Pensions Blind Spot: Reducing the Risks Associated with Pension Schemes

The Pension Protection Fund (PPF) has recently reported that UK pension schemes have a combined deficit of more than £265bn. Stories like this serve to highlight the risks associated with company pension schemes, and in particular defined benefit (DB) schemes. Most DB schemes were set up in more benign economic times, and were valuable recruitment and retention tools for their employers, providing generous benefit promises which – today – are protected by law from changes. Pension schemes and their employers now face a number of challenges, including a strict regulatory environment, falling asset values and increasing longevity of scheme members. Companies which fail to meet these challenges may incur significant costs now and in the future, negative publicity, and even regulatory sanctions.

Pension Scheme Deficits

The headline issue for DB schemes is the increase in the funding deficit between the schemes’ assets and their liabilities for promised benefits. The deficit is not an immediate liability for a scheme’s employer, but indicates the amount which would need to be contributed to the scheme in order to meet those liabilities. As a DB scheme makes a promise to members as to the level of benefits they will receive, the funding risk lies with the employer, not with the members. The scheme’s deficit is quantified during the valuation process, which normally takes place once every three years and, where there is a deficit, the scheme’s trustees will negotiate for higher levels of employer contributions to be made. These deficit recovery payments must be paid in addition to the ordinary employer contributions, and are typically aimed at recovering the deficit over a period of up to 10 years. If a company fails to agree a ‘recovery plan’ with the trustees, the pensions regulator may become involved in the process, leading to possible sanctions. Employers can reduce the risks associated with scheme deficits in a number of ways, including:

  • Understanding who controls the legal power to set contributions, and working with the trustees to agree an affordable recovery plan to reduce a deficit.
  • Considering whether operational cost savings could be made by, for example, a merger of legacy schemes.
  • Considering whether giving a guarantee, or another form of contingent asset such as a security over cash or real estate, or a letter of credit (L/C) or bank guarantee, to the trustees may facilitate less conservative investment strategies, or lead to a reduction in the scheme’s risk-based levy.
  • Considering – for those schemes that are still open – whether it is appropriate to change the benefit design in order to reduce the future build-up of liabilities – this may mean investigating the possibility of closing a defined benefit scheme to future accruals, and moving scheme members into a money purchase arrangement where risk is borne by employees.

Takeovers, Restructurings and Group Membership

Even companies which do not have a pension scheme of their own need to be aware of potential risks, particularly when considering a takeover, a group restructuring, or even simply being a member of a group in which there is a DB scheme.

When seeking to acquire a company, a purchaser should carry out due diligence to bring to light any hidden liabilities, which may include legacy pension schemes (possibly acquired by the target itself in past takeovers) which may not have current active members, or even liabilities for the company to make contributions, or to pay a statutory pensions debt (due under section 75 of the Pensions Act 1995) which may have arisen in the past. When such liabilities are discovered, it may be necessary to adjust the purchase price to compensate for the potential costs, or to restructure the acquisition to purchase only the business (rather than the shares) of the target. Water-tight legal warranties and indemnities will be required to provide protection.

Where a group restructuring is taking place, care must be taken to manage any section 75 debt that could be triggered. This can happen where an employer who participates in an underfunded multi-employer DB scheme ceases to employ any active members at a time when at least one other employer continues to employ at least one active member (this is described as an ‘employment-cessation, event). In this situation, the exiting employer will become liable to pay to the trustees of the scheme a debt equal to that employer’s share of the buy-out debt of the scheme, meaning the shortfall between the value of the scheme’s assets and the amount it would cost to buy out the scheme’s liabilities immediately with an insurer.

Thankfully, there are several options for an employer to exit from a pension scheme without becoming liable for its full section 75 debt, provided the legal boxes are ticked, including:

  • Withdrawal arrangements: in which the exiting employer can pay its share of the deficit on the scheme funding basis (lower than the buyout basis), with the remainder being guaranteed by another group company or companies.
  • Scheme apportionment arrangements: under which the debt of the exiting employer can be ‘apportioned’ to the other scheme employer or employers rather than falling due immediately.
  • Flexible apportionment arrangements: a recently-introduced option under which the exiting employer simply apportions its liabilities under the scheme to another employer which can ‘step into its shoes’, rather than its share of the deficit (meaning the debt does not need to be calculated).

