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The trm Report - May 2007 Why worry about surpluses? Many trustees will by now have received the first actuarial valuation under Part 3 of the Pensions Act 2004. A significant number of pension funds show a deficit on this basis. This being the case, why are so many employers worried about surpluses? Employers know that while the deficits in well–run defined benefit schemes appeared relatively suddenly – helped by the collapse in equity markets, as well as by increasing longevity – they are now having to agree medium term recovery plans under the watchful eye of the Pensions Regulator. But employers also know that just as deficits appeared, they can disappear as a result of the movement of two highly volatile numbers. Pension scheme assets are valued at market value and as markets fluctuate, asset values can change rapidly. Pension liabilities are even more volatile. Their valuation is arguably more of an art than a science as a significant number of assumptions are utilised. They rise or fall significantly following even small changes in the underlying assumptions, such as the discount or mortality rate. This situation creates a serious problem for employers since, while being driven both by ethical commitment and by regulation to agree recovery plans, they know that if markets and the value placed on liabilities both move favourably, their pension schemes very quickly becomes in surplus; yet they also know it is very difficult to recover any surplus from the pension scheme. This is because current regulations apply a different set of criteria for liability valuation if a return of surplus is envisaged – schemes must have assets in excess of those required to match liabilities calculated on a “full buy out basis” rather than an “ongoing scheme” basis before the scheme is permitted to return surplus to an employer. When agreeing a recovery plan, neither the employer or the trustees can actually know the appropriate level of funding necessary to meet the schemes liabilities while at the same time ensuring surpluses do not arise. Only time will tell whether the employer has been unnecessarily generous. How can this uncertainty best be managed, given the pressures on both trustees and employers? Escrow – only a partial solution One solution would be to put part of the employer’s contributions under the recovery plan into an escrow account, rather than into the fund itself, with the scheme having rights to the money under agreed circumstances. A well-structured escrow account would protect the trustees against default of the employer. It could provide the trustees with the authority to determine the investment strategy of the funds in escrow but those funds would not be a pension scheme asset. Furthermore, an employer would not get tax relief on the funds placed in the escrow account but would be assessed for corporation tax on any investment income earned. A better alternative – a pension support bond A more efficient solution would be for the pension scheme to invest in a pension support bond (PSB). A PSB has the functionality of an escrow account in that it protects the trustees against default of the employer, but at the same time counts as an asset of the scheme. However, the employer is eligible for tax relief on contributions made to the pension scheme to finance the bond. How does a PSB work? The trustees and employer agree as part of the recovery plan negotiations that in consideration of the employer making additional contribution(s) the trustees will invest an agreed amount of these contributions in a PSB which will be surrendered at the end of the recovery plan period. The PSB is issued by an authorised insurance company through a “Segregated Account” which ensures each account is ring-fenced from other segregated accounts. The account is opened by the employer who subscribes for a nominal number of shares that entitles it to profits arising in the account, but does not give the employer control over the account. When the agreed contribution(s) from the pension scheme (or from the employer on behalf of the scheme) have been paid into the segregated account, the insurance company issues a PSB to the trustees, the initial value being the same as the amount contributed. Thereafter, the value of PSB (the “surrender value”) is the lower of:
The assets backing the PSB , meanwhile, are invested in accordance with an investment policy agreed with the Trustees, using (if desired) the same investment manager(s) as appointed for the other pension scheme assets. The bond on surrender The trustees can surrender the PSB if the employer becomes insolvent, or (with the agreement of the employer) following an actuarial valuation, and latest at the end of the recovery plan period. On surrender, the value of the PSB as defined above is paid to the pension scheme. Where the deficit is less than the assets backing the PSB , a profit arises in the segregated account being the difference between the assets and the amount paid to the pension fund – the account can then be liquidated and the profit distributed to the employer as the owner of the segregated account. Thus the scheme gets as much of the value (up to 100%) of the PSB as it needs to close its deficit, but once closed, any surplus does not form part of the surrender value (and hence does not get paid to the trustees). Instead this is paid by way of dividend to the company. Purchasing a PSB How to put one in place? Both the Employer and the Trustee needs to obtain independent