Plugging your pension deficit

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1 December 2010 Plugging your pension deficit In association with

2 A new point of view De-risking past pension liabilities has become an increasingly important goal for trustees and pension plan sponsors. TowersWatson sunrivalledexperiencemeansourinnovativeandpracticalsolutionsaretailoredtomeetyourneedsandto helpyoude-riskattherighttimeandatapriceyoucanafford. By combining its market leading actuarial, investment, insurance and communications expertise, Towers Watson has designed and implemented solutions for its clients wherever they are on their de-risking journey. This flexible service ranges from the execution of complex longevity hedging transactions to the management of successful pension increase exchange or enhanced transfer value projects. To find out how we can help your scheme please call your Towers Watson consultant or: Simon Bleach Towers Watson. A global company with a singular focus on our clients. Benefits Risk and Financial Services Talent and Rewards towerswatson.com Copyright 2010TowersWatson.Allrightsreserved. TW-EU September TowersWatsonisrepresentedintheUKbyTowersWatsonLimited, TowersWatsonUKLimitedandTowersWatsonCapitalMarketsLimited. TowersWatsonLimitedisauthorisedandregulatedbytheFinancialServicesAuthority.

3 Pension deficits DECISIONS Whisky in the jar Securitising assets against your pension scheme is a prudent way to plug the gap if you do not have the cash to fund it, finds Anthony Harrington It is perhaps not surprising that with cash being so tight, companies are scouring their asset base to find unencumbered bits of something that they can offer to their pension fund trustees in lieu of a big cheque. As Gavin Bullock, pensions partner at Deloitte explains, the idea of asset-backed structured partnerships between the company and the scheme trustees tends to be very popular with finance directors since it has instant treasury and tax benefits. For a start, it frees up cash for more profitable ventures and uses inside the business. For a second, there can be some interesting tax advantages, Bullock says. Once the asset is invested in the specialpurpose vehicle then the company has access to accelerated tax relief, which is attractive to finance directors provided there are profits to set off against it. Considerable assets Since Marks & Spencer did the first groundbreaking deal in 2007, a number of asset-backed funding deals have come through. In fact, 2010 has seen a rash of them, with assets, from whisky stocks to property, being offered to trustees (see table, page 34). Moreover, asset-backed arrangements have benefited from what amounts to a blessing from The Pensions Regulator (TPR), which is putting increasing pressure on trustees to seek contingent assets from employers where they can. Where these assets are associated with a revenue stream, such as a property that has rental income associated with it, they can go a good way to plugging the scheme deficit. Bullock says that the average so far is for these schemes to fill in for about 50 percent of the deficit. And it can work for smaller companies too. A survey by KMPG on asset-backed funding points out that another benefit for companies going down this route is that it can materially stretch out the time frame TPR is prepared to allow for scheme recovery plans. Data from TPR suggests that the average recovery plan for conventional cash contributions is around eight years, whereas the asset-backed funding structures have an average term of 17 years, the report s authors say. The reason for this more relaxed attitude on the part of TPR is obvious. With highquality assets in place, the whole position of the scheme looks a great deal better to everyone, from the trustees to TPR. According to KPMG, more than 4bn of asset-backed contributions have been made so far to UK pension schemes, and trustees have been granted security over nearly 9bn of assets. Mike Smedley, pensions partner at KMPG, points out that FTSE-100 companies pumped a record breaking 11bn in their schemes in 2009, the vast bulk of which was cash. That created real challenges and a non-cash solution is clearly very attractive, he says. December

4 DECISIONS Pension deficits Martin Potter, a consultant at Hymans Robertson, points out that one of the stumbling blocks in the way of companies going ahead with asset-backed structures in the past has been the rule that prevents trustees from investing more than five percent of their fund in the sponsoring company. However, this barrier has now been effectively overcome through the use of Scottish limited partnerships (SLP). Partnership position Under Scottish law, an SLP is very clearly a legal entity able to enter into contracts. The position of a partnership under UK law is far less certain when it comes to contracts. This is important because as the SLP is a separate, arms-length structure, the five percent rule falls away. What is critical about the choice of assetstogointotheslpisthattheyhave to be unencumbered, and they have to have a clear value in themselves that means that they would not become valueless if the sponsoring company failed, says Potter. Provided the assets meet this rule and the trustees can be confident both that the value of the assets will hold up and that Asset-backed securitisation deals Year Company Asset type Value 2010 Diageo Whisky 430,000, Travis Perkins Property 35,000, Sainsbury s Property 600,000, Marks & Spencer Property 300,000, Whitbread Property 100,000, GKN Intellectual property and property 331,000, ITV Subsidiary 124,000, John Lewis Property 95,000, Lloyds Banking Group Bonds 1,000,000, Marks & Spencer Property 200,000, Marks & Spencer Property 500,000,000 they can get hold of the assets left in the partnership if the company folds up, then a deal can be done, he says. Potter adds that company bankers tend to be comfortable with these arrangements. They see these deals as evidence that the companies are getting on top of worryingly large deficits in a manner that does not strain cash resources, he says. Another interesting feature of the assetbacked approach, Potter says, is that these deals are pretty neutral from the perspective of users of the company s accounts. Bullock agrees. From an accounting perspective there is very little change in terms of presentation in your consolidated accounts, before and after the deal, he says. There is full awareness in the market as to what has been done, but the assets and the pension fund are still within the consolidated accounts. So far the deals done have been in the hundreds of millions of pounds range. Bullock says it is feasible that deals will come down in scale to the point where a 10m deal might be doable. However, he says there is a limit to the degree to which an asset-backed funding approach can become an off-the-shelf solution. These are complicated deals and by their nature they are bespoke, he says. That makes them quite expensive. Get your house in order Anthony Harrington offers a checklist for FDs to tidy up their pensions liabilities if they are looking to sell the business Wes Thorp, Flickr So the board has decided to sell either the whole company or group, or a subsidiary. Let s say that in each case, there is a final salary pension scheme in the entity being prepared for sale. Gary Cullen, head of pensions at law firm Maclay Murray & Spens, suggests the following checklist of actions that should be taken. Clean up your data. It goes without saying that the buyer will expect all the data on the scheme to be in good order. This should be a no-brainer, but pensions experts who are asked to look at schemes with a view to a buyout say that the schemes they look at are often extremely messy, with dead members still on the books. It s a put-off. 34 December 2010

