The problem lies in the defined nature of the benefits payable under these arrangements. Typically, these are set out in the plan’s rules and defined as equivalent to a proportion of the individual’s final salary. Because of the extended timescales over which pension schemes operate — and the variables at play, such as investment returns and inflation — it is almost impossible to know ahead of time exactly how much money will be needed to provide the defined benefit promised to any given individual when it falls due for payment.
The risk of there being a shortfall at the critical time rests almost entirely with the sponsoring company. Put bluntly, if there is not enough cash in the fund, it is normally the sponsoring company that has to dig deep. If the shortfall is serious enough, the company might simply not have enough cash to plug it, and can face insolvency as a result.
This is the result of several contributory factors:
- technically speaking, the plan is an unsecured creditor of the company to the tune of the shortfall;
- the trustees who run the plan are subject to a legal duty to act in the best interests of the plan members — including recovering as much as possible from the company;
- the Pensions Regulator has high expectations of trustees and recently commented that they should “act like banks”; and
- many defined benefit plans are sponsored by companies in traditional legacy industries such as manufacturing where business is tough, margins are tight and there is unlikely to be much spare cash available to prop up pension arrangements.
This all makes for a heady mix presenting very real insolvency risks for weak companies sponsoring defined benefit pension arrangements.
Until recently, companies in this situation could try to escape their pension liabilities by reinventing themselves via an insolvency process. Effectively, the struggling company would sell its business and assets to a newco (usually run by the same people), leaving the pension scheme and its crippling shortfall behind with the shell of the original company. The newco would then be free to resume the trade formerly carried on by the original company, without the constraints of the pension plan and its deficit.
Two factors now make this kind of approach less palatable. The first is that the pensions regulator has extensive powers under the Pensions Act 2004 to reopen transactions such as this which are prejudicial to a pension scheme. Although these powers have yet to be tested in practice, in theory they allow the regulator to require those responsible for prejudicing a pension scheme to pick up the tab for supporting it financially.
The regulator was given these powers to try and dissuade companies from dumping their pension schemes on the Pension Protection Fund (PPF). The PPF is the back-up arrangement (often described in terms of an insurance scheme or lifeboat) established under the 2004 legislation to take over underfunded pension schemes where their sponsoring company goes bust. The PPF absorbs the scheme’s assets and liabilities and ensures that at least minimum benefits are paid to the members.
Since the regulator is statutorily required to protect the PPF, there is a risk that, in this type of insolvency set up, it could pursue the newco and its directors for the original scheme deficit.
The second factor against using an insolvency process to escape pension liabilities is that putting a trading company through this can be fatal in itself. It can create significant trading, human resources and public relations risks since employees, suppliers and buyers may simply decide the business is too risky to deal with. And any licences, authorisations and contracts in the name of the original company — likely to be critical to the commercial viability of the business — will die with it unless they are transferred across.
The risk of the newco and its directors being pursued for the original deficit can be managed by seeking clearance from the pensions regulator. This process allows parties that might be at risk of later intervention by the regulator to approach it before the deal happens, confess all, and receive advance absolution. Effectively, a party cleared in this way cannot later be called upon by the regulator to contribute to the scheme’s shortfall.
The more general risks of putting a company through the process are harder to manage — the whole idea turns, after all, on an insolvency taking place, allowing the company to escape its pension scheme.
However, there are alternatives. The solution
The challenge lies in simultaneously meeting the needs of the various parties. For the trading companies, the priority is to shed the crippling pension deficit and trade on without going through an insolvency process. The trustees’ priority is to secure what they can for the scheme’s members. Often, this will equate to PPF benefits since it is usually clear that the sponsoring company will never be able to fund the plan properly and will become insolvent unless it is freed from meeting the plan deficit. While the trustees in these cases were prepared to co-operate, they needed certainty that this would not later exclude the plan from the PPF. The PPF’s key aim is to extract the best terms possible for taking on the plan in such circumstances, and the pensions regulator will typically work closely with the PPF on this. The regulator will need to be satisfied that the deal terms are appropriate for clearance.
The ultimate solution in these cases entailed involving a new shell company in the pension plan and agreeing that the plan shortfall would be split so that the vast majority fell on this new company. This allowed the trading company to exit the plan with finality, paying on the way out its engineered (and miniscule) share of the shortfall. The newco, saddled with the rest of the deficit, went insolvent, thus triggering the scheme’s entry to the PPF. The PPF and the Regulator’s price for PPF entry/clearance typically involved a mix of cash, loan notes and an equity stake in the cleaned-up trading company — assets which will ultimately pass to the PPF with the plan.
These cases have been among the first occasions in which a distressed company — threatened with insolvency because of its pension plan deficit — has been surgically separated from the offending arrangement without going through an insolvency process. Given the prevalence of legacy-defined benefit pension plans in traditional industries such as manufacturing, all the indications are that this will not be the last time this strategy is used.
Francois Barker and Philip Sutton are partners at
