UK Act sparks wide disarray

Multinationals with UK subsidiaries are bracing themselves for a potential reduction in repatriated profits as UK sponsors of underfunded defined benefit (DB) pension schemes enter a five- to 10-year period during which they must meet new a new solvency standard set by the Pensions Act 2004.
Where the deficit is significant relative to the balance sheet, sponsors will find that the higher contributions demanded by trustees, who are responsible for setting the ‘recovery plan’ to meet the solvency requirement, will restrict their ability to pay dividends, change the ownership of the company, and raise loans, among other factors.
Sponsors with comparatively weak financial strength ratings will also be forced to pay a substantial annual levy to the Pension Protection Fund (PPF) – the new insurance scheme established by the act to support members of underfunded schemes in the event of corporate insolvency. From April 2006 this levy will be based largely on the relative size of the deficit and the employer’s credit rating.
The efficient use of capital will be central to the recovery plan, which the trustees must draw up following the next triennial valuation from 30 December 2005. Companies with substantial DB obligations will need to determine the relative merits of injecting larger contributions into schemes. A capital injection may enhance the company’s negotiating powers with the trustees and also reduce the size of the PPF levy.
Sponsors and trustees might also wish to consider some form of contingent funding strategy, whereby the trustees agree to a prolonged recovery period, and the sponsor purchases a financial instrument - such as a credit default swap or bank guarantee - that serves as an insurance policy to provide full funding for the scheme should the sponsor become bankrupt before the recovery schedule has been met.
For parent companies outside of the UK the most pressing concern is the control of the pension scheme, which, under the new legislation, has been ceded to the scheme trustees, who will be supported by the regulator if the sponsor refuses or is unable to pay the required contributions.
The regulator has the power to impose contribution notices and financial support directions on the sponsor itself, other companies in the group and even individual directors – in effect dictating how the pension scheme should be funded. However, the regulator’s powers have yet to be tested in the courts, and there are questions over whether overseas courts, particularly those outside the EU, will enforce the regulator’s decisions.
The act, together with rules introduced in June 2003, has converted the scheme deficit - hitherto regarded as a very long-term and relatively ‘soft’ liability - to a material debt on the employer. Trustees have effectively been redefined as unsecured creditors to the company and are required by the legislation to act in a robust and business-like manner, as though they were bank lenders. They are now required to pay much more attention to the credit outlook of the sponsoring employer and the resulting ‘covenant’ held by the pension scheme in terms of promised future contributions.

All sponsors of UK DB pension schemes must now seek to understand the issues raised by the legislation in terms of its impact on corporate financial decisions. Any strategy designed to manage the DB scheme deficit must focus on the management of key relationships with the company’s stakeholders and with the Regulator. This will include the trustees (and many groups will have several trustee boards), shareholders, lenders and, of course, the employees and their representatives.
Trade unions in the UK have become particularly vocal in their bid to save DB schemes from closure to future accrual – a step many employers are considering in order to cap their rising DB liabilities. The avoidance of strike action, and the consequent damage to the employer’s reputation in the market and with customers, will be an important issue for many sponsors. Private equity-backed companies in particular will need to avoid any labour problems that could undermine the prospects for a future sale.
Problems will be exacerbated where the dynamics of the trustee board change in the light of perceived conflicts of interest. As the Pensions Institute’s latest research on the impact of the act reveals, many company directors who are members of the trustee board are reconsidering their dual role and in some cases are resigning as trustees. This raises questions over the effective governance of the trustee board and the maintenance of a two-way flow of information between the trustees and the sponsor.
A good example of the type of conflict that might trigger a resignation is where a company wishes to reduce the pension fund deficit over a relatively long recovery period and the trustees are under regulatory pressure to push for more immediate contributions. It is difficult to see how an individual who is a director and trustee can take both sides of this negotiation. Even where the directors’ resignation from the trustee board is avoided it will be necessary to establish clear guidelines that dictate when a director should abstain from voting during the period in which corporate transactions take place.

Trustees and sponsors might also have to consider engaging separate advisers when scheme funding is negotiated. Historically, many companies have shared advisers with their trustee boards, but this looks unsustainable in the new environment.
Sponsors must also become familiar with the ‘clearance’ procedures, introduced to enable the employer to negotiate proposed corporate transactions with the regulator in order to avoid the risk of being issued with a contribution notice in the future. The regulator will wish to discuss any transactions that could undermine the security of the pension scheme and will look for agreement between the sponsor and the trustees.
An important implication of this need for agreement is that trustees will become involved in transactions at an early stage, often requiring them to be given non-public, price-sensitive information. The Pensions Institute report notes that full funding on the Financial Reporting Standard 17 (FRS17) basis is an important cut-off in terms of regulatory interest in corporate finance transactions.
One pensions lawyer quoted in the report says: “The regulator seems to be taking FRS17 solvency as the basis for negotiation. If a scheme falls below this then the Regulator will use clearance as an opportunity to force the employer to improve scheme funding.”
In most of the cases that have already been processed the quid pro quo for clearance has been an agreement on the part of the sponsor to inject capital into the scheme. Furthermore, anecdotal evidence suggests that the regulator has often required sponsors to improve their initial proposal for scheme funding before clearance was given. Clearly, corporate finance advisers will be working hard to assess the approach of the regulator and the thresholds for granting of clearance.
Given this changing environment, multinational companies will be looking at how to manage their UK pensions obligations and limit the adverse impact on the profitability of their business. One option could be to move DB pension provision offshore and so avoiding some of the UK obligations, such as the PPF levy. A more likely response will be to look to exit from providing salary-linked pension benefits.
The Pensions Institute report notes that many UK employers - domestic as well as multinational - are dismayed by the more onerous requirements imposed by the Act and are looking seriously at ending DB pension accrual for existing employees, having already closed their schemes to new members. The likely replacements are contract-based defined contribution schemes, with lower employer contribution rates and less strict governance obligations on the employer. From the perspective of the UK government and existing DB scheme members this may mean that the improvements in DB scheme governance created by the act come at a high price in terms of reduced occupational pension provision – what might be termed a Pyrrhic victory.
Alistair Byrne and Debbie Harrison are with The Pensions Institute at Cass Business School in London

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