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United Kingdom: Plan Sponsors Under Siege

By: Charles Young & Paul Maclean

The fundamental burden of sponsorship of Defined Benefit pension plans in the UK has been altered. Charles Young and Paul Maclean, of Hymans Robertson, examine these changes and their impact.

Pension reform in the employersponsored pension provision in the United Kingdom is in the midst of a period of flux. In particular, legislative changes, both recent and imminent, have fundamentally altered the burden of sponsorship of Defined Benefit (DB) plans, to such an extent that employers are reassessing their commitment to continued support of such arrangements. This article gives a brief overview of the main developments.

Pension Protection On Insolvency

The Pension Protection Fund (PPF) is a compensation arrangement, participation in which is mandatory for most private- sector DB pension plans. It became operational April 6, 2005. The PPF provides security for members of these plans if their sponsoring employer becomes insolvent. Stated in broad terms, it will pay 100 per cent of the pension benefits for members over retirement age and 90 per cent (subject to a cap – initially £25,000 (C$50,000) per annum) of the accrued pension benefits for other members.

The PPF takes over the assets and liabilities of plans for which it assumes responsibility. It relies on annual levies payable by eligible solvent pension plans to meet the shortfall between the assets appropriated in this way and the value of the liabilities taken on. From April 2006, levies will be based to a large extent on a variable ‘riskbased’ charge reflecting the degree of underfunding of those plans with deficits and the likelihood of their sponsoring employers becoming insolvent.

plan sponsors seige

The levy for a ‘weak’ employer can be as much as 100 times the levy for a ‘strong’ employer, for an identically-funded pension plan. The charge can vary from around 0.1 per cent to 15 per cent of the plan funding shortfall. The strength ratings, provided by credit-rating firm Dun & Bradstreet, have proved to be controversial, particularly for company groups with complex corporate structures.

Non-UK employers which employ UK pension plan members through a UK branch (as opposed to a UK subsidiary company) will pay a levy based on the average strength of the company’s UK competitors. The resulting levy may, therefore, bear no relationship to the sponsor’s financial strength. A number of companies are looking at revisions to their company structure before the April 2006 start date. A

New Pensions Regulator

At the same time that the PPF was introduced, the UK’s independent pensions regulatory body, the Occupational Pensions Regulatory Authority (Opra) was replaced with a more ‘risk-focused’ organization, the Pensions Regulator. The regulator’s statutory mandate is to:

The regulator is responsible for the production of Codes of Practice, giving practical advice on compliance with legislative requirements. Whilst failure to comply with a code will not automatically be a breach of law, they are admissible as evidence in legal proceedings, and should be taken into account by the judiciary. The volume of new guidance produced by the regulator has been enormous – our impression is that their draughtsmen must be paid by the weight of the resulting documents!

Where the regulator thinks that a company or individual has been party to an attempt to evade the obligation to fund a DB plan, it is able to enforce payment of all or part of the shortfall on any of the conspirators. If it considers that a sponsoring employer is financially weak by reference to its pension plan funding obligations, it can require that other companies in the corporate group provide support.

The regulator views a pension plan as being an unsecured creditor of the sponsoring employer, and may use its powers in response to any activities considered to have a detrimental effect on the pension ‘creditor.’ Activities that the regulator has identified include granting or extending a charge over company assets, paying large dividends, share buy backs, and changes in the structure of the corporate group to which the sponsor belongs.

In response to fears that the threat of regulatory intervention would impede legitimate business activities and deter potential investors, a procedure has been established under which companies may approach the regulator to obtain advance clearance for a proposed transaction. It is not unusual for the regulator to offer clearance only if the employer puts additional money into the plan to deal with underfunding.

Plan Funding

In April 1997, UK private-sector DB pension plans were made subject to a ‘Minimum Funding Requirement’ (MFR). As the name suggests, the aim was to provide a minimum level of advance funding of DB pension promises. The MFR has been criticized almost from the moment of its birth. Sponsoring employers have complained that its contribution requirements are too prescriptive, whilst others have suggested that it provides an inadequate level of protection for plan beneficiaries. From an actuarial perspective, the prescribed methodology and assumptions for assessing funding and determining minimum contributions under the MFR are outdated and inflexible and the timescales for rectifying funding shortfalls are arguably overly rigid.

