Uncharted territory

These are unsettling times for trustees. With concern about bank sector exposure to sub-prime mortgages escalating into fears of a full blown global recession, equity prices around the world have been in sharp retreat. Inevitably this has had an impact on the health of pension funds. In January the Pension Protection Fund announced that the aggregate deficit across the 7800 schemes in its index had risen from £5.4bn at the end of November 2007 to £19.6bn a month later. In the short term at least, it seems that the recent trend towards deficit reduction has been thrown into reverse.

Of course, managing a pension scheme is a long-term business and what we’re seeing at the moment is (hopefully) just a temporary reversal of fortune in the financial markets. Nevertheless, the sight of City screens turning red provides a worrying backdrop for those trustees who are currently grappling with the requirements of the scheme-specific funding regulations.

The demands of scheme-specific funding are well known. All pension schemes must undergo an actuarial valuation every three years at least. Once this has been done trustees are charged with assessing the balance of assets and liabilities and coming up with a framework that will ensure the scheme is fully funded. In cases where there is a deficit, trustees are required to submit a recovery plan to the regulator.

And for many trustees the current turmoil in the markets is coinciding with their first taste of working under the new rules. The scheme-specific funding regime was introduced in the 2004 Pensions Act and applied to valuations taking place on or after April 22, 2005. Depending on when the valuations of their own schemes were scheduled to take place, some trustees were thrust into the scheme-specific process almost immediately – indeed The Pensions Regulator recently issued a report on 1292 deficit recovery plans tabled by the end of 2007 – but many others are currently negotiating with employers and drawing up submissions.

Trustees now have more power and more responsibility than ever before. The Pensions Regulator has made clear that “trustees are now the decision makers on all funding matters”. As Baker Tilly’s head of pensions Ian Bell puts it: “There has now been a real shift in the balance of power away from the employer and towards the trustees.”

But trustees are also under a great deal more pressure. The scheme-specific rules require them to not only take a view on whether employer contributions are adequate but also to assess the financial health of the sponsor and its ability to deliver on its pension commitment to members. So for the first time trustees are required to carry out due diligence on the employer, and with economic conditions in the UK and elsewhere expected to worsen this in itself is a challenging task. Added to that is the fact that trustees are also required to examine the assumptions that underly the projections for each individual scheme and assess whether they are “prudent” and realistic. Again, it’s a testing role, particularly if we are entering a prolonged period of volatility in world markets.

Business as usual
So what does all this mean in practice? Well The Pensions Regulator’s first report on the workings of the scheme suggests trustees have taken the new regime in their stride. Out of the 1292 recovery plans submitted (based on valuations carried out in the last quarter of 2005 and the first three months of 2006) only 10pc required regulatory intervention while the average projected timescale for dealing with deficits was 7.5 years, well under the 10 years that would trigger a response from the regulator. In other words, the early evidence suggests that scheme-specific funding is producing the desired result – a focus in the deficit issue that has translated into workable action plans.

According to T Rowe Price’s director of client services and former pensions consultant Philip Garcia, the apparent success of trustees in adapting to their new role should be no surprise.

“The arrival of scheme-specific funding hasn’t really changed anything,” he says. “The introduction of new accountancy rules had already put a spotlight on the deficits issue and trustees were already working with employers to bring those deficits down.”

Towers Perrin principal Mark Duke agrees, but argues that while scheme-specific funding has perhaps not revolutionised the role of trustees it has certainly created an environment where their approach to the job has become more process oriented. “In many cases trustees have had to take a more formal approach to scheme funding. There is now more thought and more science about what they do,” he says.

There has also a greater willingness to engage with employers and, if necessary, ask tough questions. “Trustees have been encouraged by the regulator to ask questions,” says Lane Clark & Peacock partner Richard Murphy. “From what I’ve seen they have been doing that very enthusiastically.”

The employer covenant
It has always been the role of trustees to negotiate with and question sponsors, but the new requirement to review the employer’s covenant is taking boards into uncharted territory. “One the things that trustees have to do is come up with a reasonable time frame for making good on the deficit,” says Bell. “And as part of that process they really have to look at the strength of the employer – this is a huge issue and if the trustees get it wrong the risks are very high.”

It is an exercise that may well involve an analysis of the company’s accounts, an assessment of how it has fared in terms of key performance indicators, an examination of its position in the market and an evaluation of the risks it faces.

Potentially it is a very technical process and, according to Bell, while some trustee boards are making this assessment themselves, demand for third party assistance has risen sharply.

If it does emerge that a sponsor is experiencing financial difficulty the trustees potentially face a difficult dilemma. “In these situations, trustees may feel they should require the employer to increase the contribution to secure the scheme for existing members in a shorter timeframe,” says Murphy. “On the other hand, it would be in no one’s interests to push the company into liquidation.” The upshot is that trustees are faced with the task of satisfying the regulator while also keeping a weather eye on the wellbeing of the sponsor and its employees – it can be a difficult circle to square.

