The large majority of DB schemes have a deficit on the buy-out basis. As a result some employers have started exploring ways in which they can reduce or manage this funding risk. Examples of risk management strategies include the use of contingent assets, buy-out of some or all member liabilities and attempts to reduce longevity risk.
In addition to the above examples, the Regulator is starting to see proposed corporate transactions or arrangements where the main intent is for the employer to “abandon” the scheme. An objective of the arrangement is to remove or limit the responsibility to the scheme of the employer or an associated or connected employer.
The Regulator considers that scheme abandonment is not likely to be in members’ best interests and is against the clear intention of pensions legislation. As a result it has decided to publish a discussion paper and draft guidance setting out how trustees should consider abandonment proposals. Consultation on the draft closes on 9 February 2007.
This briefing note outlines the details of the Regulator’s discussion paper and draft guidance on abandonment of DB schemes.
What is abandonment?
The discussion paper makes it clear that while abandonment can happen in a number of ways, there are the following two key parts to any such transaction:
- The covenant of the employer that remains with the scheme (or the section of the scheme or relates to certain of the membership) may be nominal compared with the previous covenant. There is no definition of exactly what nominal entails.
- The level of mitigation offered to the scheme is less than 75 per cent of the debt owed by the employer to the scheme calculated on the buy-out basis (“Employer Debt”).
Another likely objective of the arrangement is the removal or limitation of employer (or associated/connected employer) responsibility to the scheme.
At the same time, the Regulator is clear that it may be difficult to identify abandonment.
The draft guidance
The draft guidance is aimed at trustees. It tells trustees:
- How to recognise arrangements which may lead to abandonment.
- What factors to take into account when considering such arrangements and deciding what action to take.
- What factors trustees should not take into account as primary factors in deciding what action to take.
- To consult the Regulator at an early stage where the trustees believe an arrangement could result in abandonment. The draft guidance is intended to operate alongside the clearance guidance.
How should trustees recognise arrangements that could lead to abandonment?
The draft guidance comments that an arrangement is best judged as abandonment by reviewing the substance of the likely outcome rather than just its form or structure. In particular, it is the substance of the employer pre- and postarrangement that is important: is the employer going to be a nominal employer?
Arrangements where the full Employer Debt is paid cannot be seen as abandonment. In contrast, abandonment may occur where only a partial Employer Debt is paid.
The draft guidance comments that mechanisms that may result in abandonment may be the same as those that would otherwise seem to be normal commercial transactions.
What factors should trustees take into account when considering abandonment proposals?
The draft guidance is very clear that abandonment is not in members’ best interests. Trustees should, therefore, scrutinise proposals very carefully and carry out appropriately rigorous due diligence. The following highlights some of the factors trustees should take into account:
• The mechanism by which the link to the current employer covenant is reduced or removed
Is an Employer Debt being triggered? Are the trustees being asked to reapportion an Employer Debt? Is trustee consent being sought? Do the trustees need to consider their other powers including the power to wind-up?
• The current employer’s covenant
Trustees should form an independent view of ongoing financial strength and future viability of the existing employer. They should also review the nature and structure of any associated group. The aim of these reviews should be to establish any possible additional security which may potentially be lost as a result of the transaction.
• Nature and structure of any new employer group and ultimate owners of new employer
Trustees should look at and understand the implications of the legal structure of any replacement employer group. In particular, they should aim to establish legal domicile, any restrictions or limits on capital and cash flows in the group with attendant risks, any additional funds the trustees may be able to access as well as whether the replacement employer group adds to the strength of the employer covenant.
In addition, trustees should look at the ultimate owners of any new employer group. In particular, the legal domicile, investment framework and any potential for the scheme to have access to additional funds.
• Potential gain by parties to arrangement other than the scheme
Trustees must review the potential gain to all parties to the arrangement (including to other creditors of the current employer) to ensure that they have received appropriate mitigation. In order to do this, trustees should ideally have access to relevant documentation. The aim is for the trustees to be able to assess if the arrangement is fair.
• Security or other mitigation provided to the scheme
Trustees should seek some form of security or mitigation. In deciding on mitigation, the trustees should take account of the covenant of the existing employer, the new employer and the new employer group, any security being provided, the potential gain to the current employer and the owners of the new employer group, the potential impact on technical provisions and the level of any new money going into the scheme.
The ideal starting point for mitigation is that it should be payment of an amount to secure buy-out.
• Technical provisions
Trustees should review any covenant change in the light of any mitigation. They should ensure that the situation does not arise where it would not be possible for the scheme to meet its technical provisions using a reasonable recovery plan. Trustees should also be critical of the presumption that if the scheme does not have a deficit on an accounting basis then abandonment will not be financially detrimental to the scheme. Trustees should also consider the costs of the PPF levy.
• Scheme investment strategy
Trustees should consider the impact the arrangement would have on the scheme’s investment strategy. The investment strategy should reflect the increased exposure of the scheme and the limited protection that it has against these risks. Where the appropriate investment strategy with a nominal employer prevents the opportunity to achieve proper funding this is a strong argument for the trustees not to agree to the arrangement.
• Structure of trustees’ board
Trustees need to examine critically the make-up of the board and to consider any conflicts which exist before agreeing to any arrangement. They should consider any change to the board proposed as a result of any arrangement very carefully. In particular, trustees should be wary of any change which may result in the employer having undue influence over the trustees.
• Alternatives to the arrangement
Trustees should consider alternatives to any proposed arrangement, including buying-out benefits, changing benefit accrual managing risks and scheme wind-up. They should not accept an abandonment proposal at face value as the only option open to the scheme.
What factors should trustees not treat as primary benefits of abandonment?
The draft guidance clearly advises trustees not to treat certain factors as primary arguments for agreeing to any proposed abandonment arrangement. It is key that if the scheme could access the benefit outlined without breaking the link with the employer, the trustees should not give primary importance to this in reaching their decision. Examples of factors that trustees should not regard as primary reasons are:
- Access to improved investment management - It is likely that the trustees can negotiate access to alternative managers without breaking the employer link.
- Access to improved scheme administration - It is likely that the employer can come to agreement with the provider without breaking the employer link.
- Access to more knowledgeable and experienced advisers - Advisers should act in the best interests of clients at all times and should not be subject to a conflict.
- Increased or earlier payment of contributions from current employer - Whether this is a factor will depend on how the current employer is able to make additional funding available to the scheme.
What advice should trustees obtain?
The draft guidance provides that trustees should take independent advice (although one adviser for all parties may advise on matters of common interest) before agreeing to any proposal. The advice taken should be commensurate and appropriate to the arrangement proposed. However, in most cases the Regulator is clear that a thorough review of the arrangement and its implications will be required. Trustees should investigate the cost of advice before any work is done. The draft guidance comments that the trustees should expect the cost of this advice to be borne by the party looking to implement the arrangement (usually the employer). Trustees are also encouraged to consult with scheme members and make them aware of the type and extent of the advice they have obtained.
How does the Regulator propose to regulate?
The draft guidance comments that the trustees and employers are encouraged to report to and consult with the Regulator on any arrangement that may result in abandonment at an early stage. Trustees are also reminded of other codes and guidance which would require them to bring arrangements to the Regulator, notably the notifiable events code, scheme funding and whistleblowing requirements.
The Regulator also reminds employers of its clearance powers as well as its ability to suspend/appoint trustees and wind-up schemes. Trustees are encouraged to persuade employers to seek clearance for any proposed abandonment arrangement. In addition, the discussion paper makes it clear that abandonment proposals are against the intention of recent pensions legislation and that abandonment is not in members’ best interests.
The pensions industry is full of initiatives at the moment for employers to reduce pension scheme liabilities and so ease pension deficits. Some of these methods are specifically mentioned in the discussion paper, for example buying-out of benefits. Other ways include incentivised transfers out which have caused much debate. It is perhaps surprising, therefore, that the discussion paper and the draft guidance seem to be saying very little which is new. This is more of an “awareness” campaign by the Regulator for trustees and a “political” statement to the industry.
The bottom line appears to be (not surprisingly) that abandonment arrangements in general would be caught by the anti-avoidance regime. A financial support direction may be made against a connected or associated company where the scheme employer is either a service company or is insufficiently resourced and there is another company which, together with the scheme employer has resources to meet 50 per cent of the employer’s Employer Debt. A contribution notice may be made where an Employer Debt has been avoided.
According to the Regulator, scheme abandonment occurs where the covenant of the scheme employer becomes “nominal”. While there is no detailed definition of what “nominal” means, the better resourced the employer, the less likely that the Regulator will consider there to be a scheme abandonment.
It is likely that many situations of abandonment will also fall into the clearance regime but perhaps not all of them. At the same time it is worth noting that the Regulator is keen that the trustees draw on the clearance guidance. Unlike the draft guidance, which is clearly addressed to trustees, the clearance guidance is addressed to employers. It is possible that the Regulator felt it was necessary to have some relevant guidance addressed specifically to trustees as well as simply wanting to issue a gentle warning to employers.
One or two examples of scheme “abandonment” have been reported in the press, usually as a result of the Regulator giving clearance, for example Kvaerner and Heath Lambert. There is no detail about the clearance given since clearance is confidential. At the same time, it is important to note that the Regulator appears to have given its blessing to arrangements which would, on the surface at least, appear to contravene the draft guidance. No doubt the Regulator can defend these decisions on the basis that they were the best outcome which could be achieved in the circumstances.