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Pension Scheme Deficit Implications for Trade Creditors
A review of the factors affecting pension scheme deficits, how government policy has undermined scheme funding and the impacts on ordinary trade creditors
BHS is not the only major UK employer to go into Administration with a significant pension scheme deficit and unfortunately, it won’t be the last, but who, or what is to blame when it happens and what are the implications for other creditors when major employers enter insolvency with large pension funding deficits.
Much of the press and select committee comment has fallen somewhere between ill- informed, or scurrilous, and though the writer of this article is no apologist for Sir Philip Green, it is important to look beyond his stewardship of the business to get to the root of the pension deficit problem.
In a recent address to pension industry professionals, John Hutton, former work and pensions secretary stated that no minister has started out with the intention of damaging private pensions and though there is no reason to doubt the veracity of that statement, there have been several critical government decisions over the last thirty years that have seriously undermined the funding and overall viability of final salary pension schemes.
The Finance Act 1986 saw the introduction of rules to reduce pension scheme surpluses, forcing schemes with funding levels in excess of 106% to reduce surpluses by making (taxable) payments back to the employer. The new rules led to a number of schemes refunding money to employers and many employers taking contribution holidays for a number of years. However, these so-called pension fund surpluses were nothing of the sort; the so called surpluses were actually reserves against future shocks and safeguards against unfavourable investment returns or significant improvements in longevity; factors that have loomed large over the last 20 years.
Wiping out the financial buffers of these fledgling schemes was ruinous and had it not been for the destructive power of the 1986 finance act, many of the schemes in substantial deficit today would be in a much healthier position. The Chancellor of the Exchequer at the time was Nigel Lawson.
Removing Advanced Corporation Tax (ACT) relief for pension schemes in the 1997 Finance Act was another devastating blow to UK pension scheme funding. This was the scheme under which companies made an advance payment of tax when they distributed dividend payments to shareholders; certain recipients, including pension funds, were entitled to claim back this back until the relief was abolished. This abolition is still costing pensions schemes today and the cumulative impact of the removal of ACT on scheme funding is estimated by reputable actuaries to be in the region of £100 billion to £150 billion. The Chancellor of the Exchequer at the time was Gordon Brown (1997–2007), who gets another mention for the profligate years 2002 to 2007, which resulting in a sharp increase in government spending and borrowing.
It’s precisely because of excessive government debt that the last government implement a policy of “Financial Repression” in other words attempting to reduce debt by deliberately holding down interest rates to below inflation, resulting in falling Gilt yields. As pension schemes value their liabilities based on Gilt yields, falling Gilt yields results in soaring valuations of pension scheme liabilities.
By any measure, successive governments have created an extremely challenging environment for defined benefit pension schemes and their policies have both, directly and indirectly contributed to the significant scheme deficits that exist today.
Despite the government making the task of funding defined benefit schemes much harder than it need have been, Employers and Trustees still have a responsibility to the schemes and can’t be absolved from blame where it is due.
Quite why Sir Philip Green, presumably decided against placing BHS in to Administration himself and attempting a pre-pack as opposed to selling to the twice bankrupt Dominic Chappel is difficult to comprehend. However, this decision to sell was not what resulted in the majority of the pension scheme deficit, most of which accrued in the years 2008 to 2014, in the aftermath of the financial crisis, with another sharp deficit rise in 2014 – 2015, during a period of unprecedented falls in Gilt yields. Much has been made of the £400 million dividends taken from BHS but the last of these dividends was taken in 2004, when it seems that the scheme was not in deficit, or at the very least only had a very small, nominal deficit.
We don’t yet know much about how the Trustees role in the current crisis will be judged, but managing pension funding isn’t all about the size of the company contributions to the scheme; the Trustees should also ensure that the liabilities are managed as part of a comprehensive investment strategy, and questions will inevitably be asked about why the scheme was 93% invested in growth assets. A mere 7% allocation of pension fund assets to matching assets is remarkably low for a scheme of this maturity and provides negligible hedging against falling bond yields or inflation. The scheme has now increased the matching asset allocation to 66%, but too late to have protected the funding against the effect of falling gilt yields.
Regardless of where blame lies, the adverse trend in defined benefit scheme funding is bad news of creditors because of the relative priority of pension scheme liabilities arising in insolvency. Contributions owed by the employer to the pension scheme are at the front of the que, ranked alongside preferred creditors, ahead of secured and unsecured creditors. If the scheme is in deficit and a majority of schemes are in deficit, the full value of the debt to the pension scheme ranks with other unsecured claims, effectively diluting, or in some cases wiping out any potential dividend to unsecured trade creditors.
Credit and Risk managers might, in future want to take in to account the size of pension scheme funding deficits when making underwriting decisions.
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