Pension Protection Fund: explained

Having attracted much media coverage recently, what is the purpose of this fund and how does it work?

The main purpose of the Pension Protection Fund is to provide compensation to members of eligible defined benefit pension schemes, when there is a qualifying insolvency event in relation to the employer, and where there are insufficient assets in the pension scheme to cover the Pension Protection Fund level of compensation.

Pension protection levy

The Pension Protection Fund (PPF) covers certain defined benefit occupational pension schemes and defined benefit elements of hybrid schemes. Schemes eligible for protection by the Pension Protection Fund are liable to pay annual levies to the Fund. The levy is payable by all UK defined benefit (final salary) pension schemes whose members would be eligible for compensation from the PPF if the scheme employer becomes insolvent and there are not enough assets remaining in the scheme to pay benefits at PPF levels of compensation.

The pension protection levy is divided into two parts:

1. The scheme-based levy, which is based on the scheme’s liabilities to members on a section 179 basis. Although this cannot make up more than 20% of the total they aim to collect.
2. The risk based levy takes account of the risk of a scheme’s sponsoring employer becoming insolvent (insolvency risk) and the amount of compensation that might then be payable by the PPF (underfunding risk).

The pension protection levy is charged annually for each year to 31 March.

Which schemes have to pay the Pension Protection Levy?

All eligible defined benefit schemes – as defined in section 126 of the Pensions Act 2004 and the Pension Protection Fund (Entry Rules) Regulations 2005 – have to pay the pension protection levy (with only a few exceptions). However, for schemes in a PPF assessment period the levy is nil, provided that a scheme failure notice was issued by 31 March immediately preceding the relevant levy year, and has become binding before the calculation of the scheme’s levy.

How the levies are calculated

1. The scheme-based levy (SBL) is based on a scheme’s liabilities to members on a section 179 basis. For the 2016/17 year it is calculated: SBL = 0.000021 x UL

   UL is the scheme’s liabilities on a section 179 basis rolled forward to 31 March 2016 and ‘smoothed but not stressed’.

   All schemes pay the scheme-based levy.

2. The risk-based levy (RBL) is based on the likelihood of a scheme making a claim on the PPF and the potential size of that claim.

   RBL = Underlying risk (U) x insolvency risk (IR) x levy scaling factor (LSF)

   Underlying risk represents the size of a scheme’s potential claim on the PPF. It is the underfunding amount of the scheme determined using the scheme’s rolled-forward assets and liabilities taking into account other factors such as any contingent asset arrangements.

   Insolvency risk reflects the risk of insolvency of the sponsoring employer(s). These probabilities of insolvency have been provided to the PPF by Experian.

   The levy scaling factor is used to ensure that the total levy collected matches the levy estimate. The Board of the Pension Protection Fund, before the levy year begins, publishes an estimate of how much will be collected for the year. For 2016/17 the estimate was £615m.

   The risk-based levy is capped to protect the most vulnerable schemes. If using the above formula the RBL exceeds 0.75% of unstressed liabilities the RBL is recalculated as follows:

   RBL (capped) = Unstressed liabilities (UL) x K

   K is 0.75% or 0.0075 for 2016/17.

The administration levy is set by the Department for Work and Pensions. Pension schemes pay an amount per scheme member which varies according to the total size of the scheme. The Pensions Regulator collects the administration levy on behalf of the DWP and is invoiced separately to the pension protection levy. The fraud compensation levy can be used by the Pension Protection Fund to provide monies to the Fraud Compensation Fund.

Pension schemes transferred to the Pension Protection Fund

Before entering the Pension Protection Fund all schemes go through an assessment period. This process can take up to two years and involves many stages.

Pensions paid to members from the Pension Protection Fund

When a pension scheme is taken on by the PPF the assets previously held by the pension scheme are transferred to the PPF, which becomes liable for paying benefits to members of the pension scheme. The benefits payable to the members will vary depending on the following criteria:

1. The member is receiving a pension from the scheme and that member is beyond the scheme’s normal retirement age when the employer became insolvent.
2. The member is receiving a pension from the scheme and that member is younger than the scheme’s normal retirement age when the employer became insolvent.

   The member will generally receive 90% of the pension they were receiving when the scheme was transferred to the PPF although it is capped. The cap at age 65 from 1 April 2016 is £37,420.42 (which equates to £33,678.38 when the 90% level is applied) per year. If the member retired when younger than 65 lower annual caps are set. After pension payments have started to be paid to a member, then payments relating to pensionable service from 5 April 1997 will rise with inflation each year, subject to a maximum increase of 2.5%. Payments relating to service before that date will not increase.

3. The member is not receiving a pension from the scheme when the employer became insolvent.

   When the member reaches normal retirement age, based on the particular scheme’s rules, the PPF will pay the member’s pension based on the 90% level subject to a cap as described above.

   The member may be able to defer starting to receive the pension until after their normal retirement age. If deferred the pension will be increased by an actuarial adjustment to reflect the period it is postponed.

   After pension payments have started to be paid to a member, then payments relating to pensionable service from 5 April 1997 will rise with inflation each year, subject to a maximum increase of 2.5%. Payments relating to service before that date will not increase.

4. The member dies either after or before starting to withdraw a pension from the scheme.

   The PPF will pay compensation to any children of the member who are under 18 years old or under 23 if they are in full-time education or have a disability.

   The PPF will also pay compensation to any legal spouse, civil partner or other relevant partner, although the rules of the former pension scheme will be relevant.

5. The member is divorced.

   A member’s compensation can be shared with their ex-spouse or former civil partner if the court makes a pension compensation sharing order.

The PPF has four main sources of income:

1. An annual pension protection levy paid by eligible pension schemes.
2. When pension schemes are taken on by the PPF following a qualifying insolvency event in relation to the employer, the PPF can sometimes recover money and other assets from that insolvent employer.
3. When pension schemes are taken on by the PPF following a qualifying insolvency event in relation to the employer, the assets held by that pension scheme are transferred to the PPF.
4. Investment income from the investments held by the PPF.

Article from ACCA In Practice