Pensions cash control
January 20, 2010
The current economic conditions are placing a significant strain on scheme sponsors. Cash demands on employers are numerous, including those from banks, shareholders, liquidity requirements, capital expenditure and last, but by no means least, the pension scheme.
A defined benefit pension scheme's cash demands stem from dealing with the pension deficit, Pension Protection Fund (PPF) levy, de-risking, ongoing accrual, general operational costs and factoring in costs for automatic enrolment from 2012.
Actions can be taken to reduce the cash demands of your pension scheme. It is vital that any discussions begin by agreeing the company's objectives and defining what a successful outcome would be. This then creates a point from which a company can look at the three main areas that demand cash from the business:
- Past service cash demands, that is, deficit funding.
- Future service cash demands, that is, future accrual costs.
- Longer-term cash demands, often caused by exposure to risk and volatility.
Looking at each of these areas in turn below, we can consider how a company can look at reducing the cash demands of its pension scheme.
Past service cash
Given that a strong and viable sponsoring employer offers the best form of long-term security to a pension scheme, the sponsor's key corporate objectives should be identified and articulated from the outset. The following components then need to be reviewed to manage the cash demands that can arise from trying to repair a deficit:
Covenant. The covenant is the company's willingness and ability to make contributions to the pension scheme. It is important to provide an easily understood assessment of sponsor covenant to trustees to ensure they understand the situation. When equipped with the key business indicators, corporates and trustees can agree on an appropriate calculation of scheme liabilities relative to covenant strength, and hence any funding shortfall.
Cash availability. Businesses have a variety of cash commitments, so it is important for sponsors to clearly communicate cash availability to their pension scheme trustees and for trustees to ensure the pension scheme is being treated fairly with respect to cashflow committed elsewhere.
Recovery plan. A scheme funding valuation should result in an agreement on scheme assets, liabilities and a deficit repair plan when required. Agreeing appropriate funding prudence and an understanding of regulatory requirements are both important to facilitate effective scheme funding negotiations. Often, confusion and anxiety about the Pension Regulator's framework can undermine the funding agreement process.
Contingent funding and cash alternatives. Sponsors may be looking to offer other forms of security in lieu of direct cash contributions. This could include contingent funding, or alternative assets providing security, for example through the use of property, receivables and guarantees. Tax efficient solutions are possible.
PPF levy. Appropriately managed scheme funding positions and investment risk will lead to a reduction in the levy charged to a scheme by the PPF. Addressing covenant risk issues associated with the scheme sponsor can also reduce the levy and save cash.
Future service cash
Managing future cash exposure involves considering:
Benefit design. Appropriate benefit design ensures value is achieved on the pension provision spend and that the provision aligns with overall corporate and employee reward goals.
April Budget speech and Finance Act 2009. These raise questions as to whether occupational pensions remain an appropriate and cost-effective form of reward for all higher earners. This is because the tax efficiency of saving through pensions is expected to fall markedly from April 2011 for individuals with taxable income over £150,000 per year. Alternative vehicles which may be used to replicate existing pension arrangements include an employer-financed retirement benefit pension scheme (EFRBS) and an employee benefit trust (EBT); the impact is already being felt through the introduction of anti-forestalling measures in the Finance Act 2009 taking effect from 22 April this year.
Auto-enrolment. In 2012. UK employers will have to auto-enrol their staff into a qualifying pension scheme and make contributions. Auto-enrolment could lead to significant extra costs, which need to be managed as part of total prospective pension cash commitments.
Finally, reducing risk and stabilising cash payments in the future can help to reduce the uncertainty surrounding pension provision and ensure that only desired risks are being taken.
Taking advantage of in-house opportunities such as enhanced transfer value exercises and pensioner increase exchanges, as well as those available in the market (for example, buy-ins and longevity swaps), can help to achieve this, but timing is key to the effective implementation of such measures.
Key factors in achieving success
- Target objectives that are beneficial to both sponsoring employers and trustees.
- Ensure that any decisions are based on input from a broad range of perspectives including pensions, reward, investment, tax, accounting, legal and corporate finance as necessary.
- Consider the full range of alternative and contingent funding solutions, ensuring their feasibility is explored.
- Understand the Regulator's position and practice – vital to ensure that any plans are compliant and in line with the Regulator's guidance.
- Integrate forthcoming changes to the UK pensions system into a forward-looking pensions funding strategy.
- Be aware of the various risks involved affecting future cash commitments and implement actions to mitigate them.