UK: Human Capital (Pensions): Climate Control For Pension Schemes

Last Updated: 3 September 2007
Article by Philip Sutton, François Barker and Helen Needham

Despite the conspicuous absence of the sunshine over the UK for much of this summer, the heat has been well and truly rising for employers struggling to cope with underfunded defined benefit pension schemes over recent years. In this article, we look at the potentially catastrophic effects of scheme underfunding on sponsoring employers and we outline a radical plan that could help take the heat off a company in distress.

Underfunded defined benefit pension plans are a hot topic right now – mostly for all the wrong reasons. They get in the way of corporate deals, are hugely costly to address (both in terms of hard cash and management time), and – without careful management – can in extreme cases even cause the downfall of the company which was benevolent enough to set up the plan in the first place.

The problem lies in the defined nature of the benefits payable under these arrangements. Typically, these are set out in the plan’s rules and defined as equivalent to a proportion of the individual’s final salary. Because of the extended timescales over which pension schemes operate - and the variables at play, such as investment returns and inflation - it is almost impossible to know ahead of time exactly how much money will be needed to provide the defined benefit promised to any given individual when it falls due for payment.

The risk of there being a shortfall at the critical time rests almost entirely with the sponsoring company. Put bluntly, if there is not enough cash in the fund, it is normally the sponsoring company which has to dig deep. If the shortfall is serious enough, the company might simply not have enough cash to plug it, and can face insolvency as a result.

This is the result of several contributory factors:

  • technically speaking, the plan is an unsecured creditor of the company to the tune of the shortfall
  • trustees who run the plan are subject to a legal duty to act in the best interests of the plan members – including recovering as much as possible from the company
  • the Pensions Regulator has high expectations of trustees and recently commented that they should act like banks and
  • many defined benefit plans are sponsored by companies in traditional legacy industries like manufacturing where business is tough, margins are tight, and there is unlikely to be much spare cash available to prop up pension arrangements.

This all makes for a heady mix presenting very real insolvency risks for weak companies sponsoring defined benefit pension arrangements.

Until recently, companies in this situation could try to escape their pension liabilities by reinventing themselves via an insolvency process. Effectively, the struggling company would sell its business and assets to a newco (usually run by the same people), leaving the pension scheme and its crippling shortfall behind with the shell of the original company. The newco would then be free to resume the trade formerly carried on by the original company, without the constraints of the pension plan and its deficit.

Two factors now make this kind of approach less palatable. The first is that the Pensions Regulator has extensive powers under the Pensions Act 2004 to reopen transactions like this which are prejudicial to a pension scheme. In theory they empower the Regulator to require those responsible for prejudicing a pensions scheme to pick up the tab for supporting it financially.

The Regulator was given these powers to try and dissuade companies from dumping their pension schemes on the Pension Protection Fund (PPF). The PPF is the back-up arrangement (often described in terms of an insurance scheme or a lifeboat) established under the 2004 legislation to take over underfunded pension schemes where their sponsoring company goes bust. The PPF absorbs the scheme’s assets and liabilities, and ensures that at least minimum benefits are paid to the members.

Since the Regulator is statutorily required to protect the PPF, there is a risk that, in this type of insolvency set up, it could pursue the newco and its directors for the original scheme deficit.

The second factor against using an insolvency process to escape pension liabilities is that putting a trading company through this can be fatal in itself. It can create significant trading, HR and PR risks since employees, suppliers and buyers may simply decide the business is too risky to deal with. Any licences, authorisations and contracts in the name of the original company - likely to be critical to the commercial viability of the business - will die with it unless they are transferred across.

The risk of the newco and its directors being pursued for the original deficit can be managed by seeking clearance from the Pensions Regulator. This process allows parties who might be at risk of later intervention by the Regulator to approach it before the deal happens, confess all, and receive advance absolution. Effectively, a party cleared in this way cannot later be called upon by the Regulator to contribute to the scheme’s shortfall.

The more general risks of putting a company through the process are harder to manage - the whole idea turns, after all, on an insolvency taking place, allowing the company to escape its pension scheme.

However, there are alternatives. The solution Hammonds’ pensions team has implemented in a number of cases is to engineer a situation where the requisite insolvency occurred to a company involved in the pension scheme, but not to the main trading company.

The challenge lies in simultaneously meeting the needs of the various parties. For the trading companies, the priority is to shed the crippling pension deficit and trade on without going through an insolvency process. In each case, the trustees, meanwhile, were aware of the fact that their best option was to fall back on the PPF (in each case it was clear that the sponsoring company would never be able to fund the plan properly and that it would go under unless it was freed from meeting the plan deficit). Whilst they were prepared to co-operate, the trustees needed certainty that this would not later exclude the plan from the PPF. The PPF’s key aim was to extract the best terms possible for taking on the plan in such circumstances. The Regulator worked closely with the PPF and needed to be satisfied as to the deal terms to be able to provide the necessary clearance to the relevant parties.

The ultimate solution entailed involving a new shell company in the pension plan, and agreeing that the plan shortfall would be split so that the vast majority fell on this new company. This allowed the trading company to exit the plan with finality, paying on the way out its engineered (and miniscule) share of the shortfall. The newco, saddled with the rest of the deficit, went insolvent, thus triggering the scheme’s entry to the PPF. The PPF and the Regulator’s price for PPF entry/clearance typically involved a mix of cash, loan notes and an equity stake in the cleaned up trading company – assets which will ultimately pass to the PPF with the plan.

These cases have been among the first occasions in which a distressed company threatened with insolvency because of its pension plan has been surgically separated from the offending arrangement without going through an insolvency process. Given the prevalence of legacy defined benefit pension plans in traditional industries like manufacturing, all the indications are that this will not be the last time this strategy is used.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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