5 MORE ON PENSIONS MANAGEMENT Close the scheme to new arrivals now. In fairness, this has already been done by the majority of UK companies with final salary schemes. This at least caps the problem at the present membership level. Close the scheme for future accrued benefits. This is harder to do since employees value final salary schemes and will not take kindly to being told that henceforth their pension is being accrued through a different set of arrangements, with the new arrangement in all probability being a defined contribution scheme. This is a hard sell for the company: it should be undertaken in an open and honest way with the case for closure being put clearly to employees. Employee risk The likelihood is that the new arrangements will have to look at least as good to the employees as the old arrangements, in terms of the amount of cash being accrued by their pension. The big difference from the employer s point of view is that the new arrangement commits the sponsoring employer to a defined amount, not an undefined amount. The risk that the final sum in the employee s pension pot will not be sufficient to provide them with a sufficient pension is run by the employee, not the employer. This does away at a stroke with scheme deficits, enforced contribution catch ups, and so on and so forth. However and it is a big however the company remains at risk for any deficit on the benefits accrued up to the point of closure. This will still be a problem for an acquiring company, so they will want a full due diligence exercise showing the scope of the remaining risk. Also, some employment contracts will have embedded pensions rights in them so the employee may be protected against any attempt by the employer to close the scheme to new accruals as far as the protected employees are concerned. Examine enhanced transfer. This offers employees either an improved pension or cash in the hand to transfer out of the scheme. The Pensions Regulator (TPR) is very hot on enhanced transfers and will need to be convinced that the employer is making an honest case to the employee, setting out the benefits and disadvantages of transfer, and Schemes are often messy, with dead members still on the books. It is a put-off that the employee has the option of calling on the advice of an independent financial advisor, paid for by the company. An example here would be, say, a scheme that is 70 percent funded, where the employer offers to fund it to 110 percent in return for the employee transferring out. Examine apportionment arrangement. If the sale concerns a Despite an enormous weight of lobbying and advice from all sides, the authors of the independent review of auto-enrolment commissioned by the coalition government have opted not to allow even so called micro-employers that s you and your nanny to be excluded from the autoenrolment provisions. The Federation of Small Business (FSB), not surprisingly, has reacted with outrage, warning its members of the ticking pensions time bomb. The FSB reckons that once the administration costs and the compulsory three percent employer contributions are totalled up, the cost to the average small company with four employees will be around 2,500 each year. Lee Hollingsworth, head of defined contributions consulting at Hymans Robertson says the reason the independent review decided against allowing micro exclusions was that any exclusion level would serve as a barrier to growth. subsidiary with a multi-employer FS pension scheme, you can do an apportionment arrangement, where one of the existing employers in the group takes over as the sponsoring employer. Again, TPR will want to see that this does not weaken the employer covenant. Shop around for buyout providers. You can look around the market and find an alternative to an insurance company doing a full buyout for the scheme. The Pensions Corporation, for example, will buy schemes for cash and assume the longevity and investment risks on the grounds that they are good at managing those risks. Consider a full annuity buyout. You can bite the bullet and do a full annuity buyout, or lower the sale price of the company by the cost of the buyout so that the acquiring organisation can close the scheme through a full buyout. If it was set at below four employees, that would create a growth barrier at three employees, when employers would be loath to take on an additional staff member. Hollingsworth says that prior to the publication of the review, companies had been able to simply put off thinking through their response to autoenrolment. That time has passed. There is much to do before it becomes compulsory in 2012, he says. The six-stage process FDs need to follow to prepare is: Understand your objectives Design and test your plan financially so you know what it will cost in five and 10 years Decide on the implementation method your existing plan, NEST, or some other provider? Check that your current in-house resources can meet this Check with your payroll supplier as to its capabilities for deductions Design your administration process so it can be relied on to run smoothly. The Pensions Regulator will be watching. December

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