The COVID-19 pandemic threatens both the funding level of defined benefit (DB) pension schemes and the solvency of employers. In many cases, these risks are manageable. Schemes that have de-risked their investments will have some protection from market turbulence and many employers are calling upon the various support programmes offered by the Government, and are reaching agreements with their trustees to suspend contributions, to enable both parties to survive through the crisis.
Some, however, will not be so fortunate, and this briefing note gives an overview of some of the options available where the pension scheme cannot afford to pay benefits without the employer's support, but the pension scheme's requirements are a critical threat to the employer's survival.
Key points for employers
- If your pension scheme is a threat to your long-term survival, you are likely to have more options the sooner you act.
- The challenges caused by pension scheme deficits have forced the pensions industry to be innovative. There are more options available to employers than ever before. Some of them are outlined in this note but there are many variations and new ideas.
Key points for trustees
- The best outcomes tend to be where early action has been taken and the employer can deploy assets either to remove its future liability to the pension scheme altogether, or to reduce the pension scheme's reliance upon it.
- With a defined benefit scheme that is closed to future accrual, the trustees and the employer have an aligned interest in wanting to reduce the scheme's reliance on the employer. Trustees should therefore engage proactively and constructively with employers - it is in nobody's interest for the pension scheme to end up as an unsecured creditor of an insolvent employer.
The Corporate Insolvency and Governance Act 2020, which came into force on 26 June 2020, will alter the dynamic between employers and trustees, potentially reducing the negotiating strength of trustees. Read our analysis of the Act here.
The range of possible solutions
What is it? The Pension Protection Fund (PPF) is the statutory lifeboat fund for pension schemes sponsored by insolvent employers.
Advantage: This is the solution of last resort, but it does ensure that members will receive pension benefits, albeit at a reduced level.
Disadvantage: PPF compensation is less than full scheme benefits. In particular, the compensation is reduced to 90% for members who have not reached pension age at the relevant time, compensation for more generous pensions is capped, and pension increases are typically less generous.
For whom is it suitable? Schemes where the employer goes into an insolvency process, as no other solution could be found. We now turn to set out the ways to find a better outcome.
Regulated apportionment arrangement (RAA)
What is it? An RAA involves a company being released from its financial obligations to the scheme where certain conditions are met, regulatory approval is obtained and the arrangement has PPF support. The price for this will usually be a cash payment into the scheme (so the PPF receives more than it would if the scheme entered the PPF through insolvency), plus a stake in the employer (so the PPF will share in any upside if the employer returns to prosperity after the deal).
Advantage: The employer's business may be saved.
Disadvantage: As for PPF entry - benefits are reduced to PPF compensation levels.
For whom is it suitable? Schemes where the employer is facing otherwise inevitable insolvency which has not yet occurred, but which could be avoided if the employer is freed of its liability to the pension scheme, and the scheme does not have sufficient assets to secure a better outcome than PPF compensation.
PPF Plus (or insolvent) buyout
What is it? A transaction with an insurance company (known as a "buy-out") under which the insurer takes the assets of the pension scheme and assumes responsibility for such proportion of the liabilities that it determines, on its pricing model, that those assets are sufficient to purchase. Because of the capital reserve regime for insurers, securing the liabilities in full is expensive, but, this route enables a scheme to secure a proportion of liabilities in an insolvency situation.
Advantage: Higher benefits than PPF compensation. Insurance companies are well-established in the market and provide the greatest level of security for the benefits they take on.
Disadvantage: This option crystallises the loss for a pension scheme: it will be permanently locking into reduced benefits (albeit more generous than PPF compensation), with no opportunity to scale them up again.
For whom is it suitable? Schemes where the employer will inevitably become insolvent if it is not released from its obligations to the pension scheme, and the scheme is well-enough funded to be able to buy-out benefits in excess of PPF compensation. If the cut to benefits would still be material, however, a transfer to a superfund may be more attractive.
Transfer to a superfund
What is it? Superfunds (or "consolidators") are occupational pension schemes established to take on the assets, liabilities and governance from other occupational pension schemes, to benefit from economies of scale. Instead of being reward vehicles set up by an employer, they are commercial vehicles with external investors. The investors' funds are used to create a capital buffer which backs the pension scheme liabilities (replacing the employer's trading business in a more conventional pension scheme). Performance above the level needed to fund the pensions liabilities can be returned to the investors.
Advantage: Pricing is more favourable than with insurers, so a greater proportion of full scheme benefits can be secured.
