From 11 June 2003, solvent sponsors of UK defined benefit (DB) pension schemes have no longer been able to avoid responsibility for securing plan liabilities. This was the date when Statutory Instrument No. 403 defined the extent of the pension obligation for employers. In 2005 this was extended to insolvent sponsors. The significance of this for pension trustees is only now beginning to be appreciated.
Previously employers were only tied to the value of the liabilities on the minimun funding requirement (MFR) basis, which meant many of them could, and did, walk away from their scheme obligations. Moreover, the weakness of the MFR funding standard encouraged many of the funding and investment risks to be ignored.
Trustees’ tolerance of risk within a pension scheme largely depends on the ability of the sponsor to underwrite that risk. For example, in maintaining a risky investment strategy trustees would want to be sure that the sponsor could provide additional funding should markets, and funding levels, fall. Similarly, the period agreed for a sponsor to make good existing deficits should reflect the likelihood that the sponsor will be able to complete the funding programme. One might expect that schemes with weaker sponsors would have smaller deficits as ‘lending’ to the sponsor represents a significant risk that the debt will not be repaid.

Unfortunately for pension schemes, the concept of sponsor risk is a relatively recent revelation, following the emergence of deficits from falling interest rates, poor equity returns and increasing longevity. It is perhaps unsurprising therefore that a study recently carried out by Standard & Poor’s showed that scheme funding and investment decisions have historically been taken without regard to the sponsor’s ability to fulfil its pension obligations. There appeared to be no correlation between the size of deficit or the riskiness of the asset strategy, and the strength of the sponsor.
Martin Taylor, chairman of trustees at WH Smith, David Norgrove at The Pensions Regulator (TPR) and others, reinforced the idea that pension schemes in deficit are creditors to the sponsor. They are, however, unusual creditors as:
q In most cases trustees do not choose to provide credit;
q They perform no formal analysis as to how much credit they should provide nor do they formally agree repayment terms and the conditions under which they would demand restructuring of the facility with the borrower;
q In spite of their new powers trustees are still unable to enforce repayment of the debt;
q They are unsecured creditors and in most cases have no fixed or floating charges over any of the sponsor’s assets;
q Despite their relatively weak creditor position they are frequently the largest creditor to the sponsor.
This list is not exhaustive. The point is that in many cases pension schemes are large, unwitting and inexperienced creditors with little security over the value of credit provided and, in most cases, with little likelihood of a material recovery in the event the sponsor fails.
The value to trustees of the change in the sponsors’ responsibilities, combined with the new powers granted to trustees under the Pensions Act 2004, is that members’ benefits should become much more secure. This is a result of sponsors’ more restricted ability to abandon pension obligations and trustees’ powers and responsibilities
to pursue a level of funding which properly reflects all risks to members’
benefits.
From 23 September, trustees will be obliged to determine a statutory funding objective and funding principles indicating how the obligations of the scheme will be funded. They are also required to understand the risks that the underlying assumptions for life expectancy, investment returns, etc, are not realised and the role that the sponsor has in underwriting these risks.

Assessing the sponsor’s strength is a new area for trustees and can be complex. Trustees not only have an explicit obligation to consider the strength of their sponsors but also the changes to that strength. Whether resulting from changes in ownership, equity buy-backs or simply adverse trading, trustees have a duty to consider the implication of such changes and whether the position of their members is even indirectly affected.
Failure to link deterioration in the financial backing to a scheme, irrespective of the cause, to a compensating improvement in member security (eg, capital injection) jeopardises members’ benefits and could make trustees personally liable. The core question then is whether the sponsor is capable of funding the scheme, such that it can meet its obligations in full without material risk to the beneficiaries.
Trustees have a variety of sources from which they can obtain information on the financial or ‘credit’ strength of their sponsors. The most widely used independent benchmark for assessing the credit strength of companies is credit ratings provided by rating agencies. Rating agencies are in a unique position to provide credit information for trustees given their longstanding expertise in providing corporate analysis.
For over 100 years financial institutions have relied on the agencies’ analysis of a company’s financial strength for their own investment decisions.
Rating agencies are also unique as they can assign probabilities of default to companies over future periods. This enables trustees to easily incorporate credit information into their funding plans through the deficit removal period. That is, for any given funding period the trustees will be aware of the risk that the sponsor may fail before the funding period is complete. More generally, credit ratings also allow trustees to incorporate the credit risk of the sponsor into their overall risk management within their scheme, in particular the investment strategy.

Credit principles are becoming the currency for pension provision and references can be found throughout the new framework introduced by the pensions act. The pension protection fund (PPF) will shortly implement a risk-based funding levy determined in large part by the risk of sponsor failure. Similarly, The Pensions Regulator requires, through its codes of practice, sponsors to notify TPR of changes in their credit strength. It has also given guidelines on clearance procedures which highlight the link between corporate actions and the security of the pension scheme.
This brings me back to where I started, June 2003. This was a critical point leading to the formal recognition of the credit relationship between pension schemes and their sponsors. Subsequent legislation, regulation, codes of practice, etc have served to elevate the powers and responsibilities of trustees so that they are closer to being on a similar footing with those of other unsecured creditors.
We have come a very long way. The need for transparent and independent opinion on sponsor credit risk has been recognised