Ostriches are notorious for burying their head in the sand when danger approaches and company directors need to be vigilant to ensure that they guard against replicating this type of behaviour in their Boardroom. Only an ostrich can have failed to notice a rise in the importance of company pension schemes to corporate activity and the commensurate increased role of pension scheme Trustees. Given the provisions of the Pensions Act 2004 and the risk based approach adopted by the new Pensions Regulator I can only see the level of Trustees’ corporate involvement increasing so any degree of optimism that it can be ignored as a passing issue is undoubtedly misplaced.
A lot has been written and much has been said about final salary pension scheme deficits but in reality the options available to address these are relatively limited. In simple terms schemes have only two sources of revenue. Trustees can either seek higher contributions from scheme sponsors, or members, or both, or must rely on achieving significant out-performance from their investment portfolio.
The requirement for this out-performance implies a relatively high risk investment strategy which in turn for most schemes implies continued reliance to a greater or lesser extent on equity based investments. Equity based investments, as we all know, don’t always work out, and if they don’t, Trustees are back to looking to even higher contributions from someone.
Of course the new actuarial orthodoxy is that pension liabilities are bond like and best matched by bond like investments. The implied lower returns from bond investments in turn implies higher contributions from somebody and takes us back to the starting point that there are only two sources of money for the Trustees – contributions or investment returns.
In reality, the majority of schemes will opt for a middle course somewhere between higher contributions and an aggressive investment strategy. Where should the balance lie and how should the almost inevitable conflicts of interest between employer and scheme Trustees inherent in any discussion of this nature be addressed?
Considerable faith has been placed, in some quarters, on the ability of equity investments to “save the day”. This stance has appeared more justifiable of late given the welcome investment returns achieved over the past couple of years, however, the solvency position of many schemes has not materially improved given the fall in bond yields and improvement in mortality over the same period. These factors have had the effect of increasing the value of liabilities and thereby negating the positive returns from equity investments, leaving many schemes seeing little improvement in their deficit position over the period.
So what about increased contributions? Scheme sponsors have witnessed significant rises in their contributions over recent years. Many will seek to control further rises, especially where a direct impact on the trading position of the business would result. The Pensions Act 2004 requires Trustees and scheme sponsors to act more independently and negotiate suitable levels of contribution based upon the scheme’s specific investment strategy. It also requires Trustees to consider to what extent the strength of the employer covenant should be taken into account. An objective view of the strength of the employer, or employer covenant, could represent a particularly difficult task for those schemes where senior executives within the business also act as Trustees of the pension scheme. This is not an uncommon scenario in the SME sector.
In current circumstances it would not be unreasonable to expect employers to resist significant contribution increases and seek to pursue increased investment returns through a more aggressive investment strategy whilst the Trustees seek to pursue an opposite course. It is clear that the Pensions Regulator envisages Trustees and employers becoming involved in robust negotiations on such matters.
It will be increasingly important for Trustees not only to act entirely independently of the company in such negotiations, but also to be able to demonstrate clearly that they have so acted. Given our cynical times, demonstrating a clear separation of the trustee and company roles may prove almost impossible where company directors perform the role of scheme Trustees. This may leave room for claims from scheme members that Trustees have not acted in their best interests. Even where Trustees have identified and managed any conflicts of interest, and acted entirely properly this may not be the perception the members hold.
Negotiations on the funding of schemes will also now be played out against an increasingly transparent background as companies struggle to come to terms with the requirements of full disclosure under FRS17.
The Pensions Regulator is encouraging Trustees with deficits in their schemes to view themselves as unsecured creditors of the company, and act accordingly. Trustees will be expected to consider the financial position of the employer and negotiate with the employer as any other significant creditor would and to seek a solution based upon the overall level of risk to which the members of the scheme are exposed. Many Trustees are already beginning to commission accountants to research the company finances to ensure they are adequately prepared for negotiations with the employer. Furthermore, Trustees will be able to judge an employers ability to pay higher contributions and risk of default using the risk related levy basis which will be applied to calculate the PPF levy from 2006.
The result of Trustees’ investigations into the financial strength and security of the employer could see Trustees seeking a move to lower risk investments. All other things being equal they will then need to seek higher contributions from employers and/or members. Alternatively Trustees may begin to require the provision of a form security in relation to the scheme deficit.
Trustees may also wish to ensure they are dealt with in the same way as other creditors, such as the banks, and that their debt is paid off over a similar period as any outstanding loans. This has the potential to see repayments of deficits over shorter periods than previously, and by implication, by significantly higher deficiency contributions. Indeed it has been suggested that Trustees may wish to seek to restrict the payment of dividends until the pension deficit is addressed.
This issue represents a significant change in UK corporate governance and one of which Directors and Trustees must be completely aware. Trustees have a much greater role to play at the corporate table as the reality is that in some companies the parties with the greatest financial interest will be the banks and the pension scheme Trustees. Whilst this new reality will be unwelcome in many boardrooms, and probably in some trustee boards also, it cannot be “swept under the carpet,” particularly against a backdrop of the introduction of scheme specific funding over the next few months. There could be some difficult meetings ahead where deficit issues are addressed and Trustees need to be well informed and capable of performing their duties independently of the employer. As such will need specialist support throughout this process.
Trustees must now be in a position to question what is proposed to them by the sponsoring employer and to consider whether an aggressive equity policy is the only solution to meeting their scheme liabilities.
There is no longer any room for ostriches amongst either Trustees or Company Directors as we all know which part of your anatomy is exposed if you bury your head in the sand.
Published in Pensions Age October 2005