Although the Chancellor's decision to replace MFR with a scheme-specific funding standard was announced last March, it could be years before the necessary legislation is drawn up and agreed by Parliament
The Chancellor's Budget statement last March heralded the decision to replace the Minimum Funding Requirement (MFR) with a long-term funding standard designed to be specific for each scheme. But to scrap the MFR and actually support the move to a scheme-specific funding standard will require primary legislation, which could take several years to bring in.
While the Government believes the comments it received on proposals for the MFR with a specific-scheme funding standard were mainly positive, away from the _one size fits all' MFR regime, the recent consultation paper on the issue recognised there was concern that members' security should not be jeopardised by the change. As Opra said in its response to a previous round of MFR consultation, _a subjective funding standard might expose the scheme actuary to influence from persons other than the trustees'.
When the MFR is replaced by a scheme-specific funding standard, the trustees and the actuary will have to set that standard. However, the employer will obviously have to be included in discussions regarding funding and investment. This three-way relationship between trustees, actuary and employer, which will be crucial to the success of a new system, could be a very delicate one.
Comments to the Government on this proposal have expressed concerns as to exactly how, in practice, the trustees and actuary should take the employer's interests into account. I welcome the fact the Government has recognised there are concerns in this area and has promised further consultation.
An important change is that the actuary will have a new statutory duty of care directly to scheme members. Exactly how this will work in practice will be another crucial area in the future relationship between actuary and employer.
For example, this would require the actuary to take the financial strength of the employer into account. This is another area where primary legislation is required and the key will be to achieve the right balance between security and risk. This will also be the subject of more detailed consultation between the Government and all interested parties, including the actuarial profession.
The introduction of a scheme-specific funding standard is effectively a return to the days before the MFR, which generally worked well. However, the added advantage of the new proposal will be the introduction of a baseline, valued as 100% of the scheme's cash equivalent transfer values (CETVs) plus immediate annuity costs and expenses.
In tandem with the introduction of a scheme-specific funding standard, the Government is anxious there should be a new regime of transparency and disclosure. Unfortunately, the problem is how to achieve this laudable goal. Another key area is how transfer values will be treated under the new long-term funding basis. This is of crucial importance since it affects not only those people who stay in defined benefit schemes but also those who choose to transfer out.
Under the current system, the MFR underpins the CETV for individual members. So what happens when the MFR is scrapped? The proposal is that the CETV would instead be based on the new long-term funding basis, which has a certain logical consistency. However, since it is proposed that the basis would be scheme-specific, this would surely lead towards more variation in CETVs from scheme to scheme since they would no longer be based on a common standard.
Prior to the introduction of the MFR, there were serious concerns about the variation of CETV calculations. Generally, life offices used a deferred annuity style basis while consulting actuaries used an equity-orientated one. At least the MFR provided some consistency for CETVs. It would be a pity to see a return to the wide variation of the past but it would be good to see a minimum standard apply to CETVs so schemes could not adopt too optimistic a funding standard.
Until the primary legislation to bring in these longer-term replacements is introduced, MFR remains with us. However, the consultation document proposes changes to make it more appropriate to current conditions.
The changes focus on three key areas:
• Extending the period over which deficits in meeting the MFR must be made good
• Removing the requirement for annual re-certification for schemes that are fully-funded on the MFR basis
• Strengthening the conditions that apply if the employer decides to wind up the scheme voluntarily
Under the current MFR principles, any scheme that is below 90% of the MFR level has one year to make up the deficit and then a further five years to reach the 100% MFR level. The proposed changes would extend the 90% deficit correction period to three years and the 100% period to 10 years.
This would change the current MFR rules in a way that starts to move towards the Government proposals for a scheme-specific funding standard and would certainly take the pressure off the schemes to an extent.
These schemes have to adopt an investment strategy designed to bring them up to full funding in a short time period but this may also result in short-term investment volatility. A longer period to reach 100% of the MFR value may smooth out this volatility.
The next proposal is to remove the current requirement for automatic re-certification or schedules of contributions, which currently exist where a scheme is fully funded on the MFR basis. The aim of this is to become consistent with the move towards a scheme-specific funding standard.
However, while the detail of the proposals suggests annual checks would be removed for fully-funded schemes, the actuary would be required to reassess funding security if there were a significant changes in the funding position. This could be problematic since it depends very much on interpretation of what constitutes a significant change.
Prior to the MFR, the employer had to sign an undertaking, designed by the scheme actuary but based upon a recommended standard, that it would inform the actuary of any significant event. The undertaking listed the significant events the actuary considered appropriate for that particular scheme. A return to this basis should not be problematic ' perhaps failure to comply with the undertaking could be a whistle-blowing event leading to a possible fine.
The final measure to be introduced is the inclusion of stricter conditions when the employer is solvent and decides to wind up the scheme. This is clearly a member security measure since the Government started with the aim of passing legislation to make it clear employers must meet the accrued entitlements in full as they fall due.
In the previous document by the DWP (the DSS as it then was), the phrase used was that employers should _stand behind the benefit promise'. The issue here is precisely what the Government meant by stand behind. It is good to see that the Government has now made it clear this does not mean the trustees of the scheme would be required to secure all non-pensioner liabilities on the basis of purchasing deferred annuities. In current conditions, this would have worked out considerably more expensive than the costs of meeting the MFR and might have had the effect of persuading small and medium-sized employers to rush out and start voluntary winding-up procedures ahead of the regulations being introduced.
Instead, the Government has listened to pensions industry opinion and adopted a much more sensible and pragmatic approach. It has proposed that the debt on a sponsoring employer that decided to wind up the scheme would include:
• The administration cost of winding-up the scheme.
• The cost of annuities for pensioner members.
• The cost of CETVs calculated on the MFR basis for non-pensioner members (eventually the scheme-specific funding basis).
The development of the MFR reform will have an impact on IFAs' corporate and individual clients. Advisers will have to keep corporate clients with defined benefit occupational schemes updated. Those companies who may have previously considered rushing out to start voluntary winding-up procedures ahead of the introduction of the regulations will certainly want to reconsider their position due to the change in costing the liabilities. Corporate clients may also now want to start thinking about how the relationship between actuary, trustee and employer will work once a scheme-specific funding standard has to be agreed. It will be best to identify any pressure points that may arise in discussions between these three parties on funding and investment.
For individual clients, advisers should be aware of the change in how CETVs will be calculated once scheme-specific funding standards have been introduced. Although nothing can be done until we get the detailed changes to CETV calculations, there may be implications for clients considering transferring out of a scheme, maybe before age 45, to avoid taking a transfer test. In this case, clients may be best advised to consider a transfer before the MFR is scrapped rather than after.
In the longer term, the Government will work with the consultation panel to propose the draft bill to replace the MFR. In the shorter term, the draft regulations that set out the changes to extend the deficit correction period, remove the annual re-certification requirement for fully-funded schemes and change the voluntary wind-up conditions, should be implemented by the end of this tax year at the latest.
Scrapping the Minimum Funding Requirement will need primary legislation and may take several years to come in.
In recent consultation exercises, there has been concern that scheme members_ security should not be jeopardised.
For individual clients, advisers should be aware of the change in how CETVs will be calculated once scheme-specific funding standards have been introduced.
Clarke replacing Balkham
'Deep-dive analysis of client behaviour'
Ways to mitigate April’s increases
The best equity income funds examined