Final salary or defined benefit schemes present the biggest pensions risk to sponsors.
The employer underwrites the cost of benefits in a final salary scheme. Members typically pay a fixed rate of contributions usually expressed as a percentage of pay.
Final salary or defined benefit schemes present the biggest pensions risk to sponsors
Employer contributions to meet the balance of the cost are regularly assessed by the scheme actuary, usually every three years. The calculation of the cost of future service benefits will be made separately from additional contributions that may be needed to address any past service deficit.
In arriving at a contribution rate, the actuary needs to make certain assumptions. For example, since benefits (in open schemes and sometimes in closed ones) are calculated by reference to salaries at retirement, an assumption has to be made about projected salary growth. An estimate of staff turnover is also needed, since lower salaries can be expected mid-career. Pensions are payable for life, so changes in life expectancy must be factored in. A crucial assumption is the real rate of investment return that can be expected as a result of the scheme’s investment strategy.
It is very unlikely that all the actuary’s assumptions on these and other matters will be borne out in practice, and any changes that may be needed can be made in subsequent valuations. Funding schedules are generally agreed between the employer and the trustees within a statutory framework, with the matter being referred to the Pensions Regulator if agreement cannot be reached. A small number of schemes contain special provisions that modify this position.
Any deterioration in the company covenant (see below) may trigger a request for additional funding from the scheme’s trustees.
Any deterioration in the company covenant may trigger a request for additional funding from the scheme’s trustees
Concerns have been expressed that changes to the EU IORP (Institution for Occupational Retirement Provision) Directive could lead to more onerous funding obligations. These changes are not included in the current draft of the revised Directive, and if introduced are expected to contain lengthy transitional provisions.
The sponsor of a final salary scheme is required to guarantee that, if the scheme is wound up, it will meet any difference between the scheme assets and the cost of securing benefits in full with insurance policies. This is the ‘section 75 debt’ or ‘buy-out debt’ referred to elsewhere in these notes. Most schemes are not of course in wind-up, and the section 75 debt is purely contingent. Nevertheless, the liability is a factor that analysts will take into account.
Liability is a factor that analysts will take into account
Corporate activity is affected by the sponsor’s section 75 liability (see Strategy). If the company is the subject of an acquisition, substantial due diligence on the scheme’s financial, legal and other risks can be expected. Even if those risks are considered to be manageable, the parties will need to consider the impact of the transaction on the scheme and the likely reaction of the scheme trustees to the acquisition. The scheme trustees may be wary of increased leverage, for example; their concern will be that banking obligations will reduce the company’s ability to fund the scheme and that bank debt will rank ahead of scheme contributions. Negotiation by the trustees for increased funding or security may be the result (see Relationship Management).
The Pensions Regulator encourages trustees to monitor the ‘company covenant’ – the sponsor’s ability to deal with adverse investment returns or other factors that make the scheme reliant on more employer support. An employer is therefore well advised to consider potential corporate events from a company covenant standpoint in order to assess any disclosure, regulatory and ‘mitigation’ issues that could result. In some circumstances, corporate events elsewhere in the employer group could potentially affect the company covenant and bring them within trustee and regulatory scrutiny.
Pensions can also present companies with reputational risk (see Governance Audit). Problems may result from unpopular benefit changes, poor communication or administrative mistakes. An emerging issue is member investment activism. There have been a number of cases where AGMs have featured embarrassing questions about the investment policy of the company’s pension scheme.
The Pension Protection Fund is a statutory safety net introduced in the Pensions Act 2004 to protect members of final salary schemes whose employers become insolvent. One of the Pension Regulator’s statutory objectives is to minimise the risk of compensation being payable from the PPF and it has a number of specific powers designed to prevent companies unloading their defined benefit obligations onto the PPF. It is these ‘moral hazard’ provisions that create the principal corporate risk, since they raise the possibility of a company’s funding and section 75 liabilities being extended to associated and connected employers that do not participate in the scheme. Because of regulatory guidance that encourages trustees to push for additional funding or security to compensate for detrimental impacts on the company covenant, company activities are potentially open to trustee and regulatory scrutiny (see Strategy).
It is these ‘moral hazard’ provisions that create the principal corporate risk
The Regulator has a wide range of powers in relation to funding, disclosure and notification, and scheme trustees have to work within that regulatory framework. It is therefore essential to understand the powers that the Regulator has and, just as important, those it does not have (see Relationship Management).
Many schemes are likely to present legal risk of some sort (see Governance Audit). Changes in the law may not have been properly understood, documented or implemented – such as attempts to introduce sex equalisation following the celebrated European case of GRE v Barber. Decided cases may have thrown doubt on practices that were, historically, widely followed. Changes in benefits that were made on the basis of an announcement to members rather than by formal rule change may be subject to challenge.
Risk may come from poor administration. Since calculation methods are standardised, mistakes once made can easily be repeated. Practices followed for years may be found to have diverged from the exact provisions of the scheme’s formal trust deed and rules resulting in under or over payment of benefits. Schemes that include different benefit scales following corporate acquisitions or scheme mergers may not accurately reflect promises made at the time. The fashion for outsourcing scheme administration may exacerbate (or reveal) these sorts of mistakes.
Many sponsors of final salary schemes have attempted some risk mitigation (see Governance Audit).
Most have reduced benefits in some way. Some have closed final salary schemes to new entrants or terminated future service accrual altogether. Others have introduced salary caps, changed the definition of pensionable pay or engaged in liability management exercises.
Many sponsors of final salary schemes have attempted some risk mitigation
Investment policy may have been used to provide greater certainty, such as where some or all liabilities have been matched by the use of buy-out or buy-in insurance policies.
Most schemes have produced a risk register identifying the scheme’s principal risks, and then attempted to address those risks.
Some schemes have appointed a sole or (more commonly) joint independent trustee to improve independence and governance (see Adviser Selection).
Risk in money purchase schemes
Fewer risks are associated with money purchase (or defined contribution) schemes – particularly contract-based schemes. A number of employers have moved from trust-based schemes to contract-based schemes for this purpose.
With the decline in final salary schemes and the introduction of auto-enrolment, defined contribution schemes are relevant for more and more employees. As they rise up the political agenda, there is more focus on how defined contribution schemes (particularly contract-based schemes) are run, how they are invested and how much they cost (see Governance Audit). Changes introduced in 2015 have begun to address these concerns. It is almost certain that further changes will be made.
If you’d like help or more information please contact us.