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OPDU Report 25 - November 2008 Surplus – What Surplus?! Background The prospect of companies worrying about pension scheme surpluses seems unlikely against the current economic and investment back-ground. After all, at the time of writing, we have just witnessed some of the sharpest falls in the world’s stock markets with share prices in the US and Europe having fallen by more than a quarter and those in Asia slightly more, in a single month. Furthermore, for any scheme under-taking a scheme specific funding valuation with an effective date anytime in the last few months, the assumption made for inflation (derived from gilt yields at the valuation date) is likely to be higher than when the previous valuation was undertaken. This will place a higher value on inflation linked pensions and the revaluation of deferred pensions. For schemes which remain open for future accrual, or even those that have closed for futureaccrual but retain a final salary link, the assumption for future salary increases is likely to be greater too. Then there is the issue of mortality assumptions which will almost certainly be strength-ened. So overall, the value placed on the technical provisions (the amount required to make provision for the accrued liabilities) is likely to be greater. Yet, a number of independent reports have highlighted FTSE companies reporting an irrecoverable surplus during 2008, which in part reflects different requirements under accounting rules where the value of future liabilities are discounted based on AA Corporate Bond yields. These have increased and are currently much higher than gilt yields which scheme specific funding valuations tend to use as a starting point with some form of “equity risk premium” when calculating the value of future liabilities in today’s terms. Funding Uncertainty What this tells us is that the funding of defined benefit pension schemes is an uncertain business and predicated on assumptions that are unlikely to be borne out in practice. There is increasing volatility in the investment markets and whilst investment strategies and solutions continue to be developed, it is often not possible to precisely match liabilities, nor do many companies and trustees believe it is currently desirable or affordable to do so. If deficits can emerge and increase quickly, then it follows that the same can be true for surpluses too. Companies and shareholders in partic-ular, are asking why they should suffer the pain and costs associated with funding scheme deficits but are then precluded from benefiting from any sur-plus that may be created in the future. Although it may be counter intuitive, a time of financial stress is when some of the assumptions adopted to remove deficits in pension schemes are likely to be stronger (one or more of higher inflation and salary increases, lower gilt yields, lower investment return assumptions), and may therefore be the very circum-stances in which a surplus could be created over the Recovery Plan period. Changes in accounting standards increase the risk of irrecoverable surpluses where the maximum surplus that can be treated as an asset on the company’s balance sheet is the value of possible future refunds and reductions in future contributions. The Pensions Act 2004 and associated regulations require defined benefit schemes to have assets in excess of those required to provide benefits on the full buy out (solvency) basis before they may make a payment of surplus to the company. The scheme rules must also permit this. In practice, a return of surplus from the scheme to the company is likely to be very difficult to achieve. Alternative Approaches to Scheme Funding Against this background, companies and trustees have begun to explore a variety of approaches to scheme funding which include the use of contingent assets such as letters of credit, parental company guarantees, charges over company assets and the use of escrow accounts. An escrow account can be used as part of the overall funding programme and not just on insolvency, where payment into the scheme is triggered on an agreed level of underfunding or other specified events. The search by companies and trustees for innovative funding solutions led to the development of the Pension Support Bond which aims to provide additional security whilst at the same time removing the risk of over-funding. The Pension Support Bond works in a similar manner to an escrow account but without some of the potential drawbacks. How the Pension Support Bond Works The Pension Support Bond is written as a capital redemption policy and unlike an escrow account, the company should receive corporation tax relief on its contributions which can be paid as either regular or single contributions to the policy. This is because the value of the policy, up to the definition of scheme deficit, is a scheme asset. The trustees and the company agree the definition of scheme deficit which is specific to the scheme’s circum-stances and different definitions can apply, for example, in the event of the company’s insolvency or a partici-pating company leaving the scheme. The trustees are responsible for the investment strategy of the assets held within the bond and potentially have the same flexibility with regard to asset class and asset managers as other investments for the scheme. When the policy is surrendered at the end of the Recovery Plan period, any surplus after clearing any residual deficit will revert to the company, thus avoiding over funding. The surplus should be taxed at the company’s marginal rate of corporation tax.
Attractions for the company
Advice The Pension Support Bond is intended to be a simple solution for companies and trustees to use. The company and trustees, as with any other significant scheme activity, will want to consult their respective advisers when implementing a Pension Support Bond. The future The current economic and investment conditions present significant challenges for companies and trustees alike. As part of a range of possible approaches, the Pension Support Bond may Grant Lore |
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