Employee Benefits Review, November 2006

Is the current drive to liability-driven investment exacerbating pension deficits? In this issue of Employee Benefits Review, we examine this important trend and a range of other topical issues, as well as introducing a new flexible benefits solution.

The increasing use of liability-driven investment has led to a greater use of bonds and gilts as a means to balance pension deficits. Peter Maher warns this could be a misguided strategy.

In its interpretation of The Pensions Act 2004, the Pensions Regulator has suggested that employers and trustees of pension schemes in deficit should organise a ten-year recovery programme. Not only is this a short timeframe for pension schemes, but the drive to match assets with liabilities means mitigation is almost impossible without significant cash injections.

Bonds and gilts typically yield a lower return than equities over the longer term. As a result, liability-matching investment is fuelling the deficit. Whilst bonds and gilts tend to be less volatile than equities, UK pension schemes are paying the price of this short-termism.

The UK has benefited from successful pensions practice for more than a century, which has been largely founded on the gradual long-term rise in equities and the consequent mismatch between assets and liabilities. Any fund manager will tell you that equities outperform bonds over the long-term. Whilst there have been periods when the performance of pension scheme assets has not matched liabilities, imbalances tend to right themselves over time.

Pensions are essentially long-term investments. People are living longer, and this means that pension schemes are having to fund beneficiaries over a longer period.

The Pensions Regulator estimates that British companies would have to pay an extra £130 billion into their pension schemes to eradicate their deficits. According to the Office of National Statistics, a total of £13.2 billion was paid in by employers during the second quarter of 2006.

Rather than a company pouring money into a pension scheme – which reduces the amount that it can invest in the business – trustees might consider employing an independent auditor to assess the financial covenant of the sponsoring employer. If an employer can ultimately ‘underwrite’ the pension scheme, why spend money matching assets with liabilities?

The cost of running a pension scheme is based on underlying assumptions. For gilt or bond returns this might be 4.25% pa, whereas for equity returns it might be 6.25% pa, giving an immediate reduction in the funding requirement. Pension funds need reliable cashflows, so a sensible strategy would be to cover off likely cashflow requirements for the next five to ten years using gilts and bonds, assuming a more aggressive equity-driven approach with the balance of funds.

Other strategies that pension scheme trustees may consider include leveraged buy-out bonds. These enable employers to crystallise the full buy-out liability of the scheme by transferring all of its assets to an insurance company that will secure deferred annuities for scheme members, whilst granting a loan to the employer for the full buy-out deficit.

Additionally, the funding deficit can be insured (either full buy-out or FRS 17), so that an insurance company extinguishes the debt upon the principal employer going into liquidation or other notifiable events. This approach is finding great favour in the mergers and aquisitions market.

Structured investment products can also be used. For example, trustees could invest 80% of the scheme assets in AA-rated bonds, with the remaining 20% used to buy call options on, say, the FTSE-100 total return index for ten years. This time horizon enables long-term exposure to equities whilst protecting the downside.

Trustees need to use some common sense for the benefit of the longevity of pension schemes. In this way, employers may not see schemes as a millstone around the company’s neck and may instead start to view them as a means of attracting and retaining staff – by any standards a novel and worthy ideal! Any financially sound employer should be able to manage its pension deficit. A measured approach combining a number of strategies should help.

Protecting your business against the death or illness of a key employee, partner or shareholder – ignore at your peril, says Matt Haswell.

Failure to protect your company, fellow shareholders or partners and key staff could have disastrous consequences in the event that one of them dies prematurely or becomes ill and can no longer work. Serious illnesses can require lengthy periods of treatment or convalescence. You can’t prevent the unexpected from happening but, with planning, you can reduce its impact on you, your business and your profits. A wide range of insurance contracts are available to cushion the blow if the worst happens. Broadly, there are three main kinds of business protection.

The death or illness of a shareholding director could have a serious impact on the future of a business, its profitability and on the director’s family.

Majority shareholders may have important voting rights that directly affect the running of the company. In the event of a majority shareholder’s death, these rights would normally pass to the deceased’s dependants.

The dependants now have the right to a say in the running of the company. But do they have the necessary experience? They may have very different objectives for the business to the surviving shareholders and may even want to take the business in a different direction.

If they would prefer to receive the value of their shares in cash, who will buy them? Unless the remaining shareholders have sufficient liquid capital, they may be sold to a possibly hostile third party, perhaps even a competitor.

The provision of funds through an insurance contract on the death or disability of a business owner/partner to enable the coowners to purchase their interest in the business or compensate the business owner or their family.

A partnership may have debts that are repayable on the death or critical illness of a partner, which may include a proportion or all of a bank overdraft, hire purchase agreement, bank loan or a partner’s capital account.

