Pensions can be a major problem for charities, so click on the headlines below for articles on how you as a charity employer can save money, tackle the implementation of workplace pensions and cope with other pension challenges.
Click on the headlines of your choise to read the articles
It is clear that for many charities their defined benefit pension schemes are becoming a significant burden. Charities now have an average deficit (on an FRS102 basis) of 16% of their unrestricted reserves (prior to deducting the pension deficit); a figure at odds with the FTSE350 where the average deficit is only 1% of a company’s market capitalisation.
Research into defined benefit (DB) pension funding across 40 of the largest charities by income in England and Wales found that the average charity now has a pension deficit of 24% of annual net unrestricted income, and is paying 3% of net unrestricted income into their DB scheme.
The research shows that charity schemes are typically underfunded (with an average FRS102 funding level of 86% compared to a FTSE350 average of 95%). More significantly, charity schemes are taking more investment risk than other private sector schemes (an average allocation to growth assets of 60% compared to 40% for the FTSE350). When markets stutter these underfunding and investment risk aspects amplify each other. This makes the average charity scheme considerably more risky than its private sector counterparts.
The question is, how should charities respond? Here are some suggestions:
ADOPT A "LOWER RISK FOR LONGER" STRATEGY. In many cases charities are taking more investment risk in their pension schemes than they need to. Clearly, scheme assets should work hard enough to free up other resources for charitable activities. However, there is no point in aiming higher than you need to and exposing the charity to unnecessary risk.
Reshaping the investment risk
Defined benefit schemes are often run on the basis of taking material investment risk today, with an aspiration to take little to no investment risk in the future. Instead, consider taking a lower level of investment risk and maintaining it for a longer period of time. This reduces volatility today, enabling a slow and steady path to full funding over time, without putting undue stress on the charity. It may mean that a longer recovery plan can be used, and does not mean a need to increase the deficit – it simply reshapes when you take your investment risk.
FOCUS ON THE CASHFLOWS RATHER THAN THE DEFICIT. One way to enable a "lower risk for longer" strategy is to focus on paying off the future cashflows rather than paying off the deficit. Much has been made of falling gilt yields pushing up pension liabilities and deficits. But the projected pension payments themselves are not linked to gilt yields and have remained very stable in recent years (if anything they have reduced with falls in life expectancy).
Quantitative easing and falls in yields mean that asset returns have been very strong, and if anything schemes are arguably better placed to meet these future pension payments than they were a few years ago.
Required return on assets
A simple and informative piece of analysis to run for your scheme is to work out the required return on the scheme assets (and future contributions) to pay all the future pension payments in full over time. Using this analysis, for many charities it will turn out that the required return is often surprisingly low, typically around 3% per annum. If you design an investment strategy to deliver this amount of return (but no more) with sufficient confidence, this will give you a framework for a "lower risk for longer" strategy.
Interestingly, if you take this approach, you can even conclude that you do not need to invest materially in gilts (or LDI - liability driven investments which address interest rate and inflation risks) because you are no longer concerned about hedging yield risk. By investing primarily in credit and illiquid asset classes where most of the return is stable income rather than volatile capital growth, you achieve confidence that future cashflows will be paid and avoid being a forced seller of assets at the wrong time. It can even reduce costs as the leverage to fund the LDI is no longer required.
Adopting this approach makes it increasingly important to get the projected cashflows right. Based on longevity data, it is reasonable to prescribe a 12 year range to life expectancy depending on individual member characteristics. This means it is possible to produce accurate pension projections and strip out hidden margins that exist with more approximate methods.
Running quarterly valuations
Technology has improved to the point where one can now run full valuations quarterly at the push of a button. This reduces costs, increases the speed of decision making (by over a year compared to traditional triennial pension valuations) and most importantly increases confidence. Keeping up to date with membership movements is particularly important now that more members are transferring out of their DB scheme to take advantage of their Freedom & Choice options.
