November 17, 2018

Defined-benefit pension fund deficits: Who is responsible and who pays for them?

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Following the recent collapse of the UK department store British Home Stores (BHS), this topic is again in the media spotlight.

Under these schemes, also known as ‘final salary pension schemes’, employee members are entitled to particular benefit levels, predetermined by a formula linking the employee’s salary history, age, length of service and final salary at retirement. Scheme managers need to ensure that the contributions from both employer and employee are sufficient to provide the pension benefit.

A defined-benefit pension scheme conducts a formal actuarial valuation of its scheme every three years with an informal funding update often prepared in each of the intervening years. The triennial valuations compare the asset and liability position, from which the actuary recommends the required contribution rate.
Pension fund assets are calculated using their market value at the valuation date. A fund’s liabilities are the amount it has to pay out in benefits to all members and their beneficiaries, calculated by analyses of member data (including demographic assumptions about when members retire, how long they live and whether they leave dependants).

If the scheme’s assets are insufficient to meet its liabilities, its trustees should consult with the company and prepare a recovery plan to address the shortfall as quickly as possible.

With many major UK defined-benefit schemes suspected to be heavily in deficit (owing to successive years of near-zero interest rates, low gilt yields and volatile financial markets), companies are under increasing pressure from regulators, unions, workers and the media to address their current funding gaps.

The Pensions Regulator (TPR) studies pension funds’ triennial valuations and can require any employer whose fund is in deficit to take action to rectify the situation. The employer and pension scheme trustee have to agree a recovery plan setting out the steps to be taken to put things right. For many companies this is likely to have a substantial, probably very painful, impact on cash flow.

So pension schemes need to monitor their financial health and take action if necessary. TPR encourages schemes to manage risk, and ‘triggers’ are one method of doing so. The aim of the ‘triggers’ is to prompt a trustee review of funding strategy as certain pre-agreed levels are breached. Pension schemes with ‘triggers’ are typically faster to respond to a volatile funding environment.

Despite this, many funds remain hugely underfunded. What happens if they cannot find a way out of their difficulties and collapse? The Pension Protection Fund (PPF) was established to pay compensation to members of eligible defined-benefit pension schemes in the case of a qualifying insolvency event in relation to the employer and where there are insufficient assets in the pension scheme. It is funded by a levy on eligible defined-benefit pension funds, and these levies pay for any required bailouts. It is a government-sponsored ‘lifeboat’ that rescues schemes if their corporate sponsors fail.

A list of pension funds already transferred to the PPF can be found here.

So, are taxpayers on the hook for the alleged ‘hole’ in BHS’s pension scheme? Only if the PPF itself failed might taxpayers be left with the bill.

How do companies account for these types of schemes? In essence, any surplus or deficit in the plan is calculated as the difference between the fair value of the plan’s assets and the defined benefit obligations and is recorded on the balance sheet as a net liability or asset.

Ongoing financial market volatility, the recent reduction in interest rates to 0.25% and continued uncertainty surrounding the impact of Brexit will make it problematical to establish a scheme’s true and fair valuation and, if there is a net liability, the exact extent of it.

Many questions arise:

  • What is the extent of underfunding throughout the UK?
  • How many companies and organisations have underfunded schemes or, indeed, actually know if their schemes are underfunded?
  • Could many face bankruptcy trying to fund a deficit?
  • How does the accounting profession grapple with how to disclose/report on/advise on/audit these schemes?

As turbulent economic times continue, answers to these questions must unfold.

 

 

Colin Garvie, Teaching Fellow About Colin Garvie, Teaching Fellow

Teaching Fellow and Chartered Accountant, delivers Accounting to on-campus students in Edinburgh, Malaysia and Dubai.