A suitably structured partnership protection strategy would ensure that the business remains in the control of the active partners whilst, at the same time, greatly assisting the deceased partner’s dependants.

The basis for this type of strategy is for each partner to effect a life assurance policy on their own life and for the policy to be placed into a specially designed partnership trust arrangement in favour of the remaining partners. In the event of the partner’s death the policy proceeds would immediately be made available to the trust’s beneficiaries.

All businesses have key people whose particular skills, knowledge, leadership or experience contribute to continued financial success. They may be a partner, chairman, managing director, IT specialist or a sales director with irreplaceable contacts and relationships. The death or disability of any of them could threaten your company’s profitability. Indeed, its very survival could be at stake.

A key person insurance contract provides funds on the death or disability of a key person in order to repay debt, replace lost business income or pay for recruitment or temporary staff.

When arranging cover to protect businesses against such eventualities, great care must be taken in selecting a suitable product and a suitable provider so that:

• competitive premiums are secured
• cover is arranged with the minimum of underwriting
• tax efficiency is maintained
• the policy is written on the correct basis with suitable trust documentation.

More companies than ever are recognising that their most valuable assets are their people. The key questions are: how do you attract good employees, and how do you keep them?

The answers are simple: motivation and reward. But how do you offer more financial value to employees and how do you manage it? That’s where Smith & Williamson Flexible Solutions can help.

Smith & Williamson Flexible Solutions opens up a whole world of solutions and options for your employees, from total reward statements, flexible benefits and pensions communication to voluntary benefits and financial advice.

Taking the pain out of HR

And it makes things easy for HR too. A powerful absence and holiday management application is included, and payroll and HR systems can be integrated. Employee data records and benefits information can all be accessed instantly.

As a leading edge company we only deal with leading edge partners, particularly in systems and technology. We lead in innovation, research and design, and need the same qualities from our IT providers to deliver security, reliability and flexibility.

Which is why our infrastructure is supported by a range of world class technology partners, including Oracle, Weblogic and Sun Enterprise.

When it comes to protection and resilience, it doesn’t get much better. Working with these technologies means we can connect your employees, enterprise applications, market data and financial product providers securely, simply and effectively.

If you want to run a comprehensive benefits package with a fully integrated HR platform, look no further than Smith & Williamson Flexible Solutions.

New technologies behind Total Reward Statements present opportunities to streamline HR processes and revolutionise a company’s approach to employee benefits says Chris Murray.

For finance directors, it can be difficult to view HR departments as anything other than an expense – but it doesn’t have to be that way.

Total Reward Statements (TRS) are an increasingly popular way of crystallising the employment costs of individuals – whether cash, benefits in kind, pensions or even training – and allow employees to be presented with a breakdown of the cost of their benefits.

This information can improve employees’ perceptions of their package and of their employer. This may be a worthwhile end in itself – after all, a happy employee is more likely to stay with a company – but the IT solutions used to produce TRS present wider opportunities for companies. One of these is to actively manage employee absence.

For many businesses, the cost of lost days through absenteeism can be alarming. Yet detailed analysis can pay dividends in this area, and means that HR teams can really contribute to the bottom line.

Companies which introduce absence management systems see worthwhile cost savings. They can identify causes of absence, monitor sickness trends and develop strategies to manage the situation.

This kind of system is only the beginning. To give employees a degree of choice over their benefits, the same TRS data can be used to implement flexible benefits programmes.

With a link to the payroll, salary-related benefits can be calculated by reference to current salary. This can facilitate salary sacrifice arrangements, which allow both employee and employer to gain through substantial savings in National Insurance contributions.

Many SMEs don’t operate a single electronic system for HR, payroll, pension records, and absence records. However, it’s now possible to install a modular package that can fulfil some or all of these functions, which can interface with or fully replace existing systems. System security is ensured with the same standard of data encryption used by online banks.

In a networked environment, many services can be incorporated, such as holiday entitlement, discount clubs, financial information and links to key sites. Services can be designed to tie in with the company brand and link with (or even become) an intranet.

A well designed and communicated interface between you and your employees can revolutionise the way that information flows through your company. Ultimately, this can become a suite of benefits and services to enhance your reputation amongst your employees, and also amongst those who aspire to join a company that understands its peoples’ needs.

For any company planning a merger or acquisition, regulations covering defined benefit schemes are an important consideration advises Ian Bulman.

The number of defined benefit pension schemes in the UK has diminished rapidly over the last few years. But there are still several thousand schemes funded by sponsoring employers at uncomfortably high rates.

Extraordinary rates of funding are required because so many pension schemes have assets that simply fall short of their liabilities.

The deficit for defined benefit pension schemes run by FTSE100 companies is believed to be around £60 billion (source: ABC Money, April 2006). Which begs the question: how large is the deficit as a whole? The answer is likely to be a scary one.

Large deficits can be deal breakers in corporate mergers and acquisitions, and the regulations introduced in July 2003 and The Pensions Act 2004 don’t (at first glance) appear very helpful to companies going through such transactions.

The regulations are designed to ensure that members who retire from schemes receive a pension that fulfils what they were promised, and also to make sure that companies don’t shirk the responsibilities of the schemes they established.

Regulations to protect member’s rights include the following key points, amongst others:

• a deficit recovery plan must be agreed between the company and the trustees and submitted to The Pensions Regulator (TPR)

• requirements for pension scheme trustees, their advisers and companies to report to TPR

• the need to recognise and mitigate the risk of a moral hazard, where an employer manipulates affairs to shift their fund deficits to the Pension Protection Fund (PPF).

With regard to moral hazard, it’s clear that the regulations aim to make corporate manoeuvring around under-funded schemes a thing of the past.

For example, if a company withdraws from a multi-employer scheme, its share of the overall fund deficit must be calculated and actions taken to pay the shortfall.

And, because of the reporting requirements, an agreement to withdraw from any pension scheme must be obtained from TPR. So, for instance, if a company group is acquired during a merger, this may have serious implications for everyone concerned in the transaction.

Beyond the three key points mentioned, the regulations are far reaching. So much so that TPR has issued in-depth guidance on withdrawals from multi-employer schemes, and clearance from TPR prior to a merger or acquisition is likely to be required.

Failure to notify TPR can have significant consequences. It has powers to unravel a transaction where the rights of scheme members have been put at risk, or where TPR believes an employer is deliberately attempting to avoid their pension obligations.

For example, if there is a deliberate attempt to avoid a statutory debt, TPR can impose a contribution notice or, in the case of an under-funded scheme, it can stipulate financial support, both of which require a company to provide additional funding to the scheme.

The effect of Financial Reporting Standard 17 (FRS 17), which sets out the treatment of pensions benefits in a company’s statutory accounts, also needs to be considered.

FRS 17 generally involves a valuation of a pension scheme’s assets and liabilities with reference to the current market. This can have a direct effect upon your balance sheet and consequent reduction in dividend payments, so you can appreciate the need to take expert advice.

Good, timely advice can help everyone achieve a reasonable outcome. We know that TPR will, where circumstances allow, accept some compromise to resolve a matter, because their principal aim is to prevent problems developing.

Companies will also need to consider whether a transaction is affected by the recently revised Transfer of Undertakings (Protection of Employment) Regulations 2006. These can impose legal obligations on a new employer when a business is taken over as part of a merger or transfer.

Contractual rights and promises also need to be thought about, including compliance with other relevant pension legislation, which can entail numerous questions.

But it’s not all doom and gloom. Taking good counsel is key, and it’s generally the case that once a problem is recognised, it is surmountable. The trick is to recognise a potential problem early in the negotiation process of a transaction.

Where those concerned are clear on their responsibilities and take sound advice, pension schemes needn’t be deal breakers.

The eagerly awaited White Paper, ‘Security in Retirement’, on the reform of the UK pensions system was published earlier this year.

Whilst the Government denies that there is currently a ‘pensions crisis’, it accepts that continuing with the present system of State pension provision is not an option if a crisis is to be avoided in the longer term. The proportion of pensioners to total working age population is currently 27%, but is projected to rise to 47% by 2050 and, although total net wealth has increased by around 60% in real terms since 1997, the number of people saving for retirement is steadily declining.

Furthermore, the Government says that only around 30% of women (as compared to 85% of men) currently receive a full Basic State Pension (BSP), and the number of pensioners reliant on means-tested benefits will continue to increase unless something is done to increase the level of BSP and the minimum income guarantee.

The White Paper seeks to address these concerns by:

• establishing a scheme of ‘personal accounts’ in 2012 to provide low-cost, high-quality pension provision for workers, non-workers and the self-employed

• reforming the BSP, most notably by reinstating the link with earnings for the BSP and the guarantee credit (by 2012 ‘subject to affordability’), by reducing the number of years needed to qualify for a full BSP to 30, and by designing a system of credits for carers of children and the disabled

• gradually raising the State pension age in line with increasing longevity from 65 (which will apply to all men and women by 2020) to 68 (by 2044/2045)

• abolishing contracting-out for defined contribution schemes by 2012 and legislating to allow schemes to convert guaranteed minimum pensions into scheme benefits

• piloting a Pensions Law Rewrite Project in line with the Government’s ‘rolling deregulatory review’ of pensions regulation.

The consultation period for comments on the White Paper closed on 11 September 2006 and the Government intends to bring forward legislation during the second session of the current Parliament. The full White Paper (a weighty tome!) and a 35-page executive summary are available at www.dwp.gov.uk/pensionsreform/ whitepaper.asp.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.