The defined benefit pension schemes threat to charities
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.
Economic factors
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.
Multi-employer schemes
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.
Pensions freedoms
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.
