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OPDU Report 24 - May 2008 The Pension Support Bond – part of your funding solution? 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:
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
Advantages for the trustees
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 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.
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