KEEP UP WITH EMERGING DEVELOPMENTS. There are a range of emerging developments (some of which are specific to the charity sector) which you should keep on top of in order to understand the likely impact on your scheme. Some interesting opportunities to reduce cost and risk include:
MANAGING INCREASED PPF LEVIES FOR CHARITIES. The Pension Protection Fund has reviewed its methodology for setting the annual levy payable by all defined benefit schemes. This is expected to lead to an increase in PPF levies for some charities in 2018. The PPF ran analysis recently and the charity sector sector was one of the only ones where actual insolvency rates were higher than anticipated under their current model. It is addressing this with the new methodology, and a higher insolvency risk translates into a higher levy.
Reducing your PPF levy
In the meantime, planning for these higher costs and taking all the available steps to reduce levies is well worth doing.
DEFERRING SECTION 75 DEBTS. Many charities are "trapped’ in multi-employer schemes, unable to exit (or in some cases even turn off future DB accrual) for fear of triggering very substantial “Section 75” debt payments. A DWP consultation is now out which proposes the ability to defer payment of a Section 75 debt which is otherwise triggered when your last employee leaves a multi-employer scheme.
In practice this means you could carry on paying ongoing deficit contributions over time, rather than the large upfront Section 75 debt. Keep on top of this consultation and engage early with your multi-employer scheme when it comes into force. As well as the more obvious action of ceasing defined benefit accrual where this was otherwise not possible, it also frees up options for defined contribution (DC) pensions as you do not need to be tied to your multi-employer provider for DC for fear of triggering a DB Section 75 debt.
INCREASING FUTURE SERVICE COSTS. For charities which are still open to future accrual, future service contribution rates at the next triennial valuation are likely to be eye-wateringly expensive. Plan for this, and if appropriate, consider closing to future accrual to stop the defined benefit problem getting any bigger.
Easier ceasing accrual
Many of the sector’s multi-employer schemes, including the Universities Superannuation Scheme and the Social Housing Pension Scheme, have triennial valuations this year. Ceasing accrual may become more straightforward if deferring Section 75 debts becomes possible.
CHANGES FROM THE GREEN PAPER ON THE FUTURE OF DEFINED BENEFIT. It’s possible that the Green Paper on pensions published earlier this year could lead to some changes for DB schemes for charities. These are likely to be limited, and mainly apply in distressed situations, but it may be possible to reduce indexation or suspend pension increases if this saving enables the scheme to carry on and ensure a better chance of delivering all members pensions over time.
Scheme consolidation is also proposed, which could reduce running costs and provide access to asset classes that are otherwise not available for smaller schemes. These are all things to watch.
Ultimately, the opportunities are there for the taking - to plan for proactive charities to manage their scheme funding and investment more effectively; planning for their future and more importantly the futures of their members.
Regarding charities and pension provision I’m constantly reminded of the old joke about the man stopping and asking for directions in Ireland and being told, “Well sur, if you’re trying to get there I wouldn’t be wanting to start from here!” This feeling of being a bit lost, and not quite sure where to turn, is an all too consistent theme.
So in terms of developing a suitable pension strategy for the future what process should charity trustees be going through?
Understand your existing arrangements
When starting with a blank sheet of paper and planning a future pension strategy the position is always much simpler and indeed one of the first steps is really to try to understand where you would like to get to, even if it can sometimes take a while and many intermediate steps to actually get there.
However, for most charities there is a legacy to deal with. Many charities competed with the public sector for staff and there was historically a drive to provide pensions similar to those in the public sector, or where taking on outsourced public sector work there was a requirement to provide broadly comparable pension schemes.
Charities therefore tend to participate in defined benefit arrangements such as local government pension schemes or multi-employer schemes (such as those run by the Pensions Trust, ITB, Federated Flexiplan etc.). Some larger charities may well have established their own defined benefit scheme and/or be running defined contribution arrangements.
Defined benefit pension schemes have become much more expensive to offer. Higher administration costs, lower investment returns, low inflation and increasing longevity are the main contributors, and increasing deficits have put a strain on resources. Also, often defined contribution schemes offer a bewildering array of choice.
Most multi-employer defined benefit schemes are written on a "last man standing" basis which means that should any organisation fail, its shortfall would be distributed amongst the other participants. A large failure could have potentially catastrophic implications for some smaller charities.
It is therefore really important to first understand exactly what you have and the options available.