In 2010, two further easements in the legislation came into effect, which mean that in some restructurings, certain events may not be regarded as employment-cessation events, so no debt is triggered. The easements apply to small or low-value restructurings, or restructurings where all the assets, liabilities, employees and scheme members of the exiting employer are transferred to a single receiving employer, and the trustees agree that they are satisfied that the receiving employer is at least as likely as the exiting employer to meet the transferred liabilities in addition to its own liabilities. However, these easements are rarely used in practice.

Companies should still be aware of DB schemes within their group (or acquiring them), even if they themselves do not participate in the scheme. This is because, where an employer defaults on its liabilities to fund the scheme, the pensions regulator can exercise its anti-avoidance powers to impose contribution notices or financial support directions on associated or connected companies (and individuals in the case of contribution notices). Contribution notices require a sum to be paid into the scheme where, broadly, there has been an act or failure to act which is materially detrimental to the chances of scheme members receiving their full benefits. Financial support directions require a company to provide funding support for the scheme. This means group companies can be made liable to support pension schemes even where they did not participate in the scheme, as long as the legal tests are met, and the regulator believes it is reasonable for it to do so.

Liability Management

Faced with the risks associated with DB schemes, companies are often keen to explore mechanisms for risk reduction. Many options are available, depending on the scheme’s structure, including changes to future service benefits to reduce the build-up of liabilities, transfer incentive exercises for members, liability hedging to target specific risks such as increases in longevity, and total closure of schemes. Two options which have gained in popularity in recent years are buy-outs and buy-ins. In a buy-out, the liability for providing benefits to scheme members is permanently transferred from the scheme to an insurance company, and the trustees are discharged. A buy-out can either be for all the scheme’s liabilities, or only for certain categories, such as current pensioners. This option is expensive, as it requires the scheme’s future liabilities to be funded immediately.

A second option is a buy-in, where a scheme’s liabilities are transferred to an insurer under an insurance policy (including current and deferred annuities for the scheme members) which is purchased by the trustees. As the annuities are owned by the scheme, and the members remain in the scheme, this is effectively an investment of the scheme’s assets, and the strength of the insurer, and its ability to pay in the future, is therefore critical.

While liability management can significantly reduce pensions risks, it can be complex legally, so it is important for companies and trustees to choose the right option for a particular pension scheme and implement it properly.

Solvency II

The Solvency II Directive is a hot topic, as its onerous funding requirements may affect DB schemes in the future. In short, the Solvency II Directive (2009/138/EC) is intended to raise the capital reserve requirements for insurers in the EU, to lower the risk of an insurer’s insolvency. The requirements are not yet in place, and are currently expected to be implemented for firms in 2014. In 2010, an EC Green Paper proposed that the Solvency II requirements could (in adjusted form) potentially be applied to DB schemes. This suggestion has been met with strong opposition from the CBI, the insurance industry and the pensions industry, as it would potentially require employers to make significantly higher contributions to their DB schemes.

Even if the Solvency II requirements were not ultimately applied directly to pension schemes (there is real uncertainty here), the regime may still affect schemes because insurers may change their annuity pricing, making risk-reduction (buy-ins and buy-outs) more expensive, and leading to retiring members of money purchase schemes receiving a lower income in retirement. The potential impact of these changes should be monitored.

Summary

With the many uncertainties surrounding defined benefit pension schemes, companies now need to be aware of their actual and potential liabilities in this area, and need to consider taking active steps to reduce or manage those liabilities. While the risk profile of each scheme is different, companies and trustees have access to a broad range of options to mitigate – and in some cases eliminate – the legal and funding risks. Companies should seek to address these issues by focusing on risk awareness, clear strategic planning, and medium and long-term risk reduction, in addition to the perennial short-term issues faced by all DB schemes.

18 views

Related reading