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OPDU Report 26 October 2009 Advisory Service Forum Raise the subject of pension scheme surpluses and the initial response is likely to be “that’s not something we’ve had to worry about for a long time and it’s unlikely we will need to do so in the near future”. This is hardly surprising when, set against the recent economic and investment background, almost all the headlines and discussion has been about pension scheme deficits. After all, we have recently witnessed a significant number of successive quarters of falling equity markets to the end of March 2009. Furthermore, companies have reported increasing deficits on their balance sheets with estimates that under the accounting standard IAS 19, the aggregate FTSE 100 UK pensions deficit stood at £96 billion at mid July 2009, the highest deficit ever recorded. (Source: Lane Clark & Peacock Accounting for Pensions 2009). Similarly, for any scheme which has undertaken a scheme specific funding valuation in the recent past, the value placed on the liabilities is likely to be higher than when the previous valuation was undertaken. By contrast, a number of independent reports in 2008 high-lighted FTSE companies reporting an irrecoverable surplus which in part reflects different requirements under accounting rules where the value of future liabilities are discounted based on AA corporate bond yields. Moreover, at the time of writing, there has been a significant recovery in world share prices with headlines proclaiming the biggest six month rally for 50 years. The FTSE index of leading shares reached a twelve month high of over 5100, a rise of more than 40 per cent since the beginning of March. The yield on fixed interest gilts of appropriate duration can be one of the key assumptions for scheme valuations and this too can be volatile. Some commentators are predicting a sharp rise in inflation which could drive interest rates back up, thereby lowering the value placed on liabilities (although account needs to be taken of a scheme’s inflation linked liabilities). Funding Challenges What this tells us is that the funding of defined benefit pension schemes is an uncertain business and predicated on assumptions that are unlikely to be borne out in practice. There has been significant volatility in the investment markets and whilst investment strategies and solutions continue to be developed, it is often not possible to precisely match liabilities, nor do many companies and trustees believe it is currently desirable or affordable to do so. If deficits can emerge and increase quickly, then it follows that the same can be true for surpluses too. Companies and shareholders in particular, are asking why they should suffer the pain and costs associated with funding scheme deficits but are then precluded from benefiting from any surplus that may be created in the future? Although it may be counter intuitive, a time of financial stress is when some of the assumptions adopted to remove deficits in pension schemes are likely to be stronger (one or more of higher inflation and salary increases, lower gilt yields, lower investment return assumptions), and may therefore be the very circumstances in which a surplus could be created over the Recovery Plan period. Some companies have become concerned, particularly as many have seen their pension contributions increase substantially. One report indicated that company contributions tripled between 2001 and 2007 (source Aon Consulting). Changes in accounting standards increase the risk of irrecoverable surpluses where the maximum surplus that can be treated as an asset on the company’s balance sheet is the value of possible future refunds and reductions in future contributions. As more schemes close to new entrants and increasingly to future accrual, this restricts the use of reducing future contributions to eliminate surplus. Further clarification issued by the Accounting Standards Board means that for a pension fund surplus to be treated as a balance sheet asset, the company must have an unconditional right to the surplus or have sufficient scope to decrease future contributions. The Pensions Act 2004 and associated regulations require defined benefit schemes to have assets in excess of those required to provide benefits on the full buy out (solvency) basis before they may make a payment of surplus to the company. The scheme rules must also permit this. In practice, a return of surplus from the scheme to the company is likely to be very difficult to achieve.
Developments in Scheme Funding Against this background, companies and trustees have begun to explore different approaches to scheme funding which include the use of contingent assets such as letters of credit, parental company guarantees, charges over company assets and the use of escrow accounts. An escrow account 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 underfunding or other specified events. The search by companies and trustees for innovative funding solutions led to the development of the Pension Support Bond which aims to provide additional security whilst at the same time removing the risk of overfunding. The Pension Support Bond works in a similar manner to an escrow account but without some of the potential drawbacks. A possible solution The Pension Support Bond is written as a capital redemption policy and unlike an escrow account, the company should receive corporation tax relief on its contributions which can be paid as either regular or single contributions 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 company agree the definition of scheme deficit which is specific to the scheme’s circum-stances and different definitions can apply, for example, in the event of the company’s insolvency or a participating company leaving the scheme. The trustees are responsible for the investment strategy of the assets held within the bond and potentially have the same flexibility with regard to asset class and asset 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 company, thus avoiding over funding. The surplus should be taxed at the company’s marginal rate of corporation tax. Attractions for the company
Attractions for the trustees
The need for advice The Pension Support Bond is intended to be a simple solution for companies and trustees to use. The company and trustees, as with any other significant scheme activity, will want to consult their respective advisors when implementing a Pension Support Bond. The future The present economic and investment conditions present significant challenges for companies and trustees alike. As part of a range of possible approaches, the Pension Support Bond can help companies and trustees work together in finding a solution to their pension scheme funding issues. Grant Lore
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