go into immediate wind up. The specified portion of the Debt has yet to be decided upon and will be stated in regulations.

The Regulator may issue a contribution notice to the employer or to any connected or associated party if it believes that an act or failure to act by that party at any time since 27 April 2004 had as one of its main purposes the reduction or avoidance of the Debt. The level of contribution in the contribution notice will be equal to the amount by which the Debt was reduced as a result of the act or omission.

The provisions are expected to come into force in April 2005. However, in the case of contribution notices, they apply to any act or omission from 27 April 2004 onwards. A notice can only be given up to six years after the event it relates to and a direction may be given at any time, although once the winding up of the pension scheme is complete it is unlikely that the Regulator will make such a direction but is not precluded from doing so.

The Regulator is not obliged to make these orders in every circumstance and will consider, amongst other things, the compliance with any duties of that party to notify the Regulator of its actions, the financial circumstances of the party and the financial gain of that party from the action. In making a financial support direction, the Regulator must consider whether it is reasonable to do so.

Following extensive lobbying from businesses, the Act now provides for a clearance procedure. In giving clearance for a contribution notice, the Regulator will confirm that the act or omission would not give rise to a contribution notice. In relation to a financial support direction, the Regulator may confirm that:

• the employer in question is not a service company;

• the employer in question is not insufficiently resourced; or

• the issue of a financial support direction would not be reasonable.

The Regulator will be bound not to issue either a notice or a direction once clearance has been given, but will not remain bound if circumstances change or it becomes aware of details not disclosed in the initial clearance application.

When the Regulator decides that it wishes to make such a direction or contribution notice, there will be an opportunity for the parties involved to object and, if necessary, refer the matter to the Pensions Regulator Tribunal which will review the decision.

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.