legal, tax, accounting and actuarial advice before setting up a PSB. They then need to agree the amount of the premium (contribution) and the premium schedule that will be used to finance the PSB. The amount of the premium should be set so that it does not exceed the present value of the scheme’s deficit calculated on an actuarial basis. The trustees and the employer also need to agree a definition of how the deficit will be calculated (i.e. both the basis of the assumptions and the methodology) for the purposes of using the PSB , since this will be crucial to determining how the funds backing the PSB will be divided between the employer and the trustees upon surrender. The parties need to agree both the definition of the deficit calculation and the assumptions to be used to calculate the deficit. These could be the same definitions as are used in their normal ongoing actuarial valuation. To open the segregated account, the employer enters into a shareholders’ agreement with the insurance company. This sets out the rights and obligations of the parties, and records that any PSB issued will be for the benefit of the scheme. The principal right of the employer is the right to receive dividend on its preferred shares; no dividends will, however, be paid under the terms of the shareholders’ agreement until the PSB has been surrendered. The trustees will control the investment within the PSB and have the powers to surrender the PSB under agreed circumstances. Investment of the Underlying Funds Once the insurer has issued the PSB , the trustees (having consulted their investment advisors) need to nominate an authorised investment manager (which could be an existing investment manager), who will be appointed by the insurance company to manage the funds paid into the segregated account for the PSB. The investment return (net of expenses) will accrue to the segregated account. The insurance company will thereafter provide the trustees with a regular report on the value of the assets backing the PSB . The trustees monitor the performance of the investment manager of the PSB in exactly the same way they monitor the performance of the other managers of their scheme. The appointment of the investment manager for the PSB can be reviewed at any stage and the insurance company will follow the wishes of the trustees should they want to appoint another investment manager. Surrendering a PSB As part of the regular tri-ennial actuarial valuation, the scheme actuary (or another actuary as agreed between the parties) will determine the level of funding . At this time the trustees will need to review whether it is still appropriate to hold the PSB. If the scheme’s circumstances have changed and it is no longer appropriate to hold the PSB the trustees may, with the approval of the employer, surrender the PSB. The trustees can also surrender the PSB – without consulting the employer – if the employer becomes insolvent. Upon receipt of a notice of surrender from the trustees, and (if necessary) any consent required from the employer, the insurance company will determine the surrender value of the PSB. The manager will pay the surrender value directly to the trustees and thereafter distribute the balance, by way of a dividend or payment on liquidation of the account, to the employer. Conclusion A PSB is an effective and efficient alternative to an escrow account. It provides the trustees with security and control over the underlying assets and gives the employer a mechanism to ensure surpluses do not become trapped in the pension scheme for years to come. Whenever there is a potential prospect of over-funding during the course of a recovery plan, employers should consider such a solution at the time the plan is constructed in order to achieve a fair balance of interests between their shareholders and their pension scheme members. The concept of the Pension Support Bond was developed by Leeward Insurance Company Ltd (“Leeward”), a Bermuda-based Segregated Account Company, working closely with opdu. The bond is issued by Leeward through a “Segregated Account” – Leeward is authorised as an insurance company in Bermuda and designed to host these accounts under Bermuda legislation which ensures each account is held independently of every other similar account. As the Pension Support Bond is issued by a Bermuda based long-term insurance company it is only suitable for trustees of pension schemes that have at least 50 members and £10 million assets under management. The management and solvency of Leeward are not supervised by the Financial Services Authority. Pension Support Bond holders will not have the right to complain to the Financial Ombudsman Service if they have a complaint against Leeward and will not be protected by the Financial Services Compensation Scheme if Leeward should become unable to meet its liabilities to them. Leeward Insurance Company Ltd is authorised to carry on long-term and general insurance business by the Bermuda Monetary Authority. It is also registered as a segregated accounts company under the Segregated Accounts Companies Act 2000 of Bermuda as amended. It operates through its Principal Representative and Managers, Leeward Management Company Ltd, a subsidiary of Thomas Miller Holdings Ltd, the parent company of The Occupational Pension Defence Union Limited (opdu). opdu is an authorised introducer of the Pension Support Bond for Leeward. For further information view the psb section of this website or contact: |
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