Understand the exit position
Defined benefit pension schemes are funded on the basis that they continue indefinitely with the cost of benefits paid over the working lifetime of the scheme member. The position should a charity wish to exit the scheme is significantly different as the costs of securing the benefits at that point will be considerable higher and frequently well in excess of the net asset value of the charity.
Many charities are therefore faced with Hobson’s choice in relation to their scheme – namely dealing with continually rising annual contributions or an unaffordable exit cost.
In addition the way pensions legislation is currently framed for these multi-employer schemes means that should an organisation run out of "active" members the debt will trigger regardless of its affordability, threatening the very existence of the charity and further impacting on the "last man standing debt" within the scheme. There are, however, steps that can be taken but the earlier the identification and engagement with the problem the better.
Understand the contractual position
Charities need to understand what promises have been made to staff and the risk that these place on the charity. These might not only be risks from within the pension scheme but also where contractual benefit promises have been made, particularly to senior employees.
Charities also need to understand that when providing benefits through a local government scheme they could be assuming responsibility for liabilities and costs related to an individual’s prior period of service and these can be very significant. I’ve seen examples where legacy liabilities prior to the formation of a charity accounted for 80% of the total and where charities incurred hundreds of thousands of pounds of "strain costs" for employees with only very limited service with the charity. It is worth understanding this and potentially contesting it with the fund.
Understand your accounting position
Pension liabilities are now much more transparent – accounting standard FRS17 has meant that charities running their own schemes are used to disclosing their liabilities. Most participants in local government pension schemes (LGPS) will also disclose and LGPS administrators have streamlined processes for providing these figures. In private sector multi-employer schemes most employers are unlikely to disclose, however with the introduction of FRS102 they are likely to have to in some form from 2016.
Charities also need to be aware of the impact these changed disclosures will have on their finances. Donors may have a concern that too much of their money is going to staff pensions and not to support their charitable objectives. Local government sponsors may prefer to fund charities without defined benefit pension liabilities as more money goes directly to the service. Service suppliers may require financial security before delegating to charities to provide services.
The accounting disclosure assumptions are the responsibility of the charity trustees and they should be adopting a basis which reflects their individual circumstances – so don’t just accept the status quo provided by the LGPS.
Beware of change
Pension schemes can frequently be a major obstacle, if not the most significant barrier, to a financial restructure such as a merger or incorporation, as the change of status of an organisation can trigger the exit debt. Charities should not look to restructure without having sought professional advice about their pension at a very early stage.
Implementation of auto-enrolment
Auto-enrolment will require employers to make contributions on behalf of their staff and charities need to be prepared for not only the financial impact but also any additional administrative burden.
Charities without a pension scheme will see themselves having to establish one whilst those with existing arrangements will need to consider how best to incorporate any necessary changes. Should charities already have a defined benefit pension scheme, but with a low staff take up, they could see a significant increase in costs and associated risks. Those with multiple schemes could find implementation complex.
Get a strategy
Ultimately charities need a strategy for their future pension provision which meets their human resources requirements, provides attractive benefits for staff and is affordable both now and in the future. The strategy may not deliver an "instant fix" but may need to be run over a period of time to arrive at a suitable long term solution.
There are undoubtedly solutions to the problems charities face but the issues need to be addressed head on.
With the introduction of new UK Generally Accepted Accounting Practice (UK GAAP), and subsequently, the introduction of Financial Reporting Standard 102 (which replaces Financial Reporting Standard 17 as the financial reporting standard in the UK and Ireland) charity employers should be considering the impact this may have on their P&L and balance sheet, and be noting some actions they can take to limit this impact.
The most significant change under the new UK GAAP for defined benefit pension schemes is in relation to non-segregated multi-employer arrangements where employers are unable to identify their share of the assets and liabilities in the scheme.
Under old UK GAAP (and hence FRS 17) there was an exemption that allowed employers in this position to account for their pension costs on a defined contribution basis, by recording the contributions paid to the scheme in the profit and loss account. No account had to be taken of any pension deficit which may have existed at that date.
Under new UK GAAP this is no longer an option and employers which were previously "exempt" under the old rules have two options:
- If it is possible to reasonably identify your share of the assets and liabilities in the scheme then you must produce a full FRS 102 disclosure.