Ultimately, if no agreement can be reached on the level and rate of employer contributions, the matter will be decided by the regulator – something that all parties would probably like to avoid. However, as CMS Cameron McKenna partner Neil Smith points out, concern about an employer’s ability to pay can be addressed in a number of ways that won’t necessarily impose short-term financial pressure on the sponsor. “Trustees should be looking at measures to guarantee that the employer will meet its commitments,” he says. “These could include the use of contingent assets, guarantees from parent companies or charges on property.”

The use of contingent assets is becoming more widespread. Assets are identified but will only be factored into the pension scheme if one or more pre-agreed events – such as employer insolvency – occur. It’s a strategy that provides a degree of comfort for the trustees, while also offering a major benefit to the employer. Because the assets are not committed to the scheme unless it is deemed necessary, employers do not face the pain of locked in surpluses.

Conflicts of interest
This new role for trustees has inevitably created the conditions for conflicts of interests. Traditionally, trustee boards have included representatives of the sponsoring company, as well as independents and representatives from interest parties such as trade unions.

Under the scheme-specific funding rules – particularly in terms of reviewing the employer’s covenant – there is much greater scope for those members who are also company directors to find themselves in a conflicted situation. This is already having an impact on the make up of trustee boards. “What is happening is that finance directors are stepping down from boards of trustees,” says Smith. “In some ways that is a shame because it is a trend that is depriving many boards of valuable financial expertise.”

Given the increasingly technical demands of the trustees’ role it’s a vacuum that has to be filled and according to Jonathan Evans, a barrister specialising in commercial law in Wilberforce Chambers, there is a marked trend towards the appointment of independent trustees.

He says: “Boards are bringing in independents to avoid conflicts of interest. In practical terms that means that trustee boards will be looking for professionals with the financial knowledge rather than lay trustees.”

Any move from the current arrangements to the formation of boards dominated by professionals and independents is likely to be long-term and evolutionary rather than something that happens as a big bang. In the meantime, boards should certainly be addressing the conflict of interest problem as it affects them in the here and now.

“It should be part of the planning process as you prepare to undertake the scheme-specific funding exercise,” says Murphy. “You really have to think about how you’re going to deal with any conflict of interest issues that arise.” In some cases that will mean certain members of the board absenting themselves from discussions that would create a potential conflict, but as Evans stresses, it is advisable to take legal advice on how best to deal with the problem.

Investment strategy
Closely tied to the issue of the contribution rate is the question of whether the assumptions that underpin a particular scheme’s finances are prudent – and ultimately whether the investment strategy is aligned with the targeted outcome for members. This is an increasingly complex area for many trustees to address, particularly as the scheme-specific funding philosophy underlines the fact that there is single strategy that will be right in all circumstances. “Scheme-specific funding means that strategies to deliver the right outcome will be different in every case,” says Morgan Stanley Investment Management’s head of UK business Richard Lockwood.

However, Lockwood has observed some distinct trends in investment strategy over the last few years. “One of the things that we have seen is a move towards diversification,” he says. “At first the trend was to invest in overseas equities as well as the UK market. Today many pension funds are looking at a much wider range of asset classes.”

Describing Morgan Stanley as evangelists for diversification, Lockwood cites hedge funds (particularly those that aren’t closely tied to performance in the equity markets), property, currency and private equity as classes in which pension schemes can invest to hedge against risk and deliver on targeted returns. As Lockwood admits, this makes life more complex for trustees especially if they are asked to take a view on the role of, say, complex derivative instruments in a scheme portfolio, but he argues trustees are, generally speaking, rising to the challenge. “The bar is being raised in terms of trustee knowledge,” he says. “Trustees are getting more up to speed.”

But even the best laid strategies can be thrown off course by changes in the market and Duke contends that trustees will have to take this into account when considering investment strategies.

He says: “Trustees are seeing the numbers wobble. What they’re saying is, ‘we agree an investment plan and six months later the numbers look different’.”

The answer, he believes, is to design an investment plan that contains timetabled trigger points to ensure that it is reactive to long-term market movements. By agreeing trigger points – say, failure to meet certain performance targets over a six month period – the process of investment reassessment is formalised.

Power and risk
Trustees have more responsibility, but do they have more real power to make a difference? According to Smith the answer to that question is “yes”, even if much of that power comes indirectly from the regulator.

He says: “Trustees have to work within the rules of the pension scheme and in most cases that will mean reaching agreement with the employer, rather than imposing a solution. However, if they can’t get an agreement then they are backed by the power of the regulator.”

Smith adds that trustees also have statuary powers to ensure that employers provide all the information necessary to assess the covenant – although these only apply to the entity that is sponsoring the scheme and not, say, a parent – and they are also entitled to appoint legal and financial advisors.

Arguably new responsibilities and powers could also mean that trustees face a greater exposure to legal action. “Trustees have always been liable,” says Evans. “However, now that they are doing more you could say that the risks they face have also risen.”

Smith, however, is not so sure. While he accepts that in theory trustees are more exposed, in practice he does not expect to see an upturn in legal actions against those who have allegedly failed to fulfil their duties properly. “Provided they get professional advice they should be fine,” he says.

Nevertheless, there’s a broad consensus that some trustees will step down, if only because the duties associated with the role have become too time consuming. Thus, the unintended consequence of scheme-specific funding could be an outflow of lay trustees and the arrival of a new professional class.