Funding the future

UK defined benefit pension schemes have suffered badly in the recession with soaring funding deficits. Last summer Lane Clark & Peacock, the actuaries, reported that schemes were running a £96bn deficit in mid-July, more than double the shortfall in July 2008. Other factors such as assumptions about life expectancy have further significantly increased pension fund liabilities.

So, what are the legislative obligations upon employers in these recessionary times and what role does the pensions regulator play?

All defined benefit occupational pension schemes must be funded according to the requirements of the Pensions Act 2004 and regulations. The regulator has produced a code of practice and additional guidance. The basic principle is that schemes must have sufficient assets to make provision for the benefits already accrued under the scheme '“ this is known as the 'statutory funding objective' (SFO). Regular valuations must be obtained by the trustees to check whether the SFO is met. Trustees are required to adopt prudent actuarial assumptions for the funding calculation. Where the valuation shows a deficit, a recovery plan must be put in place to eliminate the shortfall 'as quickly as the employer can reasonably afford'.

Another factor to consider is the strength of the employer's covenant. Trustees must form an objective assessment of the employer's financial position, prospects and willingness to continue to fund the scheme's benefits. Where the employer covenant is strong, the trustees may allow a longer period for recovery of the deficit compared to where the covenant is weak.

So, how have these funding principles been affected by the recession? Clearly a recession is a time when businesses may have significant cash flow constraints and sometimes greater uncertainty about longer-term prospects. The financial pressure of funding the pension scheme deficit can place unmanageable burdens on employers. Employers have therefore approached trustees to review their recovery plans and reduce the immediate burden to scheme employers by, for example, extending the period for repayment or back-end loading the plan. Another trend is for trustees to consider calling for an earlier valuation on the basis that the drop in assets values has led some trustees to believe that the existing valuation is unreliable.

The regulator's message

The pensions regulator recognises these difficulties and has issued four statements to assist employers and trustees. A key message is to reassure schemes and employers that the regulator understands that the current economic conditions are of real concern and that the existing scheme funding regime is flexible enough to cope. Other key messages are:

• Trustees need to monitor the employer's financial position and, as necessary, consider reviewing recovery plans where there is a significant decline (or improvement) in the employer's covenant.
• Where an employer believes that an existing recovery plan is at serious risk of jeopardising the company's future development, it will be a matter for discussion with the trustees.
• Trustees are akin to unsecured creditors, and therefore the continuing health of the employer is important in order to recover the deficit.
• Although pension scheme deficits should not be allowed to push otherwise viable employers into insolvency, pension scheme trustees should make sure that they are not disadvantaged by a revised recovery plan as compared with other unsecured creditors or shareholders.

In addition, trustees should not compromise the requirement for prudence when calculating the deficit just to make a recovery plan look affordable. Indeed, the regulator's view is that the weaker the employer's financial position, the more conservative the underlying funding assumptions should be. This contrasts with the regulator's desire to maintain the health of viable employers. However, the underlying concern with a weak employer is that if overly optimistic assumptions are adopted, the employer cannot be relied upon to make up any funding gap arising if the returns are less than expected.

The regulator's message is that employers can gain any necessary flexibility through the recovery plan and highlights that annual contributions should be reasonably affordable for the employer. What is affordable will be informed largely by the trustees' assessment of the employer's financial position. Suggestions from the regulator to ease the financial strain in appropriate circumstances are to consider back-end loading the recovery plan or consider using contingent assets; for example, securing guarantees from related companies or third parties instead of paying higher contributions.

In a report published by the regulator dated 10 November 2009, it was noted that there has been an increase in both recovery plan lengths and back-end loading. This emphasises the regulator's flexibility in the funding framework where employers face short-term cash constraints.

Reducing pension liabilities

Another effect of the recession has been the move by employers to reduce their pension liabilities if they can. There are a number of strategies available. One of the most common is for the employer to close the scheme to future accrual. This usually means that from a given date no more pension liabilities will build up in the scheme. A large number of household names such as Barclays, BP and Wm Morrison have taken the plunge over the last year or so and propose to, or have actually, shut their defined benefit schemes to future accrual.

For the employer, there will be an immediate cost saving as no further funding will be required for future accrual. It also enables crystallisation of liabilities, allowing more accurate future planning and financial forecasting. The employer must still fund the past service benefits and, if there is a deficit, a recovery plan must be put in place.

