The majority of DB schemes have a deficit on the buy-out basis. This has led some employers to explore 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 Pensions Regulator has also seen proposed corporate transactions or arrangements where the employer’s main intention is 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. It has issued final guidance setting out how trustees should consider abandonment proposals. This briefing note outlines details of the regulator’s guidance. For details of the regulator’s discussion paper on abandonment please see the January 2007 briefing note “Regulator’s discussion paper on abandonment of DB schemes”.
What is abandonment?
The guidance is clear that abandonment may happen in a number of ways. It is the substance of the likely outcome for the scheme which is important rather than its form or legal structure. In particular, abandonment mechanisms may be the same as those which would otherwise be considered as normal commercial transactions.
Key issues to look for are:
- Whether the covenant of the employer that remains with the scheme (or the section of the scheme or relates to certain of the membership) is nominal compared with the previous covenant even if the employer’s covenant might improve. A nominal employer is one whose principal activity directly relates to the scheme (for example the administration of scheme benefits or management of scheme assets) or one which has little or no value as a business, other than the scheme.
- Whether the level of mitigation offered to the scheme is less than the employer debt - the section 75 debt owed by the employer to the scheme calculated on the buy-out basis.
Factors trustees should take into account
The guidance’s overriding message for trustees considering a proposal is that it may not be in the best interests of the members. As a result, trustees should apply a high level of scrutiny. The following lists some of the factors trustees should take into account:
- Trustees need to consider the mechanism by which the link to the current employer covenant is reduced or removed.
- Trustees should form an independent view of the existing employer covenant as well as the employer’s future viability.
- Trustees should assess the replacement employer covenant as they did the current employers. They should form a view on the
loss of any support provided by the scheme employer.
- Trustees need to understand (after independent advice) the implications of the legal structure of any replacement employer group.
- Trustees need to assess the potential gain by parties to the arrangement other than the scheme to help them decide if the proposal is fair.
- Trustees need to seek security or other mitigation. The ideal starting point for mitigation should be payment of the Employer Debt.
- Trustees should ascertain, as far as possible, any potential change to technical provisions in light of the change in covenant and mitigation offered.
- Trustees should consider the impact of the proposed arrangement on the scheme’s investment strategy.
- Trustees need to examine critically the make-up of the board and to consider any conflicts which exist before agreeing to any arrangement as well as any proposed changes to the board’s structure.
- Trustees should consider alternatives to any proposed arrangement.
What factors trustees should not treat as primary benefits of abandonment?
The guidance highlights factors which trustees should be wary about as primary reasons for agreeing any abandonment arrangement. Examples of factors which trustees should be wary of include:
- Access to improved investment management.
- Access to improved scheme administration.
- Access to more knowledgeable and experienced advisers.
- Increased or earlier payment of contributions from current employer.
How does the regulator propose to regulate?
Trustees and employers are expected to report to and consult with the regulator on any arrangement that may result in abandonment at an early stage in the process. The regulator will consider any proposed arrangement on its merits and will take appropriate action.
At the same time the regulator reminds employers of its clearance powers as well as its ability to prohibit, suspend and appoint trustees and wind-up schemes. However, it makes clear that its role is as a referee. It cannot actively participate in decision-making concerning the proposed arrangement.
In adopting this approach, the regulator comments in its consultation report that it does not believe it is creating any additional burden for trustees or indeed is passing on its regulator responsibility to the trustees. Instead the guidance directs trustees to take into account appropriate factors when considering if the transaction is in the members’ interests.
Should trustees obtain independent advice?
The short answer is yes. The guidance makes it clear that the arrangements which may lead to abandonment are often very complex, so appropriate and commensurate independent advice is necessary. In most cases this is going to result in a thorough review of the proposal and the implications for the scheme covering the factors set out in the guidance. However, the guidance does comment that all parties can rely on advice provided by one firm where the adviser can confirm there are no conflicts of interest.
The consultation report comments that the regulator recognises that the independent advice required may be more costly than the typical cost of services to small and mediums sized schemes. However, the regulator considers that this should not prevent trustees from responding appropriately. The guidance comments that trustees should normally expect the costs of the advice to be borne by the employer or the party seeking to implement the arrangement. Trustees are encouraged to consult with scheme members and make them aware of the type and extent of the advice obtained.
Pension scheme deficits continue to be prevalent, with the result that employers have been looking for ways to reduce scheme liabilities and so ease deficits. It is not surprising, therefore, that the regulator is keen to provide guidance both in relation to abandonment and inducement offers. However, as was the case with the discussion paper, it is a shame that the finalised abandonment guidance says very little which is new.
The regulator is keen to emphasise that the trustees should be informed by the clearance guidance. It is interesting to note from the consultation report that the clearance guidance is under review and will be updated to refer to the abandonment guidance. Since abandonment exercises would normally be caught by the clearance regime it is perhaps not surprising that the regulator wishes to have the two pieces of guidance tied together. This is especially the case because the clearance guidance is aimed at employers whereas abandonment is aimed at trustees.
As we have commented before, the reported cases of abandonment have usually been as a result of regulator clearance, for example Heath Lambert and Kvaerner. No doubt the regulator can defend these decisions on the basis that they were the best outcome in the individual case, even though they appear from the little information available to come within the regulator’s own abandonment guidance.