In response to this almost universal dislike, at around the turn of the century, the UK government began to consider the options for reform or replacement of the MFR. The solution, a new ‘statutory funding objective’ (SFO) is designed to be more flexible. It is commonly described as a ‘plan-specific’ funding standard (which may sound self-contradictory).

Responsibility for policing the SFO falls upon the Pensions Regulator. It has recently published a draft statement setting out its proposed approach, which involves the setting of ‘triggers’ that will serve to indicate the cases in which members’ benefits are most at risk, or the PPF may be called upon to assume responsibility for the plan.

Under those proposals, the regulator’s interest in a plan will be triggered if the plan sets a funding target that lies below 80 per cent of the cost of securing the liabilities with an insurance company. If less than 70 per cent, difficult questions may be asked. A funding target falling within the 70 to 80 per cent range is likely to merit some degree of further scrutiny. The regulator will consider other factors, such as the strength of the employer and the maturity of the plan, in order to determine whether it should intervene in any way.

Where a valuation under the new rules reveals a deficit, the trustees will have to put in place a ‘recovery plan’ for removing the shortfall. The regulator wants to see plan funding deficits eliminated as quickly as employers can afford. Recovery periods in excess of 10 years will raise a red flag. Shorter periods may still be questioned if the regulator thinks that the employer could make up the shortfall sooner, or the payments proposed are structured so as to increase significantly over the period of the recovery plan (‘back-end loading’).

The regulator is consulting on this approach, and intends to implement it during 2006. If adopted unchanged, it will result in a significant increase in employer contributions for many UK pension plans.

Employer Debt – The Cost Of Withdrawing Sponsorship

The end result of a series of changes since 2002 is that UK plan sponsors are, as a general rule, unable to withdraw support for a DB plan without paying the shortfall between the assets and the ‘full buy-out’ cost (the amount required to secure payment of members’ benefits with an insurance company). This measure of underfunding is very much more stringent than ordinary funding measures for an ongoing plan, and there are remarkably few UK plans that are overfunded on this measure.

For plans in which more than one employer participates, it is possible for one sponsor to withdraw without having to meet its share of the full buy-out cost, if guarantors (usually other companies in the corporate group) can be found who will agree to meet the shortfall if required to do so. Even in those circumstances, the withdrawing employer will be required to make a payment based on any shortfall under the MFR or SFO. The employer debt can be triggered by events as diverse as the sale of a company, corporate restructuring, or simply the retirement of the last employee member.

The existence of employer debts has led employers to think very hard before terminating pension plans. While many employers intend to use Defined Contribution (DC) plans as their predominant form of pension provision in the future, many have only adopted DC for new recruits, with a significant number of existing employees remaining in the old DB plan.

Pension Protection On Transfer Of Employment

Since April 2005, legislation has required that, where a business sale results in employees having their employment transferred to a new employer, and if the employees were members of an employersponsored pension plan immediately before the sale, they must also have access to employer-sponsored pension arrangements after the transfer. If certain conditions are satisfied, and unless the new employer and employee agree otherwise, the transferring employee will have a contractual right, effective from the date of transfer of employment, to membership of a plan of a minimum standard (it can be DB or DC).

Doing Business In The UK

This article only covers the story so far. There is a great deal of UK government interest in pensions, with simultaneous attempts to provide extra protection to pension plan members and raise standards of plan governance, while trying to avoid vote-losing propositions like increasing the state pension age or making people pay more for their pension. It is fair to say that the government has not fully succeeded in developing a strategy that deals holistically with the resulting tensions and we have seen many initiatives quickly – some might say hastily – introduced (and we do not think that it has finished yet).

For the overseas owner of a UK business, UK pensions can hold some nasty surprises. If you have not heard from your UK management within the last six months about changes to the costs and risks of UK pensions arising from the issues described above, you had better start asking some questions. Most of the issues do have manageable solutions, provided that you know what you are trying to manage.

Charles YoungPaul Maclean
Charles Young is a partner with responsibility for international consulting and Paul Maclean a research consultant at Hymans Robertson. Hymans Robertson is the UK member firm of the Milliman Global network, of which Eckler Partners is the Canadian member.

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