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 hold a risk reserve of approximately 5-15%. Many underfunded schemes (which are required to submit a funding proposal to the Pensions Board as early as 31 December 2012) will feel the accelerated effect of the new regime as their proposals extending beyond January 2016 must anticipate compliance with the reserve requirement.
In theory, it is difficult to argue against holding risk reserves as a “buffer” against future financial market volatility. However, introducing such a requirement at this time of economic downturn is of considerable concern for a lot of DB schemes, many of which are struggling to meet the existing funding requirements. For such schemes, meeting an additional risk reserve may prove impossible. Some DB schemes, which would otherwise have been able to continue, may be forced to wind up as a result of the reserve requirement.
DB schemes will be able to reduce the impact of the risk reserve by investing in cash and sovereign bonds as the reserve calculation gives credit for such investments. However, trustees should exercise great care when deciding on the scheme’s investment and funding strategy and be mindful of their obligation to invest scheme assets prudently. Trustees may decide to invest in sovereign bonds and avail of this incentive, notwithstanding the default risk of such bonds. Alternatively, trustees may decide to invest in lower credit risk assets and accept the requirement to build up a risk reserve.
Schemes may also meet part or all of the risk reserve through a legally enforceable employer undertaking (or promise). Such undertakings must satisfy specific conditions laid down by the Pensions Board, for example, they must become payable if the scheme goes into wind 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.
Industry professionals have strongly urged the Government to introduce the new requirements on a realistic phased basis in order to avoid premature scheme closures. If the reserve requirements proceed as currently planned, trustees and sponsors of DB schemes will be faced with difficult decisions. Given the implications of such decisions for both the schemes and employers, it is important that they both obtain independent advice when considering their options.
Contributed by Mary Greaney, Lorna Osborne.
