UK: The Global Financial Crisis: Some Issues For Pension Schemes

Originally Published In October 2008

The financial crisis has created risks and uncertainty throughout the economy. Some effects on pension schemes are clear - for example, the substantial fall in equity prices. Other consequences may be far more difficult to assess.

This Special Edition attempts to identify, from a legal perspective, some of the issues which employers and trustees of defined benefit plans are likely to have to consider. Many of those issues may appear obvious. Indeed, the review of such issues should properly form part of the ongoing governance of any plan. However, recent developments mean that employers and trustees will no doubt wish to take stock of the position from their respective viewpoints.

The importance of cooperation and the sharing of information between employers and trustees is stressed throughout this Special Update. Responsibility for the delivery of pension benefits should best be seen as a partnership between the employer and the trustees. This is particularly critical in the current troubled economic times, when circumstances may change with alarming rapidity.

We begin by identifying some of the issues from the perspective of the trustees. This is, of course, relevant not only to trustees themselves but also to employers who will want to attempt to anticipate and address the trustees' likely concerns. In addition, understanding the respective powers of the trustees and the employer is important in framing discussions.

The trustees' perspective

The trustees' prime concerns will be:

• how has the crisis affected the employer?

• how has the crisis affected the fund?

• are the plan's investment arrangements robust?

Reviewing the employer's covenant

Trustees need to monitor the continuing strength of the employer covenant (that is, the employer's ability to continue to fund the plan). They need to bear in mind that, while the financial strength of the corporate group is material, it is normally only those employers within the group whose employees participate in the plan which have a direct obligation to contribute to the plan. Trustees should revisit past analysis of the employer covenant. What information was obtained in the most recent actuarial valuation process? What conclusions were reached? Are they still valid? Is there any aspect of the employer's financing arrangements which could give rise to concern?

If the valuation showed a deficit, over what period is the employer making it good (the recovery period in the valuation)? Is this now realistic?

Is the employer's covenant supported by any collateral, such as fixed or floating charges, parent company guarantees or bank letters of credit? Has the strength or value of that collateral either diminished or become more difficult to realise? Should additional or alternative collateral be sought?

Alternatively, has any change in an employer's credit rating triggered any payments/security due to the fund under existing arrangements, e.g. funds held in escrow?

The flow of information from the employer to the trustees

The importance of maintaining a dialogue between the trustees and the employer cannot be over-emphasised. In difficult times, it is particularly important to exchange information so that issues may be addressed jointly and in a spirit of cooperation and trust.

The employer's legal obligation to provide information to trustees and their advisers under the Scheme Administration Regulations is to provide "such information as is reasonably required for the performance of duties as trustees or professional advisers". In practice, the scope of this duty is somewhat uncertain and it is far better to have an understanding - or, better still, an agreement - between the employer and the trustees as to what information should be disclosed.

The employer may be more willing to share information if the trustees enter into a confidentiality agreement. Many trust bodies already have such agreements in place and our experience is that this often assists both the flow of information and the relationship between the trustees and the employer.

Does the Pensions Regulator have a role?

The Trustees may also receive information by virtue of an application by the employer to the Pensions Regulator (the "Regulator"). The employer may, for example, seek clearance for a corporate sale, reorganisation or refinancing which could have a detrimental effect on the plan. The Regulator will inform the trustees of any relevant clearance application and the trustees may even already be party to it.

The same availability of information does not, however, apply if the employer is merely reporting a "notifiable event" to the Regulator. This could include events which are potentially relevant to the plan, such as: a decision of an employer which will result in a debt to the plan not being paid in full; an employer ceasing to carry on business in the UK; or a breach of an employer covenant with a bank. The trustees should bear in mind that the employer has no obligation to inform the trustees about such a report - and the Regulator is under a statutory duty not to disclose it. This makes it even more important that the trustees and the employer should reach an agreement between themselves to disclose information. In practice, most employers would prefer a concerned set of trustees to approach it first, rather than to approach the Regulator directly.

Regulatory involvement may also arise where the trustees are concerned that the employer (or its wider group) is taking action (such as refinancing) which is detrimental to the plan. In Guidance published in March 2008, the Regulator makes it clear that it is willing to consider approaches from the trustees for guidance even if the employer itself is taking the view that the action is not materially detrimental and hence that an application for clearance is not necessary.

Reviewing the plan's funding position

Trustees should revisit the most recent actuarial valuation and discuss with their advisers whether there are likely to have been significant changes. Potential changes may include movements in investment values, changes in the strength of the employer covenant and possible future changes in assumptions (such as mortality factors), all of which may be relevant to the overall picture.

What powers do the trustees have in relation to funding?

The trustees need to be aware of the scope of their powers to take remedial action.

They have the power, under the legislation, to commission an early actuarial valuation. Regulatory Guidance suggests that this power could be considered where the actuary advises that the present recovery plan may be significantly inadequate, an employer ceases to participate in a multi-employer scheme or there is a significant fall in the market value of the scheme's assets. Before incurring this expense the trustees would, however, need to be clear as to their objective in obtaining the valuation.

The trustees need to be aware of the scope of their powers under their plan: for example, are they able to impose additional contributions (even lump sum contributions) on the employer unilaterally? Similarly, it is important to examine the triggers under the rules which would put the plan into winding up and potentially trigger a statutory debt.

Investment and banking arrangements

Trustees should consider the extent to which they should review their investment and banking arrangements. Areas to consider include:

• reviewing the institutions and counterparties with which they have investment and banking arrangements;

• reviewing their asset allocation strategy;

• reviewing the investment, structural and counter-party risks of any derivative, swap or hedging arrangements; and

• considering their position on stock lending.

The employer's perspective

Employers will need to consider many of the same issues as the trustees but from the other side of the coin.

Handling conflicts of interest

Conflicts of interest often arise between trustee bodies and the sponsoring employer. It is important for the employer to establish how those conflicts are to be managed, for example in relation to any negotiations between the employer and the trustees which may become necessary in the context of scheme funding. This issue is also topical because new rules on conflicts for directors came into effect on 1 October 2008.

Confidentiality agreements

Employers may wish to consider inviting the trustees to enter into a confidentiality agreement, so that information may be passed to the trustees more readily in future discussions.

As mentioned above, while the legal obligation on the employer to provide information under the Scheme Administration Regulations is unclear, sharing information with the trustees is generally beneficial. Trustees who have an understanding of the commercial issues faced by the employer are more likely to engage in constructive dialogue.

Possible areas for employers to explore

Employers may also wish to consider the following:

• negotiating with the trustees to extend the recovery period, based on the principle of "reasonable affordability";

• reducing the rate of accrual for future benefits (or switching to other forms of pension provision) if they have not already done so;

• considering whether to explore buyout solutions or liability management in the light of investment volatility; and

• revisiting existing financial arrangements (e.g. contingent funding arrangements, memoranda of understanding) to establish whether any worsening of the employer's position such as a rating downgrade triggers the release of money by the employer or a separate arrangement (e.g. an escrow account) into the plan. Employers will also want to understand how changes in asset values are likely to affect their balance sheets.

Regulatory involvement

If an employer (or a group) decides to take action which is materially detrimental to the employer covenant, it needs to consider approaching the Regulator for clearance. Relevant actions could include a corporate sale, a reorganisation, paying a dividend, or incurring obligations in refinancing.

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.