UK: The Pensions Trap: Issues for Private Equity Investors

Pensions are increasingly a major focus in the acquiring and running of businesses. This articlealerts private equity investors to the implications of incoming pensions legislation and acts as a reminder of pensions related issues generally.

• Private equity investors and their management companies could be liable to contribute to final salary pension scheme shortfalls.

• MBOs and other acquisitions made by business transfers no longer wholly escape obligations to provide the pension entitlements of transferring staff.

• New funding rules are to apply to final salary pension schemes which will require greater contribution levels by investee companies.

The Pension Act 2004 (the "Pensions Act") received Royal Assent on 19 November 2004 and is expected to come into force from April 2005. Some of the features of most importance to the private equity industry are discussed below.

The Pensions Act includes provisions which are designed to prevent groups of companies from abandoning their pension liabilities by ring fencing them in one company. Inevitably the scope of these so-called "moral hazard" provisions is far wider.

These provisions give the new Pensions Regulator (the "Regulator") the power to extend liability from the employing company to any "associated" or "connected" person or company, other than a private individual, including:

• other group companies;

• any shareholder with at least one third shareholding (for example, a significant private equity investor); and

• any employer of a director of the company, such as a manager of private equity funds which appoints a special director to an investee company’s board.

Under these provisions, the Regulator will have the power to issue the following orders:

Contribution notice – where the Regulator believes a main purpose of any act or omission was to reduce or eliminate the liability on the employing company to contribute the deficit into a pension scheme on its termination, a contribution notice may be issued requiring the company or an associated or connected party which was involved in that act or omission to pay the shortfall into the pension scheme. The Regulator has powers to issue a contribution notice within six years of any act or omission occurring after 27 April 2004; and

Financial support direction – where the Regulator believes the employing company of the pension scheme is insufficiently resourced or if it is a "service company", the Regulator can require an associated or connected party to provide "financial support." This may include the assumption of some or all of the ongoing liabilities of the pension scheme. A "service company" is one whose main purpose is to employ a group’s workforce.

Advance clearance may, however, be sought in respect of actions that could, potentially, give rise to a contribution notice or to confirm that the Regulator will not issue a financial support direction at any particular time. However, any clearance obtained could be jeopardised if circumstances change or the Regulator becomes aware of relevant undisclosed facts. The clearance procedure should therefore allow some advance comfort to be obtained but may not be entirely reliable, particularly in relation to a financial support direction where relevant circumstances can swiftly change.

The government has reiterated that it intends that these moral hazard provisions should only be used in extreme circumstances and that, most of the time, the Regulator should be able to deal with funding concerns without resorting to them. However, a deepening of public concern over pension provision may increase the pressure on the Regulator to use all the powers at its disposal to ensure that schemes are fully funded, even at the expense of third parties.

It is established law that on an asset sale, employees’ terms and conditions of employment transfer to the transferee company, except in relation to occupational pension schemes.

However, under the Pensions Act, a transferee company will be required to establish an occupational or stakeholder pension scheme and pay a specified level of contributions into that scheme for transferring employees. This right will apply not only for employees who are presently members of an occupational scheme, but also those who are or will become eligible to join one.

A new fund will be established to provide pension benefits where a pension scheme is underfunded due to an employer’s insolvency. The fund will assume the assets and liabilities of these pension schemes, and the underfunding will be met by a levy on all pension schemes which will be based on the size of each scheme and its level of funding. It is expected that this scheme will be very expensive to run and that the levies, particularly those payable by underfunded schemes, will become very high. The ultimate liability for this levy will lie with the employing company, which must fund the pension scheme and its expenses.

Because pensions has become a driving force in many investments, it is valuable to consider the substantive issues in relation to pension schemes. A summary of the most compelling issues relating to a salary related or defined benefit pension scheme are set out below.

It is always possible to obtain an actuarial valuation to give a recent assessment of the funding levels of a scheme. However, there are many different bases for the assessment of assets and liabilities based on different assumptions about the future of the scheme and external factors such as inflation and mortality rates. The statutory minimum funding level at present is the Minimum Funding Requirement ("MFR"), but following the Pensions Act there will be a new "scheme specific" minimum funding basis, details of which are still awaited. This means that the minimum possible contributions to pension schemes will increase.

Even a scheme that is fully funded on the new basis will not have the ability to buy pension benefits in full for all its members. This is because the so called "buy-out" valuation method assesses the amount that is needed to allow benefits to be bought in full at that time and this, given the substantial cost of annuities to secure those benefits, is always a much higher figure than other valuation bases.

The term "closed pension scheme" can mean a number of different things, but is increasingly used to describe a scheme under which members are no longer earning any further benefits but which is not winding up.

A scheme that is winding up is required, so long as that winding up commenced on or after 11 June 2003, to assess its liabilities on the full "buy-out" basis. Any deficit on that basis becomes a debt immediately due from the employing company.

Before a scheme is closed it is important to assess whether the closure will trigger a wind up thereby imposing this substantial immediate debt on the employer. Even if no wind up is triggered, closure may shift the power to trigger the wind up to the hands of the trustees who will then have a very strong negotiating position in demanding very substantial sums from the employer.

Disclosure in the new accounting standard in relation to pensions, FRS17, will shift disclosure items from the notes to the financial statements for accounts from 2005. This will mean that deficits or surpluses in defined benefit schemes will be accounted for in the balance sheet and movement in that amount will be accounted for through the profit and loss account and the statement of recognised gains and losses. The FRS17 calculation of the deficit or surplus is on a different basis from the present statutory minimum basis or the full "buy-out" basis and may vary to some extent with the accounting policies of the company.

As well as the change to pension rights on asset transfers included in the Pensions Act, the European Court of Justice has recently held that certain employee benefits under pension schemes, in particular certain early retirement provisions, will transfer under an asset sale. This will mean that, in addition to the new contribution obligations under the Pensions Act, the employees have a right to demand that the new employer provides those particular benefits, even if the other pension benefits are not provided to them. The cost of this can be substantial and it is not clear how the court expects this to work in practice. In extreme circumstances, the purchaser may be forced to establish its own scheme to ensure that these benefits are replicated.

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.