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The trm Report - November 2006 Pension deficits continue to make the headlines. Could there be a solution that pleases both trustees and CEO’s through the innovative use of captives? Why have pension deficits emerged? Not long ago many British companies were enjoying pension contribution holidays. At the moment UK plc has an estimated pension deficit of £130 billion. Why? The liabilities of pension schemes have risen primarily because of an increase in life expectancy. Changes in the rules, such as the treatment of early leavers and inflation proofing which made pension promises more generous have exacerbated the problem. A fall in bond and equity yields and the removal of tax relief on dividends led to a compounding reduction in the investment returns generated by pension schemes. In addition, the introduction of the FRS 17 accounting standard led to an overhaul of how listed companies had to account for their pension liabilities. The old accounting standard required a smoothing of pension contributions in the profit and loss account with the balance sheet just showing the amount still to be smoothed. FRS 17 has now put the public spotlight on pension schemes’ true net asset position and forced companies to recognise deficits as liabilities. The extent of the problem There are two main types of pension scheme in the UK; defined benefit (DB) and defined contribution (DC). With a DB scheme the employer bears the risk that the assets of the scheme are not sufficient to meet all the pension promises, whilst with a defined contribution scheme the employee bears all the risk. As DC schemes do not expose companies to pension risk, only companies that run DB schemes can have pension deficits. There are around 90,000 occupational pension schemes in the UK, but approximately only 10,000 of these schemes are DB schemes. These DB schemes have approximately 14.8 million members and the split between active, deferred and retired members is 4.1 million, 5.9 million and 4.8 million respectively. The membership distribution of pension schemes is skewed. There are some 285 DB schemes with more than 5,000 members and around 4,000 schemes with between 100 and 5,000 members. Not unsurprisingly, the large and medium sized DB schemes account for most of the £130 billion aggregate pension deficit. Conflicting objectives of companies and pension trustees The Pension Regulator encourages pension scheme trustees to think of the pension liability as an unsecured loan to the company sponsoring the pension scheme. This approach is reflected in The Pension Regulator’s Code of Practice 03, which deals with the funding of DB schemes and provides a checklist for trustees when negotiating with a sponsoring company. The objectives of the trustees and the sponsoring company often conflict when negotiating a recovery plan to eliminate a pension deficit. The recovery period, the amount and timing of contributions and the assumptions about the pension liability and investment returns all need to be agreed. Sponsoring companies generally prefer a long recovery period, lower contributions, “back-end” loading of contributions and relatively aggressive investment return assumptions. However, trustees generally prefer a short recovery period, higher contributions, “front-end” loading of contributions and conservative investment return assumptions. The sponsoring company will also wish to avoid the risk of a “trapped” pension surplus. It may seem perverse that sponsoring companies worry about trapped surpluses given that so many DB schemes have currently large deficits. The valuation of pension scheme liabilities, however, is extremely sensitive to changes in the assumptions used. There is often a real and significant risk that, as a result of the employer agreeing to the trustee’s request for higher contributions over a shorter period of time, the scheme may revert to a surplus. Moreover, if this happens, it is then quite likely that trustees in the future will be reluctant or unable to agree to a distribution of the whole or part of a pension surplus to the employer on the grounds that the pension scheme is still exposed to fluctuations in the value of its assets and liabilities. How and why captives may offer the solution Can captives be used to bridge the gap between the pension scheme trustees’ and sponsoring company’s negotiation objectives? At present, this gap is often bridged by the use of contingent assets, which are made available to the pension scheme upon the occurrence of a specified event, such as the insolvency of the sponsoring company. The most commonly used contingent assets are:
In most jurisdictions, general insurance companies can be licensed to issue guarantees. Depending on the funding requirements, a captive with a licence to issue guarantees could in theory be used as a way for the sponsoring company to provide a guarantee to its pension scheme. However, the Pension Regulator advises pension scheme trustees that the financial institution issuing such a guarantee should be rated at least AA- (or equivalent) and regulated and located in an OECD member state. Most captives used by British companies, if rated at all, will not have an AA- rating and are unlikely to be based in an OECD member state. A more promising approach is for the sponsoring company to use a captive insurance company authorised to write long-term business to issue an insurance policy to the pension scheme. Under the terms of the insurance policy, the trustees would have the right to surrender the policy in certain circumstances. The surrender value would be the lower of the value accrued under the policy and the amount of the pension deficit at the time of surrender. The sponsoring company and the pension scheme trustees agree as part of the recovery plan that the trustees pay a certain amount of the contributions as premium towards the policy and that the trustees will surrender the insurance policy at the end of the recovery plan. If the pension scheme is not in deficit (disregarding the value of the insurance policy) then the surrender value is nil. If, however, the scheme is in deficit, then the surrender value is the lower of the value of the policy and the pension deficit at the time of surrender. Following the surrender of the policy the captive insurer is wound up and the remaining funds (if any) distributed to the sponsoring company, thereby avoiding any funds being trapped in the pension scheme. Practicalities, challenges and benefits The benefits of the structure outlined above are:
The decision where to base the captive needs careful consideration, and technical and reserving requirements for long-term insurance business vary significantly between jurisdictions. The Financial Services Authority has also imposed certain restrictions on the promotion of insurance products offered by long-term insurance companies based outside the European Economic Area. The operating arrangements need to be carefully designed so that the captive does not conduct regulated activities in the UK. Care is also required when setting up a captive for such a purpose lest it inadvertently create tax liabilities or problems for the employer. Accounting issues also arise. The amount accrued under the policy will be an asset of the pension scheme for as long as it is less than the scheme deficit. At each balance sheet date the accounting treatment has to be reviewed:
Reporting under FRS 17 also needs to be taken into account, and this will impact upon the structuring of the captive, and whether or not to structure the captive as a subsidiary of the sponsoring company. The next challenge: Using captives to structure ART solutions for pension deficits Many employers wish to transfer their pension risk or cap their exposure to the volatility of their pension scheme liabilities. Could captives be used for this risk transfer? At the moment two approaches are being taken. One is to enter into a commutation agreement with a large well capitalised insurance company which “buys out” the pension liabilities. It is difficult to envisage a role for a captive here. The other approach is to adopt a liability driven investment strategy which uses a combination of options, derivatives and guarantees to cap the scheme’s liabilities. The pension scheme may not be able to invest directly in such financial instru-ments. An insurance policy issued by a captive could be used as a “wrapper” for such a liability driven investment programme. Conclusion Skilful use of a captive could bridge the gap between the objectives of sponsoring companies and pension scheme trustees, giving security to trustees while at the same time reducing the risk of a trapped pension surplus. It may also facilitate the use of other financial instruments to help manage deficits generally. Employers and trustees should certainly explore these options as they wrestle with the challenges endemic in a world of occupational pension scheme deficits. Jonathan Bull For more information see the Pension Support Board page
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