Disadvantage: Superfunds do not offer the same level of security of benefits that insurers do, which is why they are cheaper. A scheme would still need to be quite well-funded to afford to secure scheme benefits in full, however. If the scheme cannot afford the superfund's cost of providing full benefits, this may crystallise a loss - albeit to a lesser extent than an insurance buy-out - and some models do allow for upside sharing. Also, this is a young market and superfunds do not yet have a track record.
For whom is it suitable? (i) Schemes that are reasonably well funded but have no foreseeable prospect of buy-out and weak employer covenants (because the capital buffer will be a better source of security than the employer covenant); and (ii) schemes that are above PPF-level funding, with a weak employer and where the benefits that could be secured on a buy-out would involve a substantial cut to benefits (because the benefit cut with a superfund would be less).
Transfer to a specially-established scheme
What is it? Members can be offered the option of transferring their benefits to a different pension scheme, established specifically for the purpose of the transaction, which will typically provide benefits that are less generous (so more affordable) than the original scheme, but above the level of PPF compensation. The new scheme may take assets of, or a stake in, the restructured business in order to provide a covenant backing the benefits.
Advantage: Avoids crystallising any losses, and enables the trustees to continue managing the scheme to try to secure the best long-term outcome.
Disadvantage: The scheme will be reliant on whatever has been found to back the new scheme - it will not have the greater resources of an insurer or superfund behind it.
For whom is it suitable? (i) Schemes where the employer will inevitably become insolvent if it is not released from its obligations to the pension scheme, but there is something to suggest (unlike with the previous options) that the scheme could be viable on its own, by using its own assets and a part of the employer's business or assets; and (ii) schemes where the employer could afford to support the scheme if the benefits were made less generous, in which case the new scheme can incorporate the reduced benefit design and therefore the link to the employer would remain to support those benefits.
Innovative solutions involving external capital
What is it? We are seeing innovation in the use of external capital to deliver win-win solutions for schemes and employers where there are concerns about employer covenant strength.
- Insured self-sufficiency®: This is a combination of an investment management agreement and an insurance policy written by Legal & General. The insurer provides cover for a loss in funding up to a 1-in-200 year event, and is paid a premium contingent on positive outcomes. The insurer also takes on the management of the scheme's assets.
- Private capital: We have also seen private capital deployed alongside scheme assets to provide a faster path to buy-out, with the upside being used to generate a return to the investors.
- Credit support guarantees, letters of credit, surety bonds: Giving the pension scheme the additional support of a provider of these products increases the security of benefits, such that trustees can demand lower levels of contributions from the employer.
Restructure the covenant without external capital
What is it? If employer insolvency is not inevitable, but the pension contributions are nevertheless unaffordable, then the position of the scheme and the employer may be salvageable simply by restructuring, without any external vehicle being involved.
There are many ways to do this, but techniques we have seen in practice include the following.
- Self-sufficient funding. If investment de-risking and/or a cash injection enables the pension scheme to reach self-sufficiency, it no longer needs any employer contributions except in an extreme and unforeseen scenario.
- Charge over assets. If existing banking covenants permit (or agreement can be reached with lenders), giving a charge over assets to the pension scheme increases covenant strength and reduces reliance on deficit recovery contributions.
- Asset-backed funding. This is a more complex form of security over assets. An asset or class of assets of the employer is placed into a special purpose vehicle. The employer makes income payments to the vehicle in order to continue to use the asset, and the vehicle pays these into the pension scheme. In a default, the pension scheme takes over the assets in the vehicle. Unlike with a charge over assets, the pension scheme's interest in the vehicle means that the scheme is technically fully-funded, which has additional advantages. This solution can also be more tax-efficient than a charge over assets.
- Escrow accounts, reservoir trusts. The idea behind these is to have assets available to the pension scheme should employer insolvency occur (thereby reducing reliance on deficit repair contributions) but which are separate from the scheme. Although most commonly used to avoid a trapped surplus, they can also be used to give trustees flexibility in a distress scenario, over whether it is better to have the funds transferred to the scheme or restored to the employer if the continued viability of the employer is in the long-term interests of the scheme.
Gowling WLG expertise
Our specialist pensions and insolvency lawyers have experience in all the solutions outlined above. Our relevant experience includes:
- Advising scheme sponsors and trustees on numerous RAAs and trustees and insurers on numerous PPF-plus buy-outs.
- Advising on the separation of the MIRA Retirement Benefits Scheme from its employer and the securing of benefits, for which we were Highly Commended by the FT Innovative Lawyer awards.
- Expertise in the PPF assessment and entry process.
- Investing extensively in developing a knowledge of the business models of all new entrants to the market such as superfunds.
Please contact us if you would like to discuss any of the matters in this briefing note.