- If it is not possible to identify your share of the assets and liabilities in the scheme then you must record the Net Present Value of your future deficit reduction contributions in your balance sheet. An allowance must also be made in the profit and loss account for the interest accruing on the deficit over the year.
So what does this mean for charity employers? Charity employers participating in non-segregated multi-employer pension schemes that previously used the exemption under old UK GAAP will now have to disclose a potentially significant balance sheet item in their accounts. The effect of this will depend largely on the size of the pension scheme deficit in relation to the net current assets of the entity as a whole. In many cases however this is likely to be significant, as follows:
- Reduction in net assets – potentially moving to a ‘net current liability’ position.
- May impact on the ability to obtain new funds for charities if the future of the charity seems "unviable".
- May be an impact on the PPF levy payable by employers if insolvency ratings rise.
- Could potentially lead to insolvency.
From an overall perspective, these changes will lead to clearer disclosure across organisations with those disclosing under the exemption in the old rules now being on a level playing field with all other organisations. It will also lead to greater consistency within organisational groups, where entities within the group were both exempt and non-exempt under the old rules.
However, there may still be some cases where groups have inconsistencies – for example where there are employers accounting under the full disclosure method and NPV method within the same group.
What should you do if you are a charity employer? Understanding your position and understanding the potential impact are key. If you are a "small entity" you have the option of deferring this change to 1 January 2017 as the accounting standard for small entities will still reference the old UK GAAP until this date when it is then expected to be revised. For charity employers affected, it is about limiting the impact as much as possible. If such a charity employer you can do the following:
- Ensure the assumptions used to value your liabilities reflect your "best estimate" of the future taking into account your own charity's future business plans. Consider especially the salary increase assumption, which can often be overstated in "standard" assumptions. It is ultimately the responsibility of the trustees/directors of the charity to set the assumptions – ensure they reflect your future plans.
- Develop a strategy for managing your liabilities going forward. Further accrual is likely to result in a larger, more volatile deficit over time and hence a more volatile balance sheet position. There are ways to reduce your deficit and the volatility of your deficit over time, such as: liability management exercises; ceasing future accrual; limiting the membership; exiting the scheme.
The changes to UK GAAP are most likely to affect charities participating in large non-segregated schemes such as the Pension Trust arrangements (SHPS, SHAPS, Growth Plan, SVSPS etc) and any employers participating in the Universities Superannuation Scheme, and any other non-segregated arrangements.
The Charity Commission requires that any charities showing a "net current liability" position in the annual accounts explain the risks attached – this will include pension risks and it is important therefore that charities have a strategy in place for managing these risks.
Charity employers should also understand the non-pension aspects of FRS 102 as there are many other changes coming into force that may improve, or worsen, your balance sheet position. For example, one charity early adopted FRS 102 - despite it adding £20m to its balance sheet – as the revaluation of its fixed assets under FRS 102 more than offset this increase.
It is recommended that all charity employers engage with the necessary advisers to understand their obligations, the potential impact of these and any possible mitigation to ensure there are no surprises when the new rules come into force.
The one dimensional approach being forced upon local government pension schemes by impractical and outdated regulation is placing the existence of many charities participating in their schemes at serious financial risk. Charities are trapped in schemes they were often encouraged to join with no warning about the risk they were taking. They are now often left in the position where they can’t afford to continue to fund benefits in the schemes but equally cannot afford to get out of them.
The current regulatory framework requires that should an admitted body exit the scheme either by running out of active participants or by formally looking to leave the scheme then the fund must have its actuary calculate a cessation amount which the employer must pay.
This amount is typically calculated on a very low risk "gilts basis", similar to an insurance company buyout cost, which looks to make sure that the remaining employers, and indeed the taxpayer, are protected from the risk of picking up future liabilities for those employers who leave. It is however becoming increasingly recognised that the basis for this calculation is excessive in relation to LGPS. Why is this?
Excessive cessation calculations
The first point is that unlike private sector schemes LGPS are not going to be in a position where they will be looking to wind up and secure annuities in the market. So valuing an exit on a similar basis to a buyout is therefore excessively prudent and not reflecting reality.
Ultimately funds do not know how much the payment of future benefits will cost but they persist in suggesting that they do and this is the gilts based cost – it is not!! I totally understand that there is a requirement for prudence, however the basis currently adopted is excessive and needs to be revised.
