Pension liabilities from defined benefit (or final salary) pension schemes have always been a flashing red warning light to private equity investors. The high profile takeover of Sainsbury's in 2007, by a consortium consisting of CVC, KKR, Blackstone and Texas Pacific Group, ultimately failed following disclosure of the size of the liabilities within the supermarket's pension plans. KKR's purchase of Boots plc gave the private equity giant a huge pension headache, with trustees exacting concessions as the price for their consent.
Companies and private equity investors are showing growing interest in liability management. But to what extent can they control pension scheme costs? The Pensions Regulator, flexing its 'moral hazard' muscles, has focused on the issue of employer covenant strength and issued guidance on the use of incentivised transfers.
But it is not all bad news for companies and investors. The Pension Protection Fund has announced that it plans to structure its levy (from 2012/13 onwards) around certain factors over which employers may have some element of control. There is now the potential for lower administration costs with cheaper electronic member communications. So is defined benefit pension provision hurtling towards more responsible affordability? Or will fear of 'moral hazard' remain a block to private equity deals? Who is in the driving seat when it comes to managing pension scheme liabilities?
Moral hazard and the Pensions Regulator
With two financial support directions (FSDs) in respect of Nortel Networks and Lehman Brothers and the first-ever contribution notice (CN) issued in respect of the Bonas scheme, it's clear that moral hazard is back on the map. Are employers being driven into more hazardous territory? Or is this simply a case of the Regulator now doing what it has always had the power to do, perhaps influenced by the current economic climate?
Some key themes emerge in the CN and FSDs. Is the parent company heavily involved in all major strategic decisions, including the setting of pension contributions? Was the enterprise run on a global basis, with activities benefitting others in the group, largely ignoring the distinction between corporate and legal entities?
One of the factors that the Regulator must take into account when deciding whether to issue a FSD, or indeed a CN, to a particular individual or body is "the value of any benefits received directly or indirectly by that person from the employer...". The fact that the Regulator paid particular attention to the Nortel group being run on business lines (where for example, one or two companies provide research and development services to the rest of the group) indicates that the Regulator assesses "the value of any benefits" widely, as opposed to focusing purely on, say, the flow of finance around the group.
Other points to watch out for are keeping trustees out of the loop, the absence of arms-length terms and an employer with a cavalier attitude to funding. Keeping trustees informed (and, by extension, not misleading them) is also common sense. However, the development of a subjective test in the Bonas decision appears to widen the circumstances in which a party's "purpose" could fall foul of the Regulator, resulting in a greater likelihood that a CN will be issued.
Nortel and Lehman Brothers challenged the FSDs issued in respect of their schemes but the FSDs were upheld. Their appeal will now go to the Supreme Court. The central point of concern relates to the enforceability of FSDs, since insolvency laws mean that only contingent debts in existence by the time that the insolvency/administration was triggered will qualify for any payout.
When it comes to the employer covenant, both employers and trustees have become the focus of renewed pressure from the Regulator. For any private equity investors, a resurgence of trustee interest in the employer covenant strength may be an unwelcome intervention in the running of their business. But, backed by the Regulator's recent approach, trustee concern for covenant strength is likely to become an increasing feature of discussions.
The Pensions Regulator has stated that "most trustees will need to monitor the strength of their sponsor's covenant on an ongoing basis and all should have a very good idea of exactly how they might respond in different scenarios." The Regulator wants trustees to ask their employers "probing questions", or obtain "professional help" to do this for them. The statement also says that "Trustees and employers should prepare plans for realising the employer support standing behind a scheme, should this become necessary. For example, this may encompass the provision of identified contingent assets, or the agreement of negative pledges such as not to grant new security".
In essence, the Regulator wants trustees to anticipate what they will do if x or y happens, rather than wait and see, in a more reactive way. While it will be hard for trustees to do this, since the surrounding circumstances at the time of any "trigger" will be key and can't be fully anticipated, it is an important point to address.
Following its statement, the Regulator has issued guidance which, among other things, expects trustees to "check that there are no company events over the period since the last meeting, or anticipated before the next meeting, that should give cause for a more detailed review or the seeking of immediate mitigation [and they] should also consider the ability of the employer to generate sufficient cash in the period until the next trustees' meeting to pay contributions due in that period".
How much of this information employers would be willing to pass to trustees remains to be seen. The Regulator wants trustees and employers to work openly together, taking a proportionate approach to assessing and monitoring the employer covenant and focusing on forecasts for the employer's future performance (although the Regulator acknowledges that the covenant can be assessed only for a limited time into the future).
The silver lining
Is there any silver lining for private equity investors surveying the grey skies of the pensions landscape? There are some signs that pragmatism and affordability are being considered by the policy makers. In particular, the following may help employers and their investors:
the shift from CPI to RPI for statutory revaluation and indexation, which is covered in greater detail in a previous alert;
the announcement from the PPF of a new formula for the calculation of the PPF levy from 2012/13 onwards (a policy statement from the PPF is planned for next Spring);
Electronic communications - lower administration costs could arise from the new (since 1 December 2010) opportunity for trustees to comply with their obligations under the disclosure regulations electronically.
All of these subjects are covered in full detail in an alert from our Pensions team.