The revised funding standard for defined benefit (DB) schemes has recently come into law. A key feature of the new measures, which will apply from 1 January 2016, is the requirement for such schemes to maintain a risk reserve in addition to meeting the minimum funding standard (MFS) under the Pensions Act. The timing of this new risk reserve requirement has been widely criticised as it is feared that it will have negative and even detrimental consequences on many struggling DB schemes.

Impact of the Risk Reserve

A scheme’s risk reserve will be the aggregate of:

• 15% of funding standard liabilities less 15% of EU sovereign bonds and cash held, and
• the increase in funding standard liabilities if interest rates fall by 0.5%

A scheme’s risk reserve will depend on its funding level and the extent to which it invests in sovereign bonds and cash. However, it is expected that the new regime will increase the funding requirements of such schemes from approximately 5% to 15%.
 
While 1 January 2016 is the date from which schemes must hold a risk reserve, many schemes will feel the accelerated effect of the new requirement.  For example, schemes which do not meet the MFS (i.e. are less than 100% funded) may be required to submit a Funding Proposal to the Pensions Board by 30 June 2013. If the Funding Proposal extends beyond January 2016, it must anticipate compliance with the risk reserve. Furthermore, where a scheme is making an application to the Pensions Board to permit a reduction in benefits (commonly known as a “Section 50 application”), the scheme must immediately satisfy the risk reserve requirement (unless the application is accompanied by a Funding Proposal, in which case the scheme must satisfy the risk reserve requirement by the end of the Funding Proposal period).
 
Mitigating the Impact

As is apparent from the risk reserve formula, DB schemes will be able to reduce the impact of the risk reserve by investing in cash and sovereign bonds. A widespread concern is that the risk reserve requirement, which is intended to protect against market volatility, will effectively reward schemes that invest in what are currently more risky sovereign bonds. Notwithstanding this incentive, trustees may decide to invest in lower credit risk assets and accept the requirement to build up a risk reserve in light of their obligations to invest scheme assets prudently.

A second way in which schemes may meet part or all of the risk reserve is through a legally enforceable employer undertaking. Such undertakings must satisfy specific conditions laid down by the Pensions Board, e.g. they must become payable if the scheme is to be wound up. This option may only be of benefit to a limited number of schemes as it requires that such undertakings are either secured on specified assets or are from an employer with an investment grade credit rating from a recognised rating agency.

Comment

It is difficult to argue against holding risk reserves as a “buffer” against future financial market volatility.  However, the introduction of such a requirement at a time of severe economic downturn in Ireland is of considerable concern for a number of DB schemes, many of which are struggling to meet the existing funding requirements. For such schemes, meeting an additional risk reserve requirement within the timeframe now specified may prove impossible. Some DB schemes, which would otherwise have been able to continue, may be forced to wind up as a result.
 
Contributed by Lorna Osborne & Mary Greaney