Starter for ten – 10 key questions FDs should be asking about their DB pension scheme

Alan Collins

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With recent market turmoil sending scheme funding levels tumbling, pensions present a potential Pandora’s Box for even the most enlightened Finance Director.

In this month’s issue of CA Magazine (pg. 56) Alan Collins, head of employer advisory services at pension actuaries Spence & Partners suggests 10 key questions that Finance Directors should be asking themselves about their defined benefit schemes and some guidance on each of these key issues.

I want the pension scheme off the balance sheet – what can I do?
In almost all cases (especially closed schemes), the ultimate goal should be to secure all benefits with an insurance company and wind-up the scheme. This is unlikely to be immediately viable in most cases, but there are steps that can be taken to bring the ultimate goal closer. These include employer led exercises such as early retirement offers, a pension increase exchange exercise, where members give up future pension increases in return for a higher initial pension or offering members an incentivised opportunity to shift their scheme benefits to an alternative.

These exercises can generate significant savings to the employer relative to the ultimate cost of buyout and allow members to shape their benefits in a manner which suits them rather than that dictated by the scheme or to retire early from the scheme.

Schemes can also move towards a lower risk investment strategy, using bonds or LDI type investments, and also consider partial insurance such as buy-ins or staged buyouts. Companies should also consider the potential for non-cash funding such as parental guarantees, contingent assets or asset-sharing with the company, such as the whisky-bond deal completed by Diageo.

What can I do to reduce my FRS 17 deficit?
Medium to long-term interest rates are significantly higher than the rates implied by the standard AA index used for measuring liabilities for accounting purposes. By using a yield curve approach to assumption setting, the discount rate appropriate for FRS 17 will be higher than the index yield, reducing the value placed on your liabilities by around 8 per cent for an average scheme.

Recent pressure from the Pensions Regulator (tPR) means that scheme trustees have also adopted very prudent assumptions for life expectancy, rather than the more realistic ones required under FRS 17. Removing the margin for prudence could reduce disclosed liabilities by a further five per cent.

Do my advisors add value?
There is no doubt that some advisors are charging too much for core services. However, any change has to be weighed up against the value that can be derived from using the right advisors for the right project.

While it is important to challenge and review the work of your advisors, removing them just to save costs can result in a lost opportunity to improve the operation of the scheme.

What can I do to reduce my PPF levy?
Before taking any action to reduce the levy ensure the cost is weighed up against any potential savings the action will generate.

Cash contributions paid into the scheme are allowed for in the levy calculation – beneficial where both the levy and the probability of insolvency – as judged by Dun & Bradstreet (D&B) – are relatively high. However, D&B assessments can be inaccurate, failing to take into account all relevant information on the company. Your advisor can help you with some simple ways to improve the score (increasing number of directors, changing registered address, etc). The use of contingent assets such as parent company guarantees can also help improve matters.

The levy calculation is significantly changing for 2012/13, with underfunded schemes where the sponsoring company is strong potentially being subject to the biggest increases.

Are the company’s pension contributions being put to best use?
Straight cash contributions are fast becoming outdated as far greater value can be created through funding liability management exercises. The use of profit-sharing arrangements between the company and trustees can allow the Company to invest cash in the business and create a win-win for all parties. Non-cash funding mechanisms such as parent company guarantees, charges over properties or limited partnership agreements should also be considered.

Why do pension scheme valuations take so long – surely it’s just a push of a button?
While it should be a fairly straightforward exercise, a lack of compatibility between administration and actuarial systems can often mean a lot of time and resources are required to manipulate the administration data before the actuarial system is ready to run, a process which is invariably repeated each time a valuation is undertaken.

However, there’s no excuse for this. The recent market turmoil clearly illustrates the need to quickly access information. If your advisor can’t deliver results in a timely fashion, you should consider finding one who can.

I am a pension scheme trustee – should I stand down?
Whilst not impossible, it has certainly become more difficult to act as a company director and also to act as a scheme trustee, partly due to legislation introduced in the Companies Act 2006. Adding a professional trustee to the trustee board can help address the conflict that can arise, can improve scheme operation and efficiency and demonstrate an arm’s length independence to both members and tPR.

The scheme is due to have its next valuation soon – what should I be doing?
One thing you should not do is rely solely on the advice of the trustees’ actuary: he or she has a statutory role to act on behalf of the trustees and their advice may not be in the interest of the company. Taking pro-active advice from your bank or other professional services firms can also help set maximum contributions and persuade the trustees that your proposed funding plan is reasonable.

Scheme data – surely that is the trustees’ problem?
Having incorrect data can affect the efficient operation of schemes and it is definitely a problem for the Company as it will make operating the scheme more costly and store up problems for the future. While it is costly to address the problem it will, in most cases, repay the investment many times over.

Accurate data will improve the certainty of actuarial numbers and reduce the chances of liabilities being under or over-stated. As producing the data set for an actuarial valuation represents a significant proportion of the fee charged, costs could be reduced by thousands of pounds if the data can be derived from a cleansed database.

Verified data will reduce the possibility of errors such as a member being overpaid or underpaid benefits. It will also reduce the likelihood of complaints to the trustees and their accompanying management costs. While difficult to quantify this is a common and costly occurrence.

The Company is facing financial difficulty – what are my options in relation to the scheme?
Difficult economic times combined with the obligations of operating defined benefit pension schemes can often be a toxic combination for companies.

If contributions are becoming unaffordable, approach the trustees for a deferral of payment for a limited period. They will need to justify such a move to the tPR but in most cases trustees will support a genuine cry for help because, in the longer term, a solvent employer is often the only available means of ensuring members receive the full benefits promised by the scheme.

If the debt is proving too much of a burden, threatening the solvency of the business, a number of options are available. If benefits above Pension Protection Fund (PPF) level can be secured, then compromising the company’s full debt will be an option, though the trustees will require some level of compensation. Where a PPF deficit exists, the PPF will seek to secure a cash payment and an equity stake in any ‘phoenix business’ – this will be at least 33 per cent where the company ownership is unchanged and around 10 per cent where wholly new ownership is involved.

It’s certainly worth asking some difficult questions and carefully considering your options.

Alan Collins

Post by Alan Collins

Head of Trustee Advisory Services at Spence he provides actuarial, funding and investment advice to trustees and sponsors of ongoing defined benefit schemes.

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