Managing pensions risk in corporate groups: constant vigilance | Practical Law

Managing pensions risk in corporate groups: constant vigilance | Practical Law

Corporate groups can face intense public scrutiny if they make decisions that could have a detrimental impact on a defined benefit pension scheme operated within the group. This risk can increase in periods of economic uncertainty, when the funding levels of pension schemes, and the ability of employers to fund any deficit, can be affected adversely or face volatility.

Managing pensions risk in corporate groups: constant vigilance

Practical Law UK Articles 4-633-8649 (Approx. 5 pages)

Managing pensions risk in corporate groups: constant vigilance

by Dawn Heath and Harriet Sayer, Freshfields Bruckhaus Deringer LLP
Published on 29 Sep 2016 • United Kingdom
Corporate groups can face intense public scrutiny if they make decisions that could have a detrimental impact on a defined benefit pension scheme operated within the group. This risk can increase in periods of economic uncertainty, when the funding levels of pension schemes, and the ability of employers to fund any deficit, can be affected adversely or face volatility.
Corporate groups can face intense public scrutiny if they make decisions that could have a detrimental impact on a defined benefit (DB) pension scheme operated within the group. Decisions made from a position of financial strength can be scrutinised years later, when the circumstances of the group have changed radically, and this scrutiny will inevitably be conducted with the benefit of hindsight. For example, a company may face investigation from the Pensions Regulator (the Regulator) where funds have been returned to shareholders, such as through dividends or capital reductions, many years before the company's financial difficulties. Even if the Regulator decides not to issue any penalty as a result of the investigation, or a penalty is challenged successfully, companies can incur significant legal and other advisory costs in defending these actions.
This risk can increase in periods of economic uncertainty, when the funding levels of pension schemes, and the ability of employers to fund any deficit, can be affected adversely or face volatility. Recent falls in the value of FTSE indices and the widening of credit spreads since the UK's vote for Brexit have increased the accounting deficit of the DB schemes operated by FTSE 350 companies by an estimated £20 billion (www.uk.mercer.com/newsroom/ftse350-pension-liabilities-reach-a-record-high-amid-Brexit-uncertainty.html). Accordingly, corporate groups should consider how corporate activity could affect their ability to fund their schemes in future, even where schemes are currently well funded.

Identifying the legal obligations

A pension scheme will be affected by anything that has an impact on its employer covenant, which is the legal obligation and financial ability of the employer to support the funding needs and investment risk of the scheme. Corporate groups should identify and assess: which entities in their group have direct obligations to the pension scheme; which entities support the employer covenant indirectly; and how those obligations will be affected by transactions involving group entities (see box "Identifying the employer covenant"). Generally, employers in DB occupational pension schemes have legal obligations to:
  • Pay contributions in accordance with the scheme-specific funding regime to meet the scheme funding objective (Part 3, Pensions Act 2004).
  • Pay the statutory debts which arise when an employer leaves a multi-employer scheme, on a scheme wind-up or when an employer enters an insolvency process (section 75, Pensions Act 1995).
  • Meet the employer's contractual funding obligations to the pension scheme as set out in the trust deed and rules, for example, for ongoing contributions and deficit repair contributions or on a winding-up of the scheme.
Employers and third parties, such as members of the employer's group, may also agree separately to provide funding to the pension scheme by way of guarantees, letters of credit, security arrangements or asset-backed contributions.
Third party obligations. Third parties that are connected or associated with an employer (or former employer) of a scheme can, in some circumstances, be made liable to contribute to, or support, an underfunded DB scheme under the Regulator's powers to issue so-called "moral hazard" orders. The test for determining whether an entity is connected or associated is wide. For example, it will catch other companies in the same corporate group as the employer, directors and shadow directors of an employer, or a one-third shareholder with voting rights in the employer's parent company. Moral hazard orders take the form of contribution notices and financial support directions. If a party does not comply with a financial support direction, the Regulator may issue a contribution notice. These can only be issued if the Regulator considers it reasonable and:
  • For a contribution notice, there was an act with a main purpose of avoiding a pension liability or an act that has detrimentally affected the security of scheme benefits.
  • For a financial support direction, the employer is insufficiently resourced or is a service company.
Events that affect the employer covenant. Scheme trustees and the Regulator will be concerned about any events which would significantly weaken the employer covenant, that is, events which are materially detrimental to the ability of the relevant pension scheme to meet its liabilities (Type A events). A Type A event may occur if a group undertakes an activity which reduces: the expected contributions to the pension scheme; the ability of the sponsoring employer or group entities to pay these contributions to the scheme (such as additional financial commitments, restrictions on capital flow, increased dependency on other parts of the group); or what the scheme can recover if insolvency occurs (such as reducing assets of supporting entities through dividends, or granting, repaying or changing the priority status of intra-group loans).
In order to assess whether a Type A event will occur, it is necessary to compare the employer covenant before and after that event has occurred, both on:
  • An ongoing funding basis, that is, what is the impact on the employers' ability to meet the ongoing funding payments.
  • A distressed scenario for the employer group, even where that distressed scenario is considered highly unlikely.
Assessing whether a Type A event has occurred can be complicated and is likely to require both a legal and financial assessment.
Identifying the extent of the employer covenant may not be straightforward. It will include not only the employer, but other companies that lend covenant support to the scheme, such as any guarantors, subsidiaries and other group companies on which the employer relies. It will also be necessary to check whether the financial support for the relevant scheme, considered on an individual supporting entity basis, is weakened by any of the proposed transaction steps. The relevant corporate activity may involve a large number of individual steps which will need to be considered both separately and together to establish the potential impact on the scheme. Some steps may appear to be neutral but in fact involve a potential detriment, for example because they result in the structural subordination of the scheme's claims.
Examples of potential Type A events include: reductions of capital; dividends; restructurings; new debt or security to creditors; sales and acquisitions, and related financing and restructuring; and switching to using a service company, rather than trading entity, as principal employer.
Type A events and corporate groups. If a Type A event occurs without appropriate steps being taken, this may affect the relationship with pension scheme trustees. Pension schemes have long-term liabilities. Sponsoring employers therefore generally expect to have a long-term relationship with the trustees of their scheme. That relationship could be damaged if a Type A event occurs and the trustees are not kept informed or if they consider that their concerns about those events have not been addressed. This could mean that the trustees will be less likely to accommodate employer requests on the funding or investment strategy of the scheme in the future. It may even mean that they look to use any powers available to them under legislation or the scheme rules to address any impact on the scheme or they may raise concerns with the Regulator.
Type A events increase regulatory risk as they are one of the main triggers for the Regulator seeking to issue moral hazard orders. The Regulator's powers are wide and this is a relatively untested area. Quantum will depend on what the Regulator considers reasonable, up to the value of the scheme's buyout deficit. In addition, it can be expensive and time-consuming for companies to defend themselves against regulatory scrutiny, which can take several years to be resolved.
Companies should also be aware that Type A events may affect disclosure obligations. Sponsoring employers are required to notify the Regulator about certain Type A events and may have further contractual obligations to notify trustees at an earlier stage in the corporate process.