The assumptions adopted by the actuary for the cessation debt calculations are very prudent. As such, and ignoring changes in market conditions, over time you would expect the buyout deficit to fall as actual experience is more favourable than that assumed.
The cessation deficit is calculated based upon the economic assumptions at the point of exit. Future conditions could be very different and while I recognise they could deteriorate further over the longer term, on the balance of probabilities, you would expect that at some point interest rates might increase with a commensurate reduction in liabilities. Those settling the exit debt on a gilts basis will derive no benefit from this.
In addition often exiting employers have little control over the timing of their exit which makes all this more unfair.
The application of a gilts basis on exit is for the most part a one way street in favour of the funds. The calculation is derived using the scheme membership at the point of exit. This ignores the fact that once closed to future accrual, this membership will change over time and always to the advantage of the fund. People will die, transfer out or draw benefits early or in different formats than expected, and none of this will be taken in to account once a settlement figure is imposed.
A very recent example I witnessed was that of a small charity which was being pressed to pay a cessation debt of just over £1m and over the period a senior member of staff accounting for around 50% of the liabilities unfortunately died. Had the debt been settled there would have been a windfall of around £250,000 to the fund.
Private sector solution
Private sector segregated and standalone schemes recognise this and allow employers flexibility to address this by allowing them to fund on an ongoing basis, initially until they decide they actually want to trigger their cessation debt. Payment on this basis allows the liabilities to unwind over a period of time.
The issue doesn’t just impact now on exit as many funds look to apply this gilts basis for employers where they have a limited period to go until the last member retires or where the membership numbers are particularly low. However, this is a sledgehammer to crack a nut.
Another charity I’ve been dealing with have seen their deficit increase 20-fold as a result of this change which has seen two members of staff in their 30s compulsorily moved to investing in gilts for a further 30 years. This just can’t make any sense. The fund has absolutely no idea how much these individuals benefits will cost in 30 years time.
To add to all this for many charities in this position the introduction of FRS102 is also hugely problematic. This is because the net present value of their deficit contributions effectively means that they are adding cessation liabilities to their balance sheet, which again impacts on their ability to compete for contracts and grants and/or encourage donations which again impacts on their solvency.
If organisations are forced to continue to accrue liabilities beyond the level which is affordable to them, as historically they have been, a day of reckoning awaits. The starting point must be that this can’t make sense for anyone, not the admitted body, other employers, scheme members or the tax payer. By forcing these employers to pay contributions on a three or four times multiple over a short period, they are placed at risk of insolvency, and if they do become insolvent then the funds will have very little chance of recovery. This also can’t make any sense.
A fundamental issue is also missed in all this. Should organisations be allowed to close to future accrual without automatically triggering a cessation debt the liabilities pre and post this event are effectively the same. On this basis I find it hard to understand the funds' calls for additional security to allow this to happen. This is especially when the risk to the fund is actually reduced as no further accrual is possible and all contributions can therefore be directed to reducing the deficit for the liabilities already built up, rather than funding for further future liabilities.
Frustratingly many funds also continue to deny the issue of inherited liabilities. It is totally inequitable to expect a small charity to pick up a cessation liability for benefits they previously inherited from a public sector body on an ongoing basis, or even in many cases a funding basis well below this.
Public sector ownership
One fund has sensibly identified this and looked to deal with it fairly and I can only hope that all others will follow suit. Indeed these liabilities should just be reallocated to public sector ownership which means that the fund has them guaranteed with no cessation debt requiring to be paid.
Many of the approaches adopted have been knee-jerk and not fully consulted upon and I believe that a totally independent root and branch review of the operation of local government pension schemes in relation to admitted bodies is required and the findings should drive reform of the regulation. With the Scheme Advisory Boards (SABs) in place and a review underway in England and Wales II can only hope that a revised approach is imminent.
Following on from the new Code of Practice 3 on Funding Defined Benefit Schemes the Pensions Regulator (TPR) has now issued much more extensive guidance on how to assess and monitor the employer covenant. The guidance has been structured in a straightforward way and TPR recommends that all trustees should as a minimum read the "At a glance" summary. Employers should do the same.
