This briefing is for UK and overseas lenders to UK companies and focuses on the most common issues relating to UK pension schemes.
There are three main categories of pension provision in the UK: state pension provision, personal pension schemes and occupational pension schemes. The type of pension scheme that can raise issues for lenders is the “occupational pension scheme”. Occupational pension schemes are established by employers for their employees under a trust. The trustees of pension schemes (or the directors of corporate trustees) must be independent of the employer (although some may be appointed by the employer) and a certain proportion must be nominated by the members of the pension scheme. Occupational pension schemes are subject to a complex legal framework and are overseen by the Pensions Regulator (Regulator). They broadly fall into two categories: defined contribution schemes (DC Schemes) and defined benefit schemes (DB Schemes).
DC Schemes (also known as money purchase schemes) provide members with benefits which are calculated by reference to the contributions paid to the members’ funds, together with the investment return on those contributions. As members are only entitled to the benefits which can be paid from their individual funds, it is not possible for a funding deficit to arise in a DC Scheme. DC Schemes are therefore less onerous for employers than DB Schemes, and will be of little concern to lenders to UK companies.
DB Schemes provide members with a set amount of pension based on the member’s salary and length of service with the employer whilst a member of the scheme. DB Schemes include final salary schemes (under which benefits are calculated by reference to the member’s salary at the time of leaving service, when salary will ordinarily be at its highest) and career average schemes (under which benefits are calculated by reference to the member’s salary averaged over the course of his employment while a member of the scheme). These schemes can be volatile and are often very expensive for employers to operate, with a statutory funding regime which requires that any shortfall in the level of scheme funding is met by the employer.
Statutory ongoing funding regime
DB Schemes are, with a few exceptions, required to comply with a statutory funding regime, known as scheme-specific funding. Legislation requires that the scheme actuary (who is appointed by the trustees) conducts an actuarial valuation at least once every three years to assess the scheme’s level of funding. The scheme actuary must value the scheme’s assets and its technical provisions, which is the amount required, based on an actuarial calculation, to meet the scheme’s liabilities on an ongoing basis. If the valuation shows a shortfall in the scheme’s assets when compared with its liabilities, the trustees and the employer must agree a recovery plan which will set out the steps which will be taken to repair the ongoing deficit over a specified timeframe. The current average UK recovery plan is 5.7 years. The trustees must also prepare a schedule of contributions, which sets out the contributions which the employer will pay into the scheme over that period.
Funding levels vary considerably among DB Schemes and are highly sensitive to changes in interest rates and longevity. Where there is a deficit, there may be tension between the employer and the trustees as to strength of the funding basis and consequent level of contributions payable by the employer and the length of the recovery plan.
Under UK legislation, there are certain circumstances in which the scheme employer is required by law to make up any shortfall in the scheme’s assets on an ongoing basis. The shortfall in the scheme’s assets is calculated on the buy-out basis, that is, the cost of securing all benefits with an insurance company. Schemes can face a significant shortfall on this basis even where the scheme is fully funded under the statutory ongoing funding regime. The shortfall is classified as a debt owed by the employer to the pension scheme and is known as a section 75 debt. In general, the circumstances in which a debt can be triggered are as follows:
- When a DB Scheme starts to wind-up.
- When the DB Scheme employer becomes insolvent.
- When a participating employer in a multi-employer scheme ceases to participate in the scheme, but accrual in the scheme is on-going. In this situation, the employer debt is the participating employer’s share of the buy-out deficit (unless a separate contractual arrangement is negotiated).
These debts can be very significant and could be a material concern to lenders if triggered.
Powers of trustees of DB Schemes
The powers of trustees are derived from UK pensions legislation, UK case law and also from the scheme’s trust deed (which will vary from scheme to scheme). Lenders may wish to review the scheme’s trust deed to establish exactly what powers the trustees may have in relation to the scheme.
Trustees of DB Schemes may be concerned if the scheme’s sponsoring employer decides to grant security to a lender, because if the sponsoring employer becomes insolvent, the scheme is, under UK law, an unsecured creditor in the insolvency proceedings. Therefore, if the employer gives security to a lender in exchange for a loan, the scheme is pushed further down the priority order in the event of the employer’s insolvency. In circumstances where the employer is being asked to give security, the trustees may seek to negotiate mitigation (for example, a cash payment or a guarantee) for the scheme.
Trustees’ duties and assessing the covenant of the employer
The trustees’ main duty is to operate and administer the pension scheme in accordance with its governing documentation and statutory requirements. Trustees are responsible for assessing the financial strength of the scheme’s sponsoring employer and its ability to support the scheme and to meet the scheme’s liabilities (known as the employer covenant). If the employer takes any action which significantly affects the employer covenant (for example, paying a substantial dividend or granting security), the trustees may seek some form of mitigation to protect the scheme and its members.
