Part III: Liabilities for underfunding
This guide is based on UK law.
Introduction
Defined benefit schemes can sometimes hit funding problems. At
the moment, though, there is, as stated in Part I: The basics, no legal requirement for an
employer to fund its defined benefit scheme at a level that
guarantees all the benefits at all times. There will be enough
money to pay benefits as they fall due while the scheme is “live”.
If, however, the scheme is wound up, there may be a problem.
In June 2003 (in response to a rising panic that employers were
deserting their defined benefit pension schemes in droves, leaving
insufficient money to pay for all the benefits), the government
announced that any employer that wound up its scheme would have to
top it up until it could secure all members’ benefits in full with
an insurance company. This is called “funding on the buy-out basis”
and is at present very expensive.
The government also worried that employers would rearrange their
affairs to avoid this buy-out debt. It therefore gave the new
pensions regulator sweeping powers to bring errant companies into
line. In theory, at least, no attempt to evade pension liabilities
will go unnoticed. The regulator’s powers are
listed below.
Directors should take underfunding very seriously. It is not
something that will go away by itself and could well take up a
significant amount of management time. It could also cost the
company a lot of money and, in some circumstances, even bring the
business down.
The regulator’s powers
- Contribution notices: the regulator is able to
recover (where reasonable) a sum up to the full statutory debt from
one or more persons (or companies) who were involved in an act – or
a failure to act – that had as its main purpose the avoidance of
pension liabilities. Any acts or omissions since April 26, 2004 can
be investigated.
- Financial support directions: if the regulator
considers that the pension scheme employer is insufficiently
resourced to pay any debt that may arise, it is able to issue a
financial support direction against other companies in the
group.
- Restoration order: where money or property has
been transferred out of a pension scheme at an undervalue in the
two years before an insolvency event or application for protection
from the pension protection fund, the regulator can order its
return.
Anyone who may be subject to either a contribution notice or a
financial support direction will be able to seek a clearance
statement from the regulator. This, however, will not guarantee
impunity.
The position of individual directors
The regulator does not have the power to make a financial
support direction against an individual unless the employer is a
sole trader or a partnership.
It does, though, have wide powers to impose contribution notices
against individuals. To be caught, you need to be “connected” or
“associated” with an employer in the pension scheme. Connected or
associated in this context is very widely defined. Any director or
employee could be caught, but shareholders are exempt unless they
“control” the company – i.e. own at least one third of the voting
shares. Shareholders can also be caught if they and someone
associated or connected with them (for example, a spouse) own one
third of the shares together.
Reducing the risk of personal liability
There are several things you could do to reduce the likelihood
of action by the regulator.
Request a clearance statement from the regulator
The regulator expects clearance to be sought only when a
particular action is financially detrimental to the ability of a
defined benefit pension scheme to meet its liabilities. This means
that the scheme must be in deficit and the triggering event must
fall within certain categories that are listed by the pensions
regulator in its published guidance. Any clearance will apply until
there is a “material change in circumstances”. The consequences of
this remain unclear; it could, though, reduce the usefulness of the
clearance statement.
Take advice
The regulator can only make a contribution notice against you if
it is reasonable to do so. It will need to look at your financial
circumstances, the purpose of the act complained of (for example,
to limit the loss of employment) and your involvement in the scheme
or failure. If you are contemplating doing anything that may result
in pension scheme liabilities being avoided you should be sure to
seek legal advice first.
Companies should also take their own advice as soon as possible.
Trustees of the pension scheme will probably have already consulted
their actuarial (and possibly legal) advisers and are likely to
demand more money from the company. The company may be able to
negotiate with the trustees, but this will depend on its financial
position, the extent of the underfunding and the terms of the
pension scheme itself.
Professional advisers will be familiar with the issues involved
and will be able to suggest ways of managing the underfunding to
fit in with the circumstances of your company. The company should
speak to professionals such as actuaries, legal advisers and
benefit consultants.
Given that the exercise can take up a lot of management time, it
may be worth putting together a small, dedicated team to look at
the issue and keep the rest of the board informed. Such a team
would obviously need to include the finance director.
Talk to the trustees
The trustees will be concerned to put any underfunding in the
pension scheme right. They have duties to the members; and they
have statutory duties to report underfunding or non-payment of
contributions to the pensions regulator. Equally, they will not
want to push the company into insolvency as that would mean job
losses (and will also make it more difficult to get any money out
of the company).
The amount that the trustees can ask for will be governed both
by legislation and by the documentation of the pension scheme
itself. Legislation requires defined benefit schemes to be funded
in accordance with the “statutory funding objective”. This is a
scheme-specific system, which the trustees must agree with the
employer. The process for setting it is fairly prescriptive, and
the pensions regulator has issued detailed guidance about what it
expects. These funding requirements are fairly new – they only
became effective in December 2005 – and some schemes at the time of
writing (March 2007) have yet to use them. They are, however,
already resulting in schemes being better funded.
The trustees have a lot of power in the process of making sure
funding requirements are met.
Find out if you need to contact the pensions regulator
Since May 2005, trustees, employers and other professional
advisers involved in the pension scheme have had to notify the
pensions regulator of certain matters. Failure to do so could leave
the offender liable to a civil fine. Issues that need to be
notified by employers are wide-ranging and include any decision to
compromise a debt, any breach of the employer’s banking covenant
and a significant change in the employer’s credit rating.
Be careful not to wind up the pension scheme by mistake
Getting rid of the pension scheme may look like an attractive
option. But if the scheme winds up (either by accident or design),
the companies participating in it will be liable for the buyout
debt. The amount of this debt can be very high: the scheme will
need to be funded to a level where the benefits of all members can
be secured with annuities bought from insurance companies; at the
time of writing (March 2007), annuities are substantially more
expensive than the standard terms for valuing benefits in pension
schemes.
Buy-out debt will often push a company into insolvency.
Sometimes (but not always), trustees will agree to a lower payment
by the company if they believe that they will get more if the
company continues than if it is wound up. However, the pensions
regulator will need to be involved in any such agreement. Again,
seeking advice early should help to avoid winding-up happening by
mistake.
