[Skip to content]

Sign up for our daily newsletter
The Actuary The magazine of the Institute & Faculty of Actuaries

The contribution rule and employer risk

Every scheme actuary will be aware of the increasingly publicised need for trustees to consider the health of the sponsoring
employer. But should the scheme actuary be monitoring this risk too?
The actuary plays a crucial role in the setting of contribution rates. Together with the forthcoming scheme-specific funding requirement and the potential for recovery plans to bring plans back to full funding, it is easy to see how the actuary needs to consider employer health.
To illustrate the point, it is useful to consider some examples.

An employer taking on new debt
Consider the scene: the directors need funds for an exciting but expensive new project. The small amount of existing bank debt is unsecured. That is, in the event of insolvency it ranks equal to the ‘ordinary’ trade creditors and the pension scheme. In recognition of the risk they have taken to support the new project, the bank has requested security over the company’s assets.
The primary impact on the pension scheme is the greatly reduced return to the scheme should, heaven forbid, something go wrong and the company fails. In giving security, the bank has first call on the proceeds of any assets, subject to some detailed insolvency rules.
An important point to note here is that even if the additional funding is unsecured, it dilutes, or more probably eliminates, the potential return to the pension scheme.

A highly leveraged transaction
A profitable and successful employer has been approached by a party that is interested in acquiring the shares and is offering a high price. Sounds great for the shareholders of the target company but what about the pension scheme? There is an impact on the net worth of the company as well as a higher risk profile. Therefore, there will be a severely reduced return to the scheme should the company fail.
How can the trustees and scheme actuary spot a highly leveraged transaction (ie a deal done with a lot of debt)? The warning signs include where the level of debt incorporated into the deal is much higher than the level of equity and where the funder is relying on the profitability and cashflow for the return.
The underperforming employer
Underperformance may not be obvious or public knowledge. It can manifest itself in many different ways. A company may be loss-making or could just as easily be profitable but at the same time absorbing precious cash.
Yes, annual accounts are filed at Companies House, but remember that given the filing timetable, these are historical and out of date. Underperformance can happen very quickly.
Warning signs might include:
– profit warning announcements or credit rating changes;
– the share price falling;
– increased bank interest in performance or reports on payment terms with creditors being stretched;
– the sale of assets within short timescales.
It is important to consider whether the scheme should be requesting additional contributions that the employer can afford while the company is around to meet the payments. After all, many funders of companies are used to receiving management accounts and requesting that surplus cash is directed their way in debt reduction. The risk here for the pension scheme is that cash is being used for bank debt reduction that could be shared between the bank and the pension scheme.

Getting the right information
The risks are easy to see once you know you have one of these situations, but how do you get advance notice of such a scenario? First, there is a need for dialogue and co-operation between the trustees, actuary, and employer. This may be more forthcoming given the new Pensions Act 2004 clearance procedure.
Second, the pension scheme should be seen as an important stakeholder in the employer and in order to monitor this investment the actuary and trustees should request regular financial information. The employer is not currently obliged to provide this information, but if it refuses to do so it may be worth asking why not.
Also, as highlighted by the three examples above, it is the impact of imminent changes and the future health of the employer that are important. The actuary and trustees should be mindful of general industry trends (eg consolidation), trading forecasts, and future strategy to pre-empt such events. The position should be reviewed regularly if possible.

Being ‘reasonable’
As well as being an obligation, the contribution rule can be a power. Depending on the powers conferred by the wording, it may be used by the trustees to revisit and increase cash contributions into the scheme at times of concern or corporate/debt changes to ensure the scheme’s interests are not prejudiced.
However, it needs to be used with care. It may not be in the scheme members’ interests for the trustees to impose full buy-out funding on a reluctant employer through the contribution rule; this itself could lead to company failure and indeed it may be unreasonable to do so if the employer is committed to supporting the scheme in the long term.
This is a particularly topical issue in light of the recent Pensions Act, which will require a statement of funding principles to be agreed between trustees and scheme sponsors. In cases where the power to set contributions has historically rested with the employer, the balance of power may shift towards the trustees.
The commerciality of the situation and future survival of the employer will be crucial for the scheme and for continued employment. These will therefore need to be carefully balanced with the funding of the scheme to avoid frustrating transactions or restructurings.

Where to go from here?
There are options available other than changing the contribution rate, for example, the scheme taking security or a profit share. Independent advice on the scheme’s position and and on the options available may help the actuary and trustees to manage risk.
Indeed, in our corporate restructuring work we are seeing more and more innovative funding structures agreed between companies and lenders so it is worth actuaries and trustees thinking in a similar manner. There can be a commercial compromise!