Establishing appropriate systems

Companies, shareholders and directors are more likely to face regulatory action to protect the pension scheme if they have not properly considered the impact of their decisions on that scheme. However, if the key issues are considered at the right time, they may find ways to mitigate how a transaction will affect a pension scheme and protect group companies from regulatory action. In particular, directors, employers and shareholders can manage their pensions risk in relation to corporate activity by establishing and maintaining appropriate corporate governance systems. This will involve:
  • Demonstrating that decisions were taken after considering the key issues at the right time.
  • Understanding which steps in a corporate transaction could benefit or weaken the employer covenant, and the extent to which these steps are linked legally.
  • Preparing for future scrutiny, for example by anticipating any concerns that the trustee and Regulator might raise and engaging with them in a way that addresses those concerns.
  • Agreeing appropriate mitigation arrangements with the trustees of the scheme.
  • Seeking advance clearance from the Regulator.
Companies can improve their corporate governance systems to accommodate these strategies by ensuring that:
  • Teams within their business with responsibility for corporate activity can identify Type A events, are aware of how these events can affect pension schemes in the group and have established processes for confirming and mitigating that impact.
  • Decisions are recorded in a way that documents how directors and working groups considered the impact of corporate activity on the pension scheme before approving that activity, for example in board minutes and briefing papers.
  • Trustees and the Regulator are notified of relevant corporate activity in a timely manner, for example alongside significant investors or credit rating agencies.
  • Specialist advice about the legal obligations owed to the pension scheme and the financial ability of the employer to support those obligations is sought when needed.
Taking these steps, and thoroughly documenting them, will put companies, shareholders and directors in the best place to defend any subsequent regulatory action.
Dawn Heath is a partner, and Harriet Sayer is an associate, at Freshfields Bruckhaus Deringer LLP.

Identifying the employer covenant

  • To identify the extent of the employer covenant, a corporate group should identify and assess:
  • Which entities are treated as current or former employers under legislation.
  • The balance of powers between employer and trustee in the trust deed and scheme rules.
  • The nature and value of obligations in funding arrangements for the scheme.
  • Indirect covenant support, that is, support for employers to enable contributions to be made, such as: the supply of personnel agreements with operating companies, including reimbursement for services; and parent company financing channels. Even though there may not be any direct contractual obligations between employers and parent companies, trustees may take comfort that the parent will support a principal employer in meeting an obligation to procure that contributions are made to the pensions scheme.