Keep the funds flowing

We have been deluged by a “perfect storm” for defined benefit occupational
pension schemes, which have faced plummeting asset values and continuing
investment volatility on one hand, and seriously weakened sponsoring employers
on the other.

Just as deficits have widened, many employers find themselves unable to
increase funding levels, or even having to reduce current contributions. On top
of this is a rise in scheme liabilities, mainly due to increased longevity
projections. This crisis is proving to be a stress test for the regulatory
regime that was put in place from April 2005, and there are key considerations
for accountancy professionals.

The key question for the trustees of funded pension schemes in deficit – and
for the Pensions Regulator, which protects pension scheme benefits – is how
quickly they should be funded. The flexible “scheme specific” funding regime
(see box) allows trustees and the regulator to decide which approach is best for
each individual scheme in light of its circumstances. Much depends on the
individual judgment made in each case – a difficult balancing exercise. Should
they prioritise protecting scheme benefits? Or do they have to consider the
ability of the employer to pay? Should funding of the scheme take priority over,
say, business needs?

Where an organisation’s covenant is strong, the decision should be easier –
the needs of the employer can be considered, provided this would not materially
prejudice the interests of the scheme’s beneficiaries. But where the covenant is
weak, then any decision is likely to involve risks. The employer could be asked
to pay more funding, more quickly, on the basis that the weakening of the
employer covenant increases the possibility of insolvency, leaving the scheme
underfunded. However, this approach could be based on a self-fulfilling
prophecy, with the increased funding demands pushing the company into
insolvency, or seriously weakening it over the long term. Alternatively, the f
act that the employer is weakened could mean the trustee does not push for more
money, as the company cannot reasonably afford to pay more. But where an
employer’s covenant is weak, this could be seen as taking a “bet” on the
recovery of the employer’s business and revenues.

Trust in the future

In practice, what we have seen is that trustees are often willing to take the
second approach. Some of the examples accountants may have seen include back-end
loading of, or moratoriums on, deficit contributions, ie. reducing or stopping
them initially but increasing them in the medium to long-term, sometimes subject
to the employer meeting agreed financial targets; and trustees releasing
security they hold to enable the employer to raise finance.

The regulator has encouraged this development. It has emphasized that pension
scheme investments are intended to be held over many years, and stressed that
trustees should focus on the key issue of the employer covenant. However, the
regulator says trustees should not over-react to a weakened covenant and should
not aim to drive employers into insolvency except as a last resort. Its overall
message is that the best outcome for a pension scheme is to have a strong
supporting employer.

To the extent that the scheme-specific regime allows this kind of
flexibility, and therefore enables companies to bear their pensions burden
during the downturn, it should be judged a success. But the regime put an
enormous responsibility onto both trustees and the regulator. The question
remains as to whether they can continue to strike a successful balance.

Spurred on by the regulator, trustees have recognised they are often the
employer’s largest creditors and sought to act like bankers, learning from the
approach that a bank with a large unsecured loan would use in managing its
relationship with a borrower. It has become standard for trustees to monitor and
assess the employer covenant and to have access to sensitive financial
information for this purpose.

In practice, as trustees are not equipped to take on such a role unaided,
this has required them to rely heavily on expert financial advice. So there has
been an enormously increased role for accountants, as well as corporate finance
advisers and insolvency specialists, in pensions funding discussions.

For the regulator, a system relying so heavily on discretion and
circumstantial judgments brings its own risks. In the wake of the financial
crisis, financial regulators have come in for heavy criticism for failing to
anticipate problems. It is unlikely to be spared such criticism in the pensions
sphere. The ultimate question is still whether the regulator is properly
structured and resourced to allow for all these risks – a massive test for its
board and staff.

David Pollard is a partner and Charles Magoffin is a senior associate in the
employment, pensions and benefits department at Freshfields Bruckhaus Deringer
in London.

The funding regime: Flexibility versus one size fits all

The Pensions Act 2004 set up a new “scheme specific” funding regime in 2005.
Unlike the previous minimum funding requirement regime, it allows for
differences between schemes’ individual situations, and does not set out a
uniform funding test. Liabilities must simply be valued on the basis of prudent

Crucially, a sponsoring employer can no longer decide what level of
contributions should be paid. Instead, the valuation of the liabilities and
contributions must be decided with or by the trustees, with the Pensions
Regulator to decide if agreement cannot be reached. If there is a deficit, there
must be a timetable to eliminate it.

But there is a tension between the flexibility of this system and the need to
protect the Pension Protection Fund, which guarantees members a minimum,
protected level of benefits if the sponsoring employer is insolvent. Accountancy
professionals should be aware that because the PPF is funded by levies on
defined benefit schemes (and the assets of schemes which enter it), its
existence increases the costs of funding those schemes. If too many underfunded
schemes enter the PPF, this would drive up the levies on all other schemes,
potentially to unsustainable levels. The regime tries to square this circle by:

• relying on scheme trustees to protect members’ interests; and

• giving the Pensions Regulator the mission statement of protecting
occupational pension benefits and minimising claims on the PPF, and the role of
intervening in a risk-based manner. Arguably the regulator was envisaged as the
“military wing” of the PPF.

So, the regulator has to police levels of funding within schemes in the
absence of a minimum prescribed funding level and valuation basis for all
schemes. Therefore, and true to the spirit of the scheme-specific regime, the
regulator tends to issue deliberately vague guidance, using words like “prudent”
when looking at funding levels, as well as informal discussions with trustees
and behind-the-scenes involvement in funding negotiations.

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