The end game

The problems afflicting final salary pension schemes and the companies that sponsor them have been much in the news in recent months. Many scheme trustees find themselves faced with employers that are unable to fund their liabilities to the scheme. These situations can lead to the insolvency of the employer and to substantial reductions in members’ benefits.

In a final salary scheme, the members pay a fixed percentage of their salaries and the employer must contribute the balance of the cost of the scheme. Traditionally, schemes have invested in a mixture of gilts, other forms of high-rated, fixed-interest investments and equities. The advantage of gilts is that they provide a guaranteed income stream that can be matched against the future liabilities of the scheme; the disadvantage is that they offer a lower rate of return than equities over the longer term. When valuing the return on the fund, an actuary would assume a higher rate of return for equities than gilts. The greater the scheme’s investment in equities, the higher the assumed value of the assets for actuarial purposes, vis-à-vis the liabilities.

This is good news for employers, because the smaller the gap between the assets and liabilities, the smaller its contributions will be. However, the obvious disadvantage with equities is that values may go down as well as up. When they go down, the employer’s liability to contribute increases. If the employer decides to stop contributing and wind up the scheme, the problem is compounded. At this point, the only way of absolutely securing members’ benefits is to buy annuities from a life company, but annuities cost far more than backing benefits with an equivalent fund of equities. A scheme with a conventional gilts and equities mix of investments, which is in balance when valued on an ongoing basis, will have a substantial deficit when it has to buy out its benefits with annuities. If the scheme already has a deficit on an ongoing basis, the position is so much worse.

Before the Pensions Schemes Act 1993, an employer’s obligation to contribute to a deficit on a winding-up was governed by the scheme rules. Invariably, the rules allowed the employer to terminate its liability to contribute at any time, without imposing any obligation to contribute to a deficit. The Pensions Act 1995 seeks to give members more protection. It imposes a statutory minimum funding requirement (MFR) for final salary schemes on an ongoing basis. This assumes that schemes invest in a mixture of gilts and equities – the mix depending on the age profile of the scheme membership. It also tackles the question of an employer’s contribution to a deficit on a winding-up. It provides, under Section 75, that the deficiency, on an ongoing basis, should be capitalised and made a debt payable by the employer to the trustees.

The thinking behind capitalising the employer’s ongoing liability is that, with the benefit of the statutory debt, the trustees can buy annuities for the pensioners and can provide transfer values for other members, which they can take into a personal pension scheme or another occupational scheme. Under the statute, pensioners’ annuities are given priority over other members’ benefits.

This regime suffers from two main flaws. First, the value placed on the pensions when computing the debt does not reflect the true cost of buying the necessary annuities. Second, the debt allows for winding up expenses on a fixed scale that is often exceeded. As transfer values are not generous in any event, many non-pensioner members, at the bottom of the winding-up priorities, are left significantly short-changed – all the more so where the employer is unable to pay the debt in full.

Since March 2002, where an employer is not in liquidation when the scheme begins winding up, the Section 75 valuation is based on the actual cost of buying annuities for pensioners and the estimated actual cost of administering the winding-up. This obviously improves the members’ position, but increases the employer’s liability. Furthermore, under draft regulations published in June 2003, which apply to schemes winding up on or after 11 June 2003, an employer that is not in liquidation must fund the deficit on the basis of the buyout cost of all benefits. These controversial and potentially retrospective regulations have yet to be enacted, perpetuating uncertainty for trustees and employers.

We now have the recently published Pensions Bill, which sets out a new funding standard and a new regulator, which will determine contribution levels where trustees and employers cannot agree them. Equally significant will be the creation of the new Pension Protection Fund, which will be funded by a levy on final salary schemes, and which will compensate members who suffer benefit reductions as a result of winding-up deficiencies.

The new statutory regime is a year or two away from becoming law. Meanwhile, for many schemes, increases in the Section 75 debt are an academic exercise as employers simply cannot afford to pay. Faced with an impecunious employer, trustees must decide whether to accept a lesser sum than their statutory entitlement and release the employer from the balance, or whether to sue for the whole amount due and place the employer into liquidation.

In Bradstock Group Pension Scheme Trustees Ltd v Bradstock Group plc [2002] the employer in an ongoing scheme, unable to pay its MFR contributions, offered to wind up the scheme if the trustees agreed in advance to accept a reduced sum in settlement of the prospective Section 75 debt. The court ruled that trustees had power under Section 15 of the Trustee Act 1925 (the power to compound liabilities) to enter into such a compromise. It was not contrary to the policy of the act for them to compromise a specific liability that had arisen already, or was about to arise. The actual terms of the compromise were then approved in a private hearing.

Since Bradstock, the trustees of several schemes have entered into similar arrangements. Negotiations of this sort, however, present difficulties for trustees. They will not have access to all of the relevant financial information and the employer may be reluctant to disclose confidential material, such as profit forecasts and business plans. Conflicts of interest may also arise: trustees who are directors or senior managers of the employer need to be excluded from the negotiations, and member representative trustees may be influenced by a desire to help the employer survive at the expense of the scheme. Often, the appointment of a professional independent trustee is the only solution.

Obviously, trustees ought to settle for a sum higher than that which might be recovered in a liquidation of the employer, but how large a payment they can secure depends on how far they can press the employer, whose directors may or may not be bluffing when they threaten that they will be obliged to cease trading if their offer is rejected.

Deals struck in these circumstances can result in big cuts in members’ benefits, while the employer walks away from the scheme having paid only a fraction of its liability. Because of the contentious nature of the deals, the trustees often seek the approval of the court for the compromise they have reached. This, of course, adds to the expense of the whole exercise.

The issues facing trustees and employers with insolvent pension schemes will not go away under the proposed new legislation, although the Protection Fund will be there to offer a measure of compensation for members in the last resort. Employers will still be left to grapple with the problem of schemes they cannot afford to run, and even less, afford to wind up. Trustees will remain faced by that most difficult of fiduciary decisions, whereby in pressing for the best return for the scheme as a whole, they risk destroying the company that created it.

Michael Furness QC is silk at Wilberforce Chambers. He was assisted in this article by barrister Tiffany Scott