During the downturn in the earlier part of the decade, pension deficits rarely featured as an issue in insolvencies and restructurings. Now, defined benefit pension schemes are increasingly at the centre of corporate restructurings, with the pension trustees and the Pensions Regulator key players. This article will examine why pensions have become increasingly important in pension restructurings, and how successful strategies have evolved in addressing these situations, allowing companies to survive whilst improving the prospects for scheme members.
Three main factors have contributed to the prominence of pension deficits in restructurings.
Firstly, mounting scheme deficits. Many companies remain responsible for substantial pension liabilities, even though the build up of new benefits under the scheme has long since ceased.
Increased member life expectancy, falling equity markets and increased regulation have all exacerbated funding deficits in recent years. The level of deficits can limit the opportunities for restructuring by divestiture.
Secondly, the way in which a pension debt due by an employer on an insolvency event occurring has increased materially. Where a formal insolvency has been triggered, the debt due by the employer (also known as the section 75 debt) is calculated on an annuitised 'buy out' basis. This involves calculating the cost of buying out the pension scheme liabilities with an insurance company and can substantially increase the pension scheme's deficit because on a buy out basis an insurance company – if being asked to take on responsibility for paying pension scheme benefits, perhaps for decades to come – would use conservative assumptions in valuing liabilities. Since no ongoing scheme targets funding on the buyout basis, any scheme will almost certainly be underfunded on that basis. Buyout deficits can easily run into tens or hundreds of millions of pounds when triggered.
Finally, the creation of the Pensions Regulator under the Pensions Act 2004, and the anti avoidance powers given to it under the legislation to protect scheme funding, have all affected corporate behaviour in advance of – and during – any insolvency or restructuring process.
In particular, the Regulator has wide powers to prevent employers from dumping pension liabilities on the Pension Protection Fund (PPF), which was created at the same time as the Regulator as a lifeboat fund to provide limited pension compensation for members of defined benefit schemes whose benefits have not been fully funded following the insolvency of the employer. Under the Regulator's so called moral hazard powers, the Regulator can impose a liability for pension scheme funding of companies – and the directors of companies – 'associated' or 'connected' with the sponsoring employer, even if the company on which liability may be imposed this way has never participated in the pension scheme.
How has the new regime affected pension restructurings?
Where the financial condition of the employer is weak, the prospect of formal insolvency proceedings on the horizon may have a bearing on the directors' decision to trade. If triggered, the pension scheme's debt at the buy out level could swamp the size of any other creditor claim (including that of the bank) on insolvency and directors need to be mindful of this. For the first time pension trustees can be major players in insolvency.
In some cases the pension deficit may be too problematic to resolve by restructuring. But, in other cases, there has been a trend to look at pensions-led sophisticated debt restructurings which can bring about a survival of the sponsoring employer and preservation of jobs. Whilst insolvency may result in PPF protection being available for scheme members, it can be a sub-optimal outcome for the business and its other stakeholders. In such cases where insolvency is looking likely and the PPF will assume responsibility for the scheme, techniques have been looked at which involve a substantial part of the Section 75 debt being avoided, while at the same time allowing companies to survive and preserving greater value than would apply on an insolvency situation. Typically this process will involve the transfer of the scheme to PPF control through sophisticated techniques, leaving the employer in a better position to meet its commitments to other creditors.
This can only be achieved with Regulator approval if the employer, lender and trustees all buy in to the process, and above all, it can be demonstrated that the outcome of going through a consensual restructuring will be better than formal insolvency.
Solutions of this kind may not work for every situation, but can have measurable benefits for protecting business and jobs if adopted successfully.
Edwin Mustard and Paul Hally are partners specialising in respectively pensions and restructuring law.at leading UK law firm Shepherd and Wedderburn LLP.