Why Section 75 of the Pensions Act has everyone quaking in their boots

Everyone in the pensions world knows the full annuity-based buyout price for a final salary scheme fund is usually exorbitantly expensive. So Section 75 of the Pensions Act, which triggers the full buyout debt if the employer, even inadvertently, crosses one of a fairly large number of lines in the sand while carrying out a common or ‘garden’ group restructuring as a tidying exercise, is a very scary piece of legislation.

The only thing that makes Section 75 a touch less scary is the fact that the legislation makes the trustees responsible for deciding whether to push for a buyout or not, following a ‘termination event’ ­ Section 75’s polite name for the employer making a major error.

Trustees, most employers would feel, are a lot easier to negotiate with than the cold and complex logic of Section 75 itself.

Now, after a prolonged string of complaints from industry and from professional advisors, HM Treasury and the Department of Work and Pensions have completed a consultation exercise looking to push through some ‘easements’ to the Section’s draconian logic, mindful of the fact that we may see more corporate restructuring in 2010. Both the pensions industry and its professional advisers ­ the lawyers, accountants, actuaries and pensions administrators ­ argue that where a restructuring exercise leaves the employer’s covenant in respect of the final salary scheme no worse, and possibly better than before, it is wildly illogical to talk about triggering a Section 75 debt.

Loophole phobia
The DWP seems sympathetic to this point, but as the consultation paper it has issued shows, it is hamstrung by its fear of creating loopholes in the legislation that will allow employers to walk away from their pension debts unscathed. This fear makes the Section 75 consultation document read like a trainee lawyer’s nightmare exam paper. As a result, most advisers are less than thrilled with it.

Clive Fortes, a partner and head of corporate consulting at Hymans Robertson puts his view bluntly. “Is this a useful consultation exercise? No. It will be of extremely little value,” he says.

There are two easements suggested in the consultation, both designed to make life easier for companies carrying out restructuring exercises. First, company A entirely consumes company B, in which case it can take over company B’s pension liabilities if a number of commitments are satisfied. This means company B is then released from its liabilities ­ which tends to be because it no longer has any active members in its final salary scheme and all the deferred members and pensioners are now under the wing of company A, which has to be able to offer at least as strong a covenant as company B in the eyes of the scheme trustees.

The second easement is a de minimus easement, a kind of parallel to the easement HM Revenue & Customs provides that allows trivial sums of money in pension schemes to be commuted rather than turned into annuity-driven pension payments of some silly sum such as 0.02p per month. For this proposed easement to work, a scheme must be fully funded to the level set by the Pensions Protection Fund; the withdrawing employer cannot employ more than 2% of the membership in the remaining fund, company A’s fund, in our example.

Out of proportion
Hymans Robertson’s Fortes says these two provisions are just about acceptable, but believes the killer clause is the one that says the proportion of employees moving from company B to company A’s scheme cannot represent more than £100,000 of the fund’s PPF liabilities. If one takes the fact that the typical scheme liability per employee with not much service with the company is about £20,000, this suggests an upper limit of schemes with no more than four members. “What kind of easement is it that only works for restructurings that involve schemes with virtually no members?” he asks.

But there are at least two more killer clauses. First, they cannot come into play if there is an expectation that the exiting employer would go into liquidation within 12 months should the deal not go ahead. This means the consultative paper does not apply if a forced restructuring is involved. It has to be a voluntary restructuring, leaving company B in good health as it goes off into the sunset. Second, the trustees have to be entirely comfortable in their minds that Company B will not be subject to an insolvency event within the next 12 months. This means they need to go through a fairly stringent financial due diligence process to sign off on the deal.

Where does this leave the consultation paper? Fortes believes it is a good thing that the government is looking to find ways of easing restructurings within the same group.

“However, its anxiety to avoid any possibility of a loophole has caused it to draft the proposed changes so tightly that it makes these changes impractical and unworkable,” he says. The upshot is that the easements proposed are not going to make any sort of major impact.

What perplexes Fortes more than anything else about the consultation the DWP is currently going through is simply the scale of the complexity it has woven around its proposed easements. It is far simpler for any group that wants to do a restructuring to ignore all this, instead going directly with its proposals to the regulator and its pension fund trustees to request they sign off on the plan.

“Most restructurings involve multiple companies and multiple restructurings, not the one-to-one model proposed by the legislation. You are better off doing multiple restructurings in a single pass and getting clearance, rather than trying to use the legislation as a multi-pass approach,” he says.

John Herbert, chief actuary with pensions administration specialist Premier Pensions Management, points out that, as things stand, before any changes to the legislation that might result from the consultation paper, a company that had just one active member left in its final salary scheme could find a Section 75 debt triggered for all its current pensioners and deferred members if that lone employee left.

“You have to remember that for most schemes, the majority of the pension liability is not for the active members who are contributing, but for former members who have moved on to other companies,” he says. “It is a real legacy weight on the company. What companies want to do is to manage down this debt over, say, 30 years, while ensuring they do not drift into a position where a Section 75 debt is triggered.”

What stops trustees from insisting that the full Section 75 debt is served on the employer on any trigger event is generally not love for the employer, but a lively sense that the employer would not have enough money to meet the debt, so members would not do well out of it. “This creates the basis for a sensible conversation between the employer and the company scheme trustees,” Fortes adds.

Looking for clarification
Premier Pensions Management’s Herbert takes a more hopeful view of the consultation exercise than Fortes. “I suspect the new consultation is simply looking to clarify a few minor points in the way easements will work in specific circumstances,” he says.

Andrew Holehouse, pensions partner at law firm Shepherd & Wedderburn, points out that once Section 75 was introduced in April 2005, employers were effectively nailed to their final salary schemes, since any attempt to walk away would trigger the full buyout debt.

In an ideal world, he says, the consultation paper would have addressed the fact that it is senseless for the legislation to trigger the debt if a restructuring leaves the final salary scheme being supported by an employer with just as strong a covenant as the exiting employer. This is not what the consultation is about. Instead, it has introduced a thick net of conditions around a couple of simple easements. “This is great for advisers, but it adds dramatically to the cost of restructuring,” he says.

One of the complexities being introduced is that even in the simple instance envisaged in the consultation paper, where employer A exits and employer B takes on responsibility for the scheme, you have to ensure that the exit and the entry happen on exactly the same date, with all the transfer of pensions going through on that date. “Section 75 is one of the most detailed and complicated pieces of legislation ever devised, and I say this against a background of a great deal of complex pensions legislation,” Holehouse muses.

As it stands, the consultation paper makes the scheme trustees responsible for deciding whether the covenant of the restructured employer is as good after the event, as it was before the restructuring. “Pension fund trustees have a serious responsibility here and they will need to get the right reports and the right advice and they will have to spend money to get themselves properly informed,” Holehouse says. Saying that one covenant is as good as another is actually a tough call to make. Many people doubtless thought Lehman Brothers was in good shape the day before it went down, for example.

Similarly, the requirement to look ahead 12 months and to confirm that neither the exiting employer nor the incoming employer are likely to go insolvent in the next 12 months is another tough call, for the same reasons.

“The DWP has decided that trying to draft easement proposals for complex restructurings is just too difficult to do. Could it have done more with this consultation document? Probably, but what we can say is that this is a start, and making a start on difficult subjects is what consultation documents are all about,” says Holehouse.

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