Importantly, for the first time there is charity-specific advice (and for other not for profit employers) in the new guidance. This has been welcomed by many, including the national representative body for workplace pensions, and with good reason.
There are also a number of case studies throughout, and some key points to consider when deciding on the extent and/or frequency of any review. These will be helpful to many charity employers and trustee groups as they wrestle with the difficulty of applying standards and assessments which are really designed for commercial enterprises and trustees of schemes which are sponsored and supported by them.
The guidance builds on the key message from the new Code of Practice focusing on the three key risk areas for defined benefit schemes - employer covenant, investment and funding – and how they interact. So, for instance, how might a change by trustees to the investment strategy affect the funding of the scheme and the employer's covenant.
TPR encourages trustees and employers, and the relevant advisers to work together but identifies the following key areas in any covenant assessment:
- Legal – what is the nature of the employer's obligations to the scheme and their enforceability.
- Scheme related - the funding needs of the scheme both now and in the future.
- Financial – the ability of the employer to contribute cash when required.
The annex dedicated to charities/NFPs states that the absence of a profit motive does not change how the employer covenant should be assessed, but the nature of some NFPs’ activities and financing arrangements means some elements of the guidance may apply differently. Two examples considered in the guidance are as follows:
- The proportion of a charity's income that comes from donations, for example, i.e. to what extent is the charity reliant on donations, compared to public funding or contracts, or funds raised through retail activities, etc.?
- Restricted funds are also a consideration outlined in the guidance. It encourages scheme trustees to check what restrictions actually apply and so establish whether the restricted funds are "off limits", and not simply take the charity's word that such funds are out of reach to the scheme.
Until now the Regulator's approach on monitoring the employer covenant has, with some justification, been classified by many as "on size fits all" and inflexible. In addition the Regulator's new "sustainable growth" objective, doesn't precisely fit the charity/NFP framework very well so the change of tack is to be applauded.
One therefore welcomes the engagement by the Pensions Regulator with the NFP sector, the Charity Commission and others, and acknowledge that this is a real and tangible shift, which should help scheme trustees and employers understand what is involved in assessing and monitoring an employer covenant.
What has not changed is the need for scheme trustees to take into account the different covenants for different participating employers. It is therefore vital that trustees are clear concerning:
- Which employers have a legal obligation to the scheme.
- The extent of that obligation.
- The strength of that covenant, e.g. the covenant of an employer which is the operator of a number of retail outlets for a charity is likely to have a very different covenant from that of the main charity or even its main funding raising operation, etc.
Of course the new funding code now recognises the need for employers (of all types) to be able to continue to invest in the business. However trustees will then need to assess whether those investment plans will restrict the funds that might otherwise be available to the scheme and, if so, how the scheme might benefit from supporting investment in the business.
So the guidance, along with the revised Code of Practice, if used and applied consistently and appropriately, should be helpful - particularly the emphasis on the need for any covenant assessment to be "proportionate to the circumstances of the scheme and the employer".
However, there are also warnings that "the covenant can change quickly" so trustees should have "well-developed contingency plans so they can take decisive action if and when required".
Again quite how this will be applied in the NFP sector is open to some debate. What seems beyond doubt is trustees will have to ensure that the process which they have in place for assessing and monitoring the employer covenant is fit for purpose – what information; how often; what procedures are in place to identify material changes, etc.
So where might this all lead?
Well there are a number of issues to consider for scheme trustees and employers:
- Do trustees have sufficient knowledge to assess the covenant of the different employers? If not then some form of external review may be needed from time to time.
- Are trustees given all of the information they need when they need it?
- Do the trustees and the employers have an agreed strategy for funding the scheme, taking into account of all the risks that are faced, including investment risk, which is often (but not always) the most significant risk?
- Are mechanisms in place to ensure that funding arrangements are capable of adjustment to protect the scheme from downside risks and to ensure that a scheme will receive benefit if the sponsor's financial position improves?
The employer covenant is always considered at the time of an actuarial valuation but the guidance is clearly underlining the need for trustees to make sure that they consider this on an ongoing basis. Of course this is what should have been happening and many trustees will have put in place arrangements, sometimes accompanied by non-disclosure agreements, by which the employer agrees to provide financial information (say every quarter); and to consult with scheme trustees before any significant financial changes are made, etc.
