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OPDU Report 24
- May 2008
The Pension Support Bond – part of your funding solution?
Grant Lore
Background
With all the publicity there has been concerning deficits in defined
benefit pension schemes, it may seem strange that concern has been
expressed about the possibility of employers finding surpluses
trapped within their schemes as an unintended consequence of
funding to remove these deficits.
We don’t need to go back too far to recall a time when schemes were
well funded, based on the criteria that applied at the time. Some
employers saw contributions to their schemes reduce whilst others
took contribution holidays. There was even a requirement prior to
April 2006 for a report or certificate to be sent to the Revenue to
state that, either there was no surplus over 5% of the value of the
past service liabilities, or to confirm the extent of the surplus
with proposals for approval for reducing this.
Since April 2006, the position has changed and regulations require
defined benefit schemes to have assets in excess of those required
to provide benefits on the full buy out basis (sometimes known as
the solvency basis) before a payment of surplus can be made to the
employer. In addition, there are various other requirements which
must be met (including the scheme rules allowing this) which mean
that in practice, a return of any surplus from the scheme to the
employer is likely to be very difficult to achieve.
More recently, the reduction in long term interest rates (with the
consequential increase in the value placed upon the scheme’s
liabilities), and the volatility of schemes’ assets has increased
pressure on funding. This has coincided with the implementation of
scheme specific funding valuations, where trustees, having taken
advice, are now responsible for setting the assumptions; with the
Pensions Regulator (tPR) setting trigger points for asking further
questions about the valuation assumptions.
The launch of the Pension Protection Fund (PPF) has provided a
valuable ‘lifeboat’ for scheme members who see their scheme’s
employer become insolvent with insufficient assets to meet the
scheme’s liabilities. One of the key objectives of tPR is to prevent
schemes falling into the PPF in the first place, so it is no
surprise that it would like to see schemes as well funded as
possible.
Trustees too have recognised that they are effectively unsecured
creditors of the employer and have conducted their funding
discussions with the employer on this basis, whilst employers faced
with increasing and unpredictable costs, coupled with accounting
issues, have moved to close their defined benefit schemes
to new entrants and increasingly to future accrual too.
Trustees therefore, are facing the challenge of obtaining as much
funding (and security) as possible whilst retaining the support of a
viable employer, taking account of the strength of the employer’s covenant. Employers, on the other
hand, are facing demands for increased funding and increased costs
of running their schemes (including levies).
With a prudent approach to scheme funding being adopted, some
employers have started to ask what will happen if the assumptions
on which the funding is based prove to be too pessimistic and
whether there is a risk of trapped surplus in the future.
Furthermore, new accounting guid-ance may mean that companies may
not be able to record the whole surplus on their balance sheet in
future, should it arise.
It is against this background, that the use of contingent assets has
begun to become more popular as trustees and employers seek to find
solutions that meet their, sometimes conflicting, objectives.
Contingent assets
Recent surveys suggest that the use of contingent assets is set to
increase with both trustees and employers believing they are useful
as part of scheme funding. Contingent assets fall into a number of
different areas and for the purpose of a simple over-view can be
summarised as follows:
- Letters of Credit. These protect
the scheme on the insolvency of
the employer
- Parental Company Guarantees.
Here a guarantee is obtained from
another group company which
may arise as part of the assessment of the employer’s covenant
during the funding discussions
and can also potentially reduce the
Pension Protection Fund risk
based levy
- Charge over company assets.
Typically this might be a company
property, in which case this is only
likely to be transferred to the
trustees if the employer becomes
insolvent but can be used to justify
a longer funding period
- Escrow Accounts. These can be
used as part of the overall funding programme and not just on
insolvency, where payment into
the scheme is triggered on an
agreed level of under funding or
other specified events.
It was against the background of trustees and employers looking for
innovative solutions for their funding challenges that the Pension
Support Bond was developed, with the aim of giving added security
whilst at the same time removing the risk of over funding.
The Pension Support Bond works is a similar manner to an escrow
account but without some of the potential drawbacks.
What is the Pension Support Bond and how does it work?
The Pension Support Bond is written as a capital redemption policy
and unlike an escrow account, the employer should receive
corporation tax relief on its contributions which are paid as either
regular or single premiums to the policy. This is because the value
of the policy, up to the definition of scheme deficit, is a scheme
asset.
The trustees and the employer agree the definition of scheme deficit
which can be specific to the scheme’s circumstances and may vary
depending upon different circumstances. For example, the definition
could be based on the scheme specific funding valuation definition
(either at outset or ongoing through the recovery plan period) but
with different definitions (such as the solvency definition)
applying in the event of the employer’s insolvency or a
participating employer leaving the scheme. The position in relation
to a takeover or merger may also need to be considered.
The trustees retain responsibility for the investment strategy of
the assets held within the Pension Support Bond and potentially have
the same flexibility with regard to asset class and assets managers
as other investments for the scheme.
When the policy is surrendered at the end of the Recovery Plan
period, any surplus after clearing any residual deficit will revert
to the employer, thus avoiding over funding. The surplus should be
taxed at the company’s marginal rate of corporation tax.
Advantages for the employer
- Avoids risk of trapped surplus
- Corporation tax relief should be
available on contributions
- Investment income should be
tax free
- Reduced Pension Protection
Fund Levy. The contributions
can be included in the Actuarial
Certificate of Deficit Reduction
Contributions and count as a
scheme asset up to the definition
of the deficit agreed in the policy
document.
Advantages for the trustees
- Cash funding into the scheme
- May assist in obtaining additional
cash funding from the employer
- Assists with support of employer
for the scheme.
The trustees will usually consider cash funding as preferable.
Comparison
The Pension Support Bond is compared with an Escrow account and
direct investment into the scheme in the table below:
Advice
The Pension Support Bond is designed to be a simple solution for
employers and trustees to use. When implementing a Pension Support
Bond, as with other significant activity in relation to the scheme,
the employer and the trustees will want to consult their respective
advisers. For employers, this will probably be their auditors (and
if different, tax consultants) whilst trustees are likely to consult
their scheme actuary, lawyers, auditors and investment consultants.
Funding and the future
With scheme funding set to continue to challenge both employers and
trustees, the need for innovative solutions is likely to increase.
It is arguable that employers and trustees positions have been
polarised recently and the Pension Support Bond may help address
this in funding discussions. Trustees can pursue securing the amount
of money they need to obtain the funding target whilst employers can
fund in the knowledge that any surplus in excess of this target can
be released to them at the end of the agreed funding plan period.
Grant Lore
Director
opdu
020 7204 2315
grantlore@thomasmiller.com
www.opdu.com
OPDU acts as an introducer to Leeward Insurance Company Limited and
is authorised and regulated by the Financial Services Authority.
Leeward Insurance Company Limited is authorised by the Bermuda
Monetary Authority and does not, and is not authorised to carry on
in any part of the United Kingdom any class of insurance business.
Hamish Wilson
Partner, HamishWilson
01737 841730
hamish.wilson@hamishwilson.com
www.hamishwilson.com
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