Natasha Browne looks at the questions schemes have to ask when managing unfunded pension promises
- Unfunded promises have to be set up with particular attention to detail
- Employers have to consider what corporate approvals would be required to allow a supplementary scheme
- Top-up schemes can weaken the employer covenant because it is spread more thinly
- ITV has begun legal action to remove its obligation towards an unfunded promise set up for four senior executives
Defined benefit (DB) is not just about final salary or career average guarantees. There are also unfunded promises, which were often set up as top-up schemes for senior staff who reached the cap on their contributions.
The employer would set up a supplementary scheme to allow a handful of top level members to reach the final salary promise that had originally been agreed.
Freshfields employment, pensions and benefits partner Dawn Heath (pictured) explains: "Unfunded promises are a contractual promise from the employer so if the employer goes bust, you would be left as an unsecured creditor and you would potentially lose all of your unfunded pension."
However, the promise can become complicated if backed by a security arrangement. The legal action ITV is taking to remove a £39m obligation in respect of an unfunded pension commitment to four former Granada executives, according to its latest annual report, shows the problems that can result.
Further investigation by The Sunday Times uncovered that the executives in question were former boss Charles Allen and directors Stephanie Monk, Graham Parrott and Henry Staunton. The arrangement, which appears to be backed by a pool of assets, was set up in 2000.
ITV's DB schemes, which are closed to new entrants, had an aggregate IAS 19 deficit of £346m at the end of 2014. Some £48m of this was related to unfunded schemes, the annual report said.
Documents seen by The Sunday Times suggest the company is disputing how the supplementary scheme was set up. It apparently argues that Granada, which merged with Carlton Communications in 2004 to form ITV, should have sought shareholder approval before creating the arrangement. When contacted by PP to verify the details of the case last week, ITV declined to comment.
Heath says that unfunded promises that include a security are less common than those without. But she adds: "They are still well within the range of things that you see out there and certainly things that were set up around that time."
She also points out there are a range of questions to consider before setting up an unfunded scheme. "An employer would need to think about what corporate approvals and formalities would be needed and what would be the impact if they didn't get them? If it's a listed company, what do the listing rules say? What shareholder and board approvals are necessary? What do the Companies Act and the company's articles say?"
Pan Governance chief executive Steve Delo explains that understanding the details of an additional promise is essential before approving it. While this may seem obvious, he says: "Historically, the sheer scale of the capital value of pension promises has not been adequately appreciated."
Delo recalls a former client who thought he had done a great deal with a difficult senior member of staff who agreed to accept a cheaper company car if the business gave him a promise he could retire at 60 rather than 65.
"The manager called me to tell me the guy was an idiot because he had given up five years of pension - it was only then he realised what he had actually done was to dramatically increase the value of the pension promise. He was hoodwinked because he didn't understand the maths," Delo says.
It is also paramount to double-check the paperwork. Delo draws on another example of a remuneration committee legitimately signing off on an unfunded benefit without noticing a typo in the documentation.
He says: "It was something like an ‘or' being changed to an ‘and'. That typo had a significant (upward) impact on the value of the promise. It would be years before the benefit came into payment and somebody would then realise they'd funded on an ‘or' but have to pay out on an ‘and'. Ergo, big additional unplanned cost."
An unfunded promise to senior staff could seem unfair to the average employee. But Heath says: "If you think about it, pensions are really no different from any other part of the benefit bargain struck with the senior people. Whether you think the arrangement is ‘fair' isn't different from an assessment of whether you thought their salary was too high, for example."
Delo adds: "There will be plenty of senior people out there who will have manipulated the system that applied at the time to get special terms approved - and special terms that might not have been approved if they had been properly understood. Only the individual knows whether it is fair compensation for their role or a ‘nose in the trough' exploitation of the situation or naivety of those approving it."
One valid concern is that a supplementary scheme may reduce the strength of the employer covenant, however. Heath explains: "If the security for the top-up arrangement falls away then you have a situation where the main scheme employer covenant is slightly better because, while you've still got the same liabilities and benefit promise, the top-up arrangement becomes unsecured as opposed to secured, and ranks alongside the main pension scheme's claim as opposed to ranking ahead of it."
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