Pensions: Liabilities for underfunding

Out-Law Guide | 21 Jun 2010 | 3:54 pm | 6 min. read

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series of guides on Pensions , aimed at company directors. The combined effects of rising life...

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series of guides on Pensions, aimed at company directors.

The combined effects of rising life expectancy and falling investment values have meant the costs of running a defined benefit scheme have grown significantly in recent years. Many companies feel they simply can’t sustain these costs in the future. As a result, schemes are being shut and staff are being put into cheaper alternatives.

Once the scheme has been shut, the employer will continue to be responsible for its costs until it’s wound up. Winding up the scheme may look like an attractive option, but often it isn’t viable for the employer. An employer that winds up its scheme (whether or not this is part of its long-term benefits strategy) has a legal duty to top up the pension scheme funding so that the trustees can fully secure all members’ benefits with annuities bought from insurance companies. (At the time of writing, the cost of securing benefits in this way is far greater than the cost of providing them from an ongoing pension scheme.) The amount of the top-up required from the employer is known as the statutory debt.

The level of this statutory debt can be very high – high enough, indeed, to bankrupt the business.

Pension schemes that cover more than one employer in the corporate group can also run into problems. Where a group company has very few employees left in the pension scheme and the last one leaves or dies, the employer will immediately become liable for its share of the statutory debt. An employer in this situation does have a 12 month period to allow another of its employees to join the scheme, but if it intends to take advantage of this option it must let the trustees know within one month. There is no leeway over either of these time periods.

Frequently, the initial one-month deadline is missed because an employer has not noticed that their last employee has left the scheme. It may not be clear from scheme records who was actually employing the particular individual (especially if records are poor or if the person worked for more than one employer). It is therefore important that employers who may find themselves in this position ensure that there is a system to inform them immediately when the last person leaves.

The pensions regulator has sweeping powers to bring into line companies that try to arrange their affairs to avoid the statutory debt. In theory, at least, no attempt to evade pension liabilities will go unnoticed. (See: The regulator’s powers, an OUT-LAW guide below.)

Directors should take underfunding very seriously. It’s 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 its ‘life’.

The regulator’s powers

  • Contribution notices: these can be served on other group companies and individuals where action has been taken that avoids the payment of a statutory debt or makes it less likely that members will be able to receive their full entitlements. As will be clear from the above, a statutory debt is triggered when an employer leaves the pension scheme – for example, when there is a takeover or company sale – and the value of the scheme’s assets won’t secure all members’ benefits with an insurance company. The debt will be far higher than any deficit disclosed in the company’s accounts under FRS17 or IAS19.
  • Financial support directions: if the regulator considers that the pension scheme employer is either a service company or insufficiently resourced to pay any debt that may arise, it can issue a financial support direction against other companies in the group.
  • Restoration orders: where money or property has been transferred from 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 immunity. (See Reducing the risk of liability, below.)

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 qualify, but shareholders are exempt unless they ‘control’ the company – ie 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 liability

There are several things individuals and companies can 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 materially detrimental to the ability of a defined benefit pension scheme to meet its liabilities. The triggering event must fall within certain categories that are described by the pensions regulator in its published guidance. In some cases, the pension scheme itself must be in deficit. 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 an individual 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 its failure. If you are contemplating doing anything that may mean pension scheme liabilities are avoided, you should 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 may try 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 such as actuaries, lawyers and benefit consultants will be familiar with the issues involved and will be able to suggest ways of managing the underfunding to fit the company’s circumstances.

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 would also make it more difficult to get any money out of the company). Trustees have become more aware of this balancing act, and the pensions regulator has published guidance to help them and the employer.

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.

The trustees have a lot of power in the process of making sure funding requirements are met. However, they will sometimes agree to a lower payment by the employer if it will keep the scheme open and the company in business. The pensions regulator will need to be involved in any such agreement. Again, seeking advice early is invaluable.

Comply with the regulator’s reporting requirements

Trustees, employers and other professional advisers involved in the pension scheme must 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 scheme debt, any breach of the employer’s banking covenant and a change of control of a pension scheme employer.

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