Pensions: Debt tough

Almost all defined benefit (or final salary) pension schemes are subject to Section 75 of the Pensions Act 1995. This legislation (supplemented by regulations) provides that when a pension scheme winds up, the scheme's employers are liable to fully fund the scheme so that all members' benefits can be bought out in full with an insurance company (the annuity buyout basis).

Crucially, however, Section 75 also applies in relation to a multi-employer scheme whenever any of the scheme's sponsoring employers cease to participate in the scheme. In these circumstances the exiting employer becomes liable for its share of the scheme's deficit on the annuity buyout basis (referred to as the Section 75 debt).

Section 75 debts are routinely crystallised in corporate transactions and internal reorganisations involving multi-employer defined benefit pension schemes. The issues arising can be complex and the liabilities in question large, occasionally running to hundreds of millions of pounds.

Recently, however, the Department for Work and Pensions (DWP) published a set of proposed amendments to the legislation - The Occupational Pension Schemes (Employer Debt) (Amendment) and Pension Protection Fund (Multi-Employer and Entry Rules) (Amendment) Regulations 2007. These are designed to deal with some of the recognised ills of the current legislation and to provide some additional flexibility for companies and trustees struggling to deal with Section 75 debts.

Triggering Section 75 debts

A Section 75 debt is triggered in a multi-employer scheme when a participating employer ceases to participate. However, determining when an 'employment cessation event' occurs is not always straightforward. This is because the current statutory definition throws up a number of grey areas.

Probably the most common interpretation for the existing definition is that an employment cessation event occurs when an employer ceases to employ active scheme members (ie, members who are still building up benefits). However, the existing definition can also be interpreted in a wider way so that there is no triggering event while a participating employer continues to have employees who are eligible for membership of the scheme (even if they have not yet joined).

The amending regulations seek to clarify that an employment cessation event will occur if an employer "has ceased to employ any person who is an active member of the scheme". This will certainly add clarity in terms of establishing if a corporate transaction involves an employment cessation event. However, as is often the case, this proposed change in the Amending Regulations has already thrown up some new grey areas of its own.

A loophole

One question to flag is what happens if all employers in a multi-employer scheme cease to employ active members at the same time?Under current legislation a Section 75 debt would not be triggered until the scheme winds up (which could, depending on the scheme's rules, be much later).

This has sometimes been described as a loophole, but is in fact an essential feature of the existing legislation since it allows employers to close their schemes to future accrual (or to merge them with other schemes) without triggering Section 75 debts, although such employers are still liable for the scheme's ongoing funding requirements.

However, the Pensions Regulator's concerns that this 'loophole' might be exploited by companies to 'abandon' their pension schemes seems to have influenced, to a certain degree, the drafting of the amending regulations (as currently drafted Section 75 debts would be triggered in these circumstances).

Fortunately, in light of the comments raised on this point, the DWP has agreed to review this aspect of the amending regulations, which introduce no fewer than four potential ways of dealing with a Section 75 debt when an employment cessation event does occur.

Section 75 apportionments

Although current legislation sets out a default mechanism for calculating a Section 75 debt, it also gives pension schemes an alternative by which pension scheme rules may provide for debts to be calculated and allocated differently between participating employers. It is this provision for calculation of the debt in a manner differing from the statutory default which has become known as Section 75 apportionment and it has become an increasingly common way of managing Section 75 debts.

To date, however, Section 75 apportionments have operated without a great deal of regulatory guidance. The amending regulations seek to provide some more legislative detail on how and when such apportionments can be used. It starts by categorising them into 'scheme apportionment arrangements' and 'regulated apportionment arrangements'.

Trustee agreement is required for a scheme apportionment arrangement and they must be satisfied that the remaining employers (after the exiting employer has left) will be able and willing to fund the scheme so that it will have sufficient and appropriate assets to cover its liabilities.

A regulated apportionment arrangement will only apply if the pension scheme is reasonably likely to call upon the safety net of the Pension Protection Fund (PPF) within the next year. Such arrangements therefore require approval from the Pensions Regulator and the board of the PPF.

Approved withdrawal arrangements

An approved withdrawal arrangement (AWA) (a possibility under existing legislation) is an agreement between an employer and the pension scheme trustees which requires payment of a reduced Section 75 debt. The balance (usually the vast majority of the debt) is postponed but backed by a guarantor. AWAs must be approved by the Pensions Regulator.

However, currently there are a number of practical difficulties, including legislative wording which often makes it difficult to get the necessary approval. The result has been that few AWAs have been made and the amending regulations relax some of the more restrictive tests.

Cessation agreements

As well as including amendments to make the AWA process easier to operate, the amending regulations propose cessation agreements (CAs) as a simpler alternative. These need only be agreed by the trustees, employer and a guarantor(s) (the Pensions Regulator is not involved unless clearance is applied for).

However, the amount that actually has to be paid up front is likely to be higher than under an AWA. The trustees must also be satisfied that the remaining employers' ability and willingness to fund the scheme is not adversely affected.

The next step

The DWP's consultation on the amending regulations closed on 1 October 2007. It is not yet known when the legislation will come into force (the original draft suggested December 2007) or the extent to which certain aspects may change. When one takes a step back from the legislation there are really only three essential elements: when is a Section 75 debt triggered? How is it calculated? And how and when must it be paid?

Although the amending regulations seek to provide clarity in relation to these three questions, the drafting is confusing in places and highly prescriptive (particularly with regard to Section 75 apportionments and the methodology for debt calculations).

The upshot is that it may now in fact be harder for some schemes to deal with Section 75 debts in a sensible and pragmatic way.

Chris Close is a partner at Sacker & Partners