The employer must comply with a number of legal requirements and it will usually have to engage with the trustees. One key requirement is for the employer to consult with the affected members regarding the change. Information about the change must be provided, followed by a 60-day consultation process. Employees can make representations to the employer which it must consider and possibly adjust the proposals as a result.

The employer must also open dialogue with the trustees. Cessation of accrual can be achieved in a number of ways, but most commonly the trust deed and rules are amended and usually such a change will require both the employer and the trustees' agreement. The trustees will typically seek concessions from the employer, i.e. a funding injection to reduce the past service deficit. Sometimes the pension scheme's amendment power will be restrictive and may require that a link to final salary remains when calculating benefits, despite cessation of pensionable service.

Sometimes the rules contain a unilateral power for the employer to stop accrual, and a thorough check of the documentation is needed initially.

As another cost cutting measure, many organisations are no longer going to reflect salary increases in members' pensionable pay. Balfour Beatty announced that it will not be reflecting any future salary increases in pensionable pay from 1 January 2011. Mitchells and Butler and RBS have decided to apply a cap to the level of any future pay rise that will be pensionable.

Presently, employers do not have to consult about changes. From April 2010, consultation will be required when new regulations will extend the consultation obligations to cover changes to pensionable salary.

What happens to the pension scheme if insolvency strikes?

The scheme could be eligible to enter the pensions protection fund (PPF), established as a 'lifeboat' for schemes whose employers are insolvent and whose funding levels fall below that set by the Pensions Act 2004. Since its inception, 200,000 people are receiving PPF protection. Increased claims on the PPF have resulted in a deficit of £1.2bn as at 31 March 2009. The PPF chairman Lawrence Churchill said in the annual report 2008/09: 'The economic downturn has highlighted how vital PPF protection has been. None of us would want to go back to an era where people lost their pension as well as their jobs.'

One key concern is that PPF compensation does not mirror the benefits that members would have received under their schemes and in many cases will be much less. It depends on the member's age and status at the point that the scheme is considered for entry to the PPF. Broadly, if the member was at an age when he had the right to take his pension unreduced at the assessment for entry date, that person will receive 100 per cent of his basic scheme entitlement '“ so most pensioners would receive their full entitlement. However, those who have not reached that age only receive 90 per cent of their basic scheme entitlement and compensation is subject to a cap '“ so the ceiling is 90 per cent of the cap. The cap for 2009/10 is £31,936.32, giving an effective ceiling of £28,742.69.

The upshot of the restrictions is that someone who took early retirement some years ago at an age when a reduction was applied for early payment would be subject to the 90 per cent limitation and the cap, if the scheme entered the PPF. This can give rise to drastic reductions in benefits received for those who were in receipt of pensions above the cap.

Malcolm Wicks MP said in a debate on the Bill in committee: 'The cost issue is important, but the greatest risk to the [PPF] is, without question, moral hazard '“ that those with the ability to influence the way in which a pension scheme is run will take less care than they otherwise would because of the new PPF. Scheme decision makers might deliberately undertake certain activities or fail to take action if they knew that the PPF will step in 100 per cent...'

The recent case of ITS v Hope [2009] EWHC 2810 (Ch) examined the extent to which trustees can consider the existence of the PPF in their decision-making processes. In this case, the trustees planned to buy out high earning early-retirees in full, leaving few assets left for other members. The effect would be to protect those most affected by the cap and secure the best possible outcomes for the members as a whole. However, the court found that as a matter of law, the prospective availability of the PPF compensation was not a relevant factor for the trustee to take into account and would be contrary to public policy.

The recession has thrown up a range of issues for trustees and employers which are largely centred around funding and management of liabilities. The existence of PPF compensation has come to the fore as the number of distressed companies has increased. The protection it offers, albeit capped, is to be welcomed. While the funding position of schemes will hopefully recover as markets and the economy improves, some actions taken in the downturn, such as cessation of accrual, are in practice final decisions which there will be no appetite to reverse even when times get better. As such, the landscape of pensions provision is changing permanently in the UK to one where defined benefit provision is rare, and the recession has provided the opportunity for employers to accelerate the decline of defined benefit schemes.