The current economic climate has highlighted the detrimental effect that UK defined benefit pension schemes can have on company balance sheets. Finance directors are facing the twin issues of materially increasing costs and increased cost volatility at a time when the traditional options for managing those liabilities have decreased.

Nonetheless, a number of potential solutions are evolving. Not every “solution” will be suitable for every scheme. Some solutions, or elements of them, may be combined with others to achieve a balance that is acceptable to the employer, the trustees (representing the interests of the members) and the UK Pensions Regulator.

Solution 1: Buyout

While the price of buying out pension schemes is falling, costs remain higher than the accounting or actuarial value of the liabilities. Under a full pension scheme buyout, the scheme assets and liabilities are transferred to an external entity, generally an insurer. In addition to price negotiation, the employer will also negotiate with the Regulator and scheme trustees (who, in the United Kingdom, are fiduciaries vis à vis the members). Trustee concerns, mirroring the Regulator’s typically focus on: the insurer’s financial strength, its administrative capabilities and experience, the degree to which it can match scheme benefits and its future business plans.

Under a partial buyout, it is possible to secure externally a portion only of the scheme’s liabilities. Typically one class of members’ benefits will be bought out (although careful legal consideration of this is required to avoid charges of favouring one class of member over another), or particular “bands” of risk, such as a certain age category, are secured.

Solution 2: Selling the Pension Scheme

Although there are variations, the principle is that a (specialist) third party corporate (as opposed to an insurer) “buys” the employer which sponsors the pension scheme and replaces it as the scheme sponsor. The new sponsor assumes at least the same level of financial commitment to the scheme as the previous employer, which is discharged from its obligations. The third party corporate, the buyer, which will sell on the underlying business after a short period, aims to achieve an investment return on the scheme assets that is sufficient to deliver a surplus in the future.

Solution 3: Investment and Funding Strategies

The discretion as to the investment of the scheme’s assets resides in the trustees, subject to an obligation to consult with the employer. The chosen investment strategy will have an impact on future contribution levels. Trustees typically want to adopt a more conservative strategy than the company does. Tailored packages that offset the risk to trustees of adopting a less conservative strategy, such as parent company guarantees, can allow the trustees to adopt a strategy targeting, for example, investment out-performance. An improvement to the scheme’s funding position, which will be ref lected in the company’s balance sheet, should also assist the trustees in adopting a less conservative investment strategy. However, substantial cash sums may not be available, and companies are reluctant to over-fund schemes because of the complexity involved in extracting surplus. A wide variety of contingent assets (such as contingent loans, external insurance contracts or guarantees), which remain outside the scheme until a particular trigger event occurs, are being used by companies to improve balance sheets and influence trustee investment strategy.

Solution 4: Managing the Accrual of Liabilities

Once accrued, members’ pension benefits may not be taken away. Many employers are amending the benefit structure of the scheme to reduce the level of benefit accrual. In addition, it is possible to encourage members individually to transfer their entitlements to other providers, although this is now under the Regulator’s spotlight. This transfer reduces the level of scheme liabilities and the risk that those liabilities will increase further through, for example, improved longevity.