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The opdu Report - Issue 20, June 2006 The need to investigate The Pensions Regulator has said that it sees 6 April 2006 not as “A-Day” but as “TKU-Day”. On this date the requirements of the Pensions Act for trustees to have appropriate knowledge and understanding came into force. Lay trustees have six months in which to acquire the knowledge they need and to get to the point where they can demonstrate that they are sufficiently knowledgeable. There has been much focus already on the need to look closely at the employer/trustee relationship in the context of corporate activity and scheme funding. It is also relevant for TKU. The scope guidance attached to the TKU Code of Practice at Unit 4 (funding for DB schemes) says that trustees have to understand the way in which funding depends upon the financial circumstances of the sponsoring employer. Trustees need to understand “the nature and strength of the employer covenant” and the employer’s ability and willingness to meet the costs of members’ benefits. Much of the efforts of the Pensions Regulator to date have been focused on the voluntary clearance procedure where the Regulator has focused on the FRS 17 ongoing position of the pension scheme and has expected ongoing deficits to be corrected in the context of corporate activity. For many employers and pension schemes this has been a challenge. Employers have also in many cases chosen over the last 12 months or so to make special contributions to their pension schemes to eliminate ongoing funding deficiencies or at least to go some way towards their elimination. Even for those schemes where the ongoing funding deficit has been eliminated, the assessment of the employer covenant is still relevant because the trustees must still have regard to the gap between the ongoing liabilities and the wind up position. This issue will come sharply into focus for many trustees this year in the context of their first valuation under the new funding regime, with the need to set a prudent funding objective and an appropriate recovery plan. The Pensions Regulator’s latest guidance on funding published on 4 May 2006 says it is essential for trustees to form an objective assessment of the employer’s financial position and prospects when planning the valuation. To do this the trustees will need information from the employer, which may be confidential. They should consider using other sources of information and be alert to information to the public domain. There is also an expectation in the scheme funding guidance that any shortfall in funding will be eliminated as quickly as the employer can afford. What is possible and reasonable depends on the assessment of the covenant. How in practice will trustees assess the strength of the employer? Trustees therefore need to monitor their employer on an ongoing basis to meet their TKU obligation and they also need to review the position in the context of a valuation or a corporate event. The difficult question is how. All trustees now have access to the Dun & Bradstreet rating of their employer for the Pension Protection Fund levy, which may give some limited insight on a short-term basis. It is unlikely to provide much comfort but it may highlight a need for further investigation. The approach the trustees take will of course depend on the circumstances of the scheme and the employer. The scheme funding position will be relevant but so also will the maturity of the scheme’s liabilities. The strength of the employer and its ability to pay off the deficit are also key, not only for the trustees, but also for the Pensions Regulator when it is deciding whether to intervene in funding discussions. It may assist to consider a few examples: Pension Scheme A Pension Scheme A is an immature scheme, which is small relative to the size of the employer. The employer’s business is profitable and growing. There is a small ongoing deficit and even the pension scheme winding-up deficit represents only a small percentage of the assets appearing on the employer’s balance sheet. In this situation the trustees need to understand the employer’s business, how it is progressing and what the key drivers are but the trustees could be reasonably relaxed about obtaining information directly from the company and making their own assessment of its strength. In the valuation context the Pensions Regulator is unlikely to intervene unless the assumptions and recovery plan take the scheme outside the lower end of the range of acceptable. Pension Scheme B Pension Scheme B is a mature scheme and it is large relative to the size of the employer’s business with a large ongoing deficit. The trustees need to be more diligent in monitoring closely the progress of the employer’s business. They need to identify key performance indicators for the business and have regular reporting against them. They may wish to ask for security over assets. When it comes to valuation time they will wish to be confident they can demonstrate they have taken a prudent approach and this may lead to some testing of the company’s ability to pay. Pension Scheme C Pension Scheme C is a mature scheme and it is large relative to the size of the employer’s business with a large ongoing deficit. The trustees are aware in this case that the employer covenant is weak and that the employer’s business is struggling. This is of course the most difficult situation. This is the situation where the Regulator would like to see a very short recovery plan for any deficit and a cautious approach to setting the scheme funding objective, so ideally a wind up objective. This is of course also the situation where the employer is least able to pay a high level of contributions to the pension scheme. If, of course, the employer is able to convince the trustees and the Pensions Regulator that it is unable to pay a reasonable level of pension contribution without jeopardising the future of its business then it will be given a longer time to pay off the deficit. The question is, where do the trustees of pension schemes B and C go? How can they realistically test what the employer can afford and the future for its business? Many trustees are currently seeking, or considering seeking, independent financial advice from accountants with experience in the area of corporate recovery. Trustees need to be wary of regarding independent financial advice as the magic answer to the problem. They need to be very clear about the question that they want answered and where the answers will take them. If an accountant is asked the question for instance, “how much can the company afford to pay us today?” or “what would we recover if we took steps to initiate the winding up of the company today?” or “are there any assets available to give us security?” the accountant would be able to come up with an answer. If in fact the question concerning the trustees is more along the lines of “will our employer be able to support our pension scheme until all of the liabilities are met approximately 50 years from now?” that question is impossible to answer with any certainty today. The latter question is more close to the issue concerning trustees of most schemes. There are some situations where trustees will need to ask all the questions and then to pay a retainer to have the independent financial advisors take a watching brief of the employer’s business. That is a very expensive approach. In other situations it may be preferable for the trustees to work out with the company the key performance indicators for the business and then to monitor these themselves. The company will itself have internal targets and if it is prepared to share this information with the trustees (as it should be) and commit to share information going forward then it should be possible for the trustees to do much of the monitoring themselves. The trustee board may already include individuals with the skills and experience to assess the employer’s business. If those individuals are currently senior executives the potential conflict will need to be considered and managed. Sometimes they will be former executives or independent trustees with relevant skills and experience. Even though the Pensions Regulator’s starting point for clearance applications is that trustees should obtain independent financial advice, we have had at least two such cases where it has been convinced by knowledgeable trustees that there was no need. The Regulator’s list of notifiable events together with the list of situations where clearance can be obtained can be a useful starting point for trustees identifying activities of concern but they do not go far enough. The aim for trustees must be to try and identify problems as they arise much earlier than the occurrence of a notifiable event. Trustees should consider having, as a standing item on their trustee meeting agendas, the strength of the employer with someone delegated to carry out monitoring in between meetings and a procedure agreed for any urgent reporting in between meetings. If companies are prepared to co-operate to help the trustees establish such a system, this is likely to be much more effective than involving independent financial advisers at regular intervals. One thing for certain is that trustees over the next few years will spend a lot on advice on this issue which is not particularly useful. Conclusion Trustees have to identify whether the strength of their employer relative to the size of the pension scheme is a concern. This is required for them to satisfy their TKU obligations and it is also key to the approach they will take in due course to scheme funding. As with much of the new regime it requires a new focus on where the scheme is going and more diligence on the part of trustees and maybe it will require independent financial advice. But it also makes sense and many would say not before time. Vivien Cockerill |
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