Financial services & Pensions Special Report: Pension tension
11 May 2009
Employers are keen to find ways of keeping pension liabilities in check as the recession continues to bite. By David Saunders
For those of you not immediately familiar with the niceties of salary-related pension scheme funding, a quick recap. In the aftermath of Robert Maxwell’s death in 1991, it became clear that the assets of his occupational pension schemes had been used to support his failing business empire. Pensioners could have been left high and dry. Among a number of subsequent initiatives, the Government enacted a minimum funding requirement (MFR), a prescriptive, one-size-fits-all method of determining a floor for pension contributions.
Sadly it became only too apparent in subsequent years that the MFR still did not offer any significant protection for members of pension schemes where their employer became insolvent. Unfortunate pensioners, stripped of most of their expected in-come in retirement, stripped to the waist and engaged in half-naked protests.
The Government responded, creating the Pensions Regulator (charged with protecting members’ benefits), the Pension Protection Fund (a lifeboat for schemes where the employer has become insolvent) and replacing MFR with a statutory funding objective (SFO).
The SFO is intended to be scheme specific and flexible. At least once every three years, trustees and employers agree the assumptions to be used for determining the amount of scheme liabilities and the time over which any deficit revealed should be paid off. This laissez-faire approach is, however, subject to a number of important limitations:
- the assumptions must be prudent;
- the Pensions Regulator’s code of practice dictates that trustees should aim for any deficit “to be eliminated as quickly as the employer can reasonably afford”; and
- a deficit recovery plan of longer than 10 years will, although permissible, trigger further scrutiny by the Pensions Regulator.
So what has been the experience so far? Well, until recently the SFO has been operating in benign economic circumstances. In the vast majority of cases, our experience suggests that trustees and employers have reached agreement within the necessary timescales and without significant difficulties. Perhaps keen to keep the Pensions Regulator at bay, many employers signed up to paying off their deficits in no more than 10 years. But the money was generally there to contribute at this pace. All sides were happy.
Negotiations this time round may be very different. A triple whammy is likely to have changed the scenery, significantly in many cases. First, asset values have fallen. Second, liabilities have gone up, not least because of a trend towards more conservative (and realistic) mortality assumptions. These factors have combined to see scheme deficits rising substantially, notwithstanding the hefty contributions some employers have been paying in. Third, against the backdrop of an economy expected to shrink by around 3.5 per cent this year, employers are feeling the pinch.
A number of things follow from this:
- there is little room to massage liabilities artificially southwards - the Pensions Regulator continually re-affirms the primacy of prudent assumptions;
- trustees will be asked by employers to wait longer to see the money - employers in the worst financial position may be coming to trustees early to renegotiate existing deals;
- trustees will increasingly be seeking professional advice to see if the employer’s story stacks up - they will not want to face members with bad news unless they can show they have done their homework first;
- if trustees cannot have cash now, they may ask to play catch up with bigger contributions once things improve, or be looking for other security to bridge the gap, such as a guarantee or charge over the employer’s assets;
- the Pensions Regulator knows there has been a seismic shift in what is reasonably affordable. But if you are a stakeholder (including a shareholder) in a company with a salary-related pension scheme, beware - the Pensions Regulator will expect you to take a share of the pain before contributions to the pension scheme can be cut back.
Of course, turning down the tap is only one way of getting pension liabilities back under control. Employers can seek to reduce their existing liabilities, including by incentivising pensioners to give up part of their increases or encouraging members to transfer out their benefits to another arrangement. Those that cannot be reduced can sometimes be better matched, as demonstrated by the blossoming buy-out market. And reducing or terminating future service benefits is an increasingly ‘dead-cert’ option for many employers - a recent National Association of Pension Funds survey suggests that more than half of the salary-related schemes still open to new members are expected to close.
Times are tough, and pensions are in the thick of it.
David Saunders is a partner at Sacker & Partners