Actuarial valuation and contributions
Under UK legislation, trustees of DB Schemes are able to set the date for the scheme’s actuarial valuation and are required to agree with the employer the schedule of contributions which the employer must make to the scheme (as discussed above). The trustees have the power under statute to bring forward the scheme’s actuarial valuation and to prepare a revised recovery plan and schedule of contributions if there are material changes to the scheme’s circumstances.
Winding-up the scheme
Under the trust deed of the scheme, the trustees may have the power to wind-up the scheme in certain circumstances. If the scheme is wound up, this would trigger a solvency deficit, meaning that the entire deficit, calculated on the buy-out basis, would become payable immediately as a debt by the employer. Some DB Schemes have significant funding deficits and triggering a solvency deficit could push some employers into insolvency.
The scheme’s trust deed should be checked to determine whether the trustees have the power to wind-up the scheme in response to the employer granting security to a lender or whether the trustees could effectively cause an insolvency, which could impact on lender recovery.
Powers of the Pensions Regulator
The Regulator is responsible for regulating occupational pension schemes and ensuring that members are protected.
The Regulator has a number of statutory powers to issue orders (either a contribution notice or a financial support direction) against participating employers of DB Schemes and against persons who are connected or associated with these employers. These powers (which are often referred to as the Regulator’s moral hazard powers) allow the Regulator, where specific criteria are satisfied, to require a cash contribution to be paid to the pension scheme or financial support (such as a guarantee) to be put in place. These criteria include the occurrence of an action which:
- Results in a material detriment to the likelihood of benefits under the pension scheme being received.
- Would materially reduce the amount of section 75 debt that would likely be recovered were the employer to become insolvent.
- Materially reduces the value of the employer’s resources in relation to the size of the section 75 debt.
The definitions of connected and associated are very wide and may include the employers who participate in the scheme and their directors (in the case of a contribution notice), and also other group companies and their directors.
The Regulator also has the power (among other things) to prosecute people whose conduct detrimentally affects in a material way the likelihood of benefits being received and to impose financial penalties of up to £1 million for conduct risking accrued scheme benefits.
These powers include imposing fines and/or imprisonment on persons who act in such a way as to avoid employer debt or risk accrued scheme benefits. The extended powers are broad in scope and could, in theory, capture lenders because there is no requirement for an association or connection to the pension scheme or employer. However, the Regulator’s guidance has noted that it does not intend to prosecute behaviour it considers to be ‘ordinary commercial activity’.
The Regulator has to date used these powers relatively rarely and usually in extreme circumstances. However, their very existence means that lenders and employers are likely to want to ensure that the trustees do not complain to and seek to involve the Regulator in any proposed financing arrangement. The Government has consulted on ways to make the Regulator a clearer, quicker and tougher regulator and there are proposals to expand the range of corporate activities which are to be treated as notifiable events (that is, notifiable in advance to the Regulator). Two of the proposed changes to the notifiable events framework which are particularly relevant to lenders are:
- The addition as a notifiable event of the granting of security on a debt to give it priority over the debt to the scheme.
- The extension of the existing notifiable event of breach of a banking covenant to include the deferral, amendment or waiver of that covenant.
It is possible for an employer, in certain circumstances, to seek clearance from the Regulator that it will not exercise its moral hazard powers in relation to a particular transaction on the basis of the information provided to the Regulator. As part of the clearance procedure, an employer will be expected to provide mitigation to the scheme. If an exercise of the Regulator’s powers is a concern, lenders may wish to consider including a condition precedent to the financing arrangement that clearance is obtained from the Regulator. However, due to practical and commercial reasons (including delays to the timetable and costs) clearance is rarely sought on financings and refinancings.
If a lender is seeking security over the employer’s shares, the lender may wish to take specific legal advice in relation to any risk that it could be considered to be connected or associated with the borrower, or could otherwise come within scope of the Regulator’s moral hazard powers.
Checklist for lenders
- Check whether any pension schemes in the group are DB Schemes and if so, which group companies participate in the DB Schemes.
- Check the actuarial valuation of any DB Schemes to assess the extent of the deficit in relation to the schemes (on an ongoing and solvency basis).
- Check the trustees’ powers to wind-up the scheme and to demand contributions under the scheme’s trust deed.
- Consider whether there is any risk of the Regulator exercising its powers.
- Consider including covenants and conditions in the loan agreement, for example:
- A covenant that each group company will ensure that no action or omission is taken in relation to a DB Scheme which is likely to trigger a solvency deficit or the winding-up of the DB Scheme.
- A covenant by the employer not to establish or contribute to any further DB Schemes.
- Consider, in extreme circumstances requiring the employer to apply for clearance from the Regulator and making this a condition precedent to the financing agreements.