Tax and pensions: Price of the long view

Norman Russell looks at how companies are searching for ways of handling the long-term challenges of defined benefit pension schemes

Financial markets all too often force companies to focus on the short term. Pensions require the long view. Other than pensions, how many financial obligations do companies enter into where they will still be paying out 70 years hence? If you think 70 years is an exaggeration, consider a 30-year-old in a defined benefit (DB) pension scheme. The actuaries tell us one person in 200 born in 1908 was expected to live to 100; today it is one in four.

For many companies, that long-term DB liability is becoming a pressing short-term problem. Since 11 June 2003, companies have not been able to walk away from their DB pension liabilities. That was the date on which the Government announced the change in the law, eventually contained in the Pensions Act 2004, requiring companies to fully fund their DB schemes on termination.

Fully fund is an expression pension experts distrust. There are almost as many different bases and assumptions that can be used for valuing DB pension liabilities as there are things that MPs can claim on their expenses. In this Pensions Act context, full funding means the price demanded by an FSA-authorised insurer to take over the DB liabilities. So, if companies cannot escape their long-term DB liabilities (without paying an insurer a price likely to be well in excess of the deficit revealed in the company's accounts), how are they grappling with the DB issue today?

Many are engaging in 'liability management' exercises:

• closing the DB scheme to new entrants;
• reducing the level of benefits, e.g. from 60ths to 80ths;
• changing the shape of the DB benefit by moving from a benefit related to final salary to one related to career average earnings;
• offering enhanced transfer values i.e. paying cash incentives to members to transfer their benefits out; and
• increasingly, closing the scheme entirely to future DB accrual and offering personal pensions going forward.

Most of these exercises still leave companies to grapple with today's past service deficit.

Companies are not free to make unilateral decisions about changing the terms of their DB scheme and how quickly they must fund the deficit. The two principal players with whom companies have to engage, or whose views they have to take account of, are the pension scheme trustees and the Pensions Regulator. They will also have to engage with the Pension Protection Fund (PPF) if the business goes badly wrong and the courts if their pension scheme documents have gone seriously awry.

Encouraged by The Pensions Regulator (TPR) in 2005 to act more like bankers, trustees have on the whole behaved sensibly, but more boldly than in the past. The Regulator - whose acronym for itself is TPR and was known by some as 'TTT' (the Toothless Tiger) - is toothless no more. It has demonstrated bite in imposing the sanction of a financial support direction successfully on Sea Containers (despite that company being in US Chapter 11 bankruptcy); and, thereby, with the approval of the Delaware Bankruptcy Court, enhanced the return for the UK pension scheme at the expense of predominantly US bondholders.

The UK courts have become more helpful in correcting complex DB scheme documents when the draftsman has, perhaps understandably, nodded off on page 97 and inadvertently granted a bigger benefit than the company intended. However, the courts have not been making it easy for companies where they have purported to alter their DB scheme without following, to the letter, the scheme's amendment power. And one of our newer Law Lords expressed disquiet with the application of the so-called rule in Hastings-Bass for being seen as "a magical morning-after pill for trustees suffering from post-transaction remorse". The Hastings-Bass rule is used by companies and trustees to say that trustees could not sensibly have meant what they had signed up to in their scheme documents, so could the courts please substitute something more sensible - and less expensive.

Companies with DB schemes will invariably need to engage with their trustees and to understand the key powers that trustees hold. Fully empowered trustees can do all of these things with DB schemes:

• set the company contribution rate;
• determine the investment strategy;
• wind up the scheme;
• call in the Regulator.

However, by no means all trustees have the unilateral power to do all of these things. To determine the sort of trustees you are facing, you need to understand two things:

• the Pensions Act 2004 regime; and
• the specific governing documentation of the DB scheme in question (that may override some of the general provisions of Pensions Act 2004).

The Pensions Act requires trustees and companies to agree on the company contribution rate, by agreeing the 'technical provisions' (the actuarial basis for valuing the DB liabilities) and the 'recovery period' (the period over which the deficit, calculated on the technical provisions, is to be paid off by the company).

As for investment strategy, the Pensions Act provides that this is determined by trustees, but that trustees must 'consult' with the company. Of course, if trustees set a cautious investment strategy, they may well need more cash to meet their DB liabilities.

Some trustees, but not many, have the unilateral power to set the company contribution rate. The British Vita trustees had such a power. Their company contribution rule said: "The amount of the contributions payable by the Employer shall be determined by the Trustees acting on the advice of the Actuary." So, when the private equity house Texas Pacific acquired British Vita, the trustees took careful advice about the impact this would have on the financial strength of the company supporting the scheme (the so-called 'employer covenant'), commissioned a new valuation and made a new contribution demand. This was based, in the words of the judge, on "very different and far more conservative actuarial and investment assumptions from those previously adopted; in particular, because it was assumed that all investments were in gilts". One of the trustees' reasons for making this increased demand was their concern about the company "moving from being a publicly-listed company to one owned by private equity". The court upheld the action taken by the British Vita trustees.

I describe a DB scheme rule that gives trustees the unilateral power to set the contribution rate as the 'Keane contribution rule'. However, it is important for such trustees to bear in mind that there was at least one well publicised occasion on which the robust former Manchester United midfielder, Roy Keane, went a step too far: his leg breaking tackle on the then Manchester City player Alf Haaland. Even the most robust trustee, armed with a Keane contribution rule, will be ill advised to use it to cripple the employer so that it has to give up the DB pensions game completely.

For trustees not equipped with a Keane contribution rule, the regulator, in an early public pronouncement to trustees, commended 'prudence' as the role model for conducting funding negotiations with companies. Now I once knew a girl called Prudence. She was a teenager at the end of the 1960s. I always thought it was brave of her parents to give her that name. But could they reasonably have expected, in the 1950s, some of the excesses of the decade that followed? Having commended 'prudence' to trustees in 2005 and stimulated a debate about whether 'prudent' really meant 'conservative', what is the regulator saying now, in today's very different economic climate? In the last couple of weeks, the regulator has said this:

"Now, more than ever, it is crucial for trustees to base their funding targets on prudent assumptions which take full account of the strength of the employer's ability to underwrite the risk. In particular, where an employer has a weak or weakening covenant, we expect trustees to ensure that this is reflected when setting the scheme's technical provisions. In some cases this will result in a higher funding target, but trustees must not allow the current economic conditions to disguise the true cost of their scheme's liabilities.

"While remaining alert to the risks associated to a weakening covenant, we are looking for trustees to engage in positive and open dialogue with their sponsor about flexibility in their deficit recovery plans. We expect trustees to use the principle of reasonable affordability to set payment schedules."

All this leads us to a position today where:

• DB pensions liabilities are becoming a much greater burden for companies, particularly if trustees insist on increasing their contribution demands to make up for recent investment losses and more prudent assumptions about longevity; and
• trustees are becoming ever more concerned about the strength of the 'employer covenant' of the company supporting their scheme and are looking at a raft of different ways of improving their security beyond simply demanding more cash.

Ultimately, until the last pension is paid or benefits are bought out with an FSA-authorised insurer, a DB pension promise is only as good as the company standing behind it.

Norman Russell is a partner at Berwin Leighton Paisner.