This seems bound to raise the issue of contingent assets again – something which may provide some charities with some breathing space if materially higher scheme contributions are unrealistic.
It is to be hoped that scheme trustees and charities take a constructive and holistic approach to scheme funding and security of benefits. In the light of the continued turbulence in financial markets and the lack of any "helpful" move in gilt yields, all options need to be on the table, and taking a joined up approach to funding, covenant and investment strategy is now essential if scheme and employers are to stand the best chance of addressing what for many is a significant and long term funding shortfall.
One has already noticed a recognition that markets are unlikely to provide any relief in the foreseeable future. The reaction has been different, of course – some have decided to change investment strategy, recognising that those risks need to be more actively managed, others are exploring use of contingent assets, and so on – but the fundamental conclusion is often the same – doing nothing is no longer a viable or appropriate option.
So the guidance, overall, presents a much clearer picture of what is likely to be needed in assessing the employer covenant. It remains to be seen, however, whether it makes the task any easier. The first task may be take stock, including which employers have legally enforceable obligations. And all of this has to take account of each scheme's own circumstances, i.e. the extent to which a scheme is reliant on the employer covenant – so a well funded scheme may be able to have a less stringent process than one which is heavily reliant on substantial future contributions from the employers.
It hasn’t been a great time for defined benefit pensions in the sector despite some early optimism, and many charities remain at considerable risk from their defined benefit pension scheme.
Concern over the Chinese economy has dented investment returns and continuing low gilt yields have seen scheme deficits remain at high and in many cases increasingly high levels, despite often significant increases in contributions. An increase in interest rates might have helped reduce the value of liabilities but we haven’t seen this happen in 2015, and it’s difficult to see the position improving dramatically over the short to medium term.
The difficulty that this presents is that the longer these economic conditions exist the more organisations have to deal with new actuarial valuations and the likely increases in contributions. This over-arching issue affects standalone schemes and multi-employer defined benefit schemes (MEDBS) in much the same way.
New state pension
The move to a single state pension should bring simplicity and hopefully make it much easier for individuals to target the likely pension income they will need in retirement. The change will however mean that from April 2016, employers in contracted out schemes (e.g. local government pension schemes) will lose their 3.4% of band earnings NI reduction and employees will lose their 1.4% reduction. So employers need to be budgeting to pay around £20,000 per annum extra for each £1m of pensionable salary.
Limiting accrual and risk
Not surprisingly many charities with stand alone schemes have looked to limit the impact of further accrual by closing their scheme to new entrants, while many are closing them to all future accrual. However, even then the cost implications are not always that simple to manage.
The living wage
In addition the Chancellor’s recent proposals to increase the living wage could well have implications for charities in defined benefit arrangements as if salaries increase at a rate above that, liabilities, deficits and contributions are ultimately likely to increase as a result.
Charities participating in MEDBS will have to deal with the above issues as well as a number of others. Most charities have identified the risk that DB pension schemes pose to their charities but find that they’re having to try to deal with the issue with one hand (and possibly a leg!!) tied behind their backs. These can be split into two categories, as while the issues are similar they are not identical:
Private sector multi-schemes
In private sector multi-employer defined benefit schemes the Section 75 legislation requires that should an employer cease to have active members in the scheme while other employers are continuing to accrue then they automatically trigger a S.75 debt. Clearly there is a risk of this happening inadvertently!
The debt calculated would be much higher than that calculated on an accounting or funding basis which leaves charities with an unpalatable choice – trigger a debt they can’t afford or keep funding for more liabilities which they are unlikely to be able to afford in the future.
The issue has been around a long time. The longer it’s left, the worse things are likely to become with signs that we are already reaching crunch time for many charities. The limitation of the legislation has led charities and their advisers to seek ever more complex work to attempt to deal with the issues when only reform of the legislation will really fully address them.
While it is going to be hard to achieve change because of so many vested interests, it would eventually lead to a positive impact on charity employers and their schemes. They could then get on top of liabilities and reduce further exposure – these schemes are not looking for special treatment or exemptions; they simply want to see reform.
While justifiable for associated employers, the legislation is frequently at odds with the interests of sponsoring employers, members and indeed the schemes themselves. It is also totally inconsistent with the flexible approach adopted by standalone and segmented schemes, as well as unfunded public sector schemes, where organisations can leave without there being any cessation debt payable.
Early in 2015 the DWP called for evidence to look to consider options, however, reporting back was a bit hamstrung as the likely timetable straddled a general election and ultimately a change of government and Pension Minister. It does however look like an output will be forthcoming over the coming weeks.
Local government schemes
For many charities participating in local government pension schemes the issues have been brought dramatically to a head following 2013 and 2014 actuarial valuations. Many LGPS have chosen to highlight employers where they believe there is a substantial risk of triggering a cessation debt, namely those with a small number of members or with staff who are very close to retiring. Some funds have chosen to move these employers to a low risk "gilts basis" which for some has resulted in very significant contribution increases, with some 4-5 times their previous level.
So for employers who had been effectively managing their participation these dramatically increased contributions have changed their outlook and pressured their finances. Funds unfortunately have provided participants with little flexibility, and through taking a decision to pull forward higher contributions have effectively created contribution, accounting and solvency issues for many charities.
Thankfully there is some recognition of the issues faced as the Department for Communities and Local Government called for evidence earlier this year and a recent report published by PWC has raised hopes that there could finally be some light at the end of the tunnel.
The PWC report was commissioned by the Shadow Scheme Advisory Board as part of its deficit management project kicked off in summer 2014. The Board was established to encourage best practice, increase transparency and coordinate technical and standards issues for LGPS as well as providing recommendations to government for future regulation.
Some key recommendations in the PWC report which will be of specific interest for admitted bodies are:
- More flexibility on when exit debts are triggered. The proposals suggest that debts would not be automatically triggered by the exit of the last member. The paper recognises that some minor changes to regulation will be required.
- Establishing a maximum level of prudence when calculating exit payments. Currently schemes tend to use a gilts basis to calculate the exit cost despite schemes not investing assets in this way. This effectively means that employers paying a cessation are cross funding other employers who remain. This is recognised as inequitable and is also a discouraging factor for charities wishing to look at an exit. This proposal would effectively reduce cessation debts for those looking to exit the scheme, for many to a point which may be affordable.
- Flexible exit arrangements. These could include continuing to pay contributions on an ongoing basis for a prescribed period and for employers to pay their cessation debts over a much longer period. This would offer welcome flexibility for many small employers.
- Employer exit on weaker terms. It is recognised that in some circumstances it could be in the interests of the fund, the remaining employers and the admitted body to allow them to exit on weaker terms and small charities are cited specifically as an example.
These items certainly reflect much of the commentary supplied by charity representative bodies, charity advisers and charities themselves. The paper hadn’t addressed the issues many charities face from transition of prior local government liabilities but a number of funds look to be addressing this issue directly which is encouraging.
Accounting changes will impact
As if all this wasn’t enough, most charities in MEDBS will also have to deal with the introduction of FRS 102. Many LGPS employers already comply with FRS 17; however, most employers in private sector MEDBS will have utilised an exemption which allowed them to disclose as if the scheme was a defined contribution arrangement and only note contributions. For many charities in MEDBS this has meant that they haven’t needed to incorporate deficits directly in their balance sheets.
This will now change as employers will either have to disclose under FRS 102 or place the net present value of their deficit contributions on balance sheet. This will make pension deficits much more visible in charity accounts, potentially impact on fundraising and even in some cases require charities to manage negative balance sheets.
One positive on the horizon is that the new freedoms and flexibilities available in pensions is likely to encourage some staff to transfer out of these defined benefit schemes into a defined contribution environment which could improve the position of the schemes they leave behind. At this stage early in the new legislation it is difficult to quantify the likely impact.
For future pension success
Whatever position charities are in they need to address these issues head on and look to deal with them as options do exist. Charity trustees should look to develop a pension strategy which specifically takes into account the objectives and constraints they are faced with.
"The debt calculated would be much higher than that calculated on an accounting or funding basis which leaves charities with an unpalatable choice..."
"This will make pension deficits much more visible on charity accounts, potentially impact on fundraising and even in some cases require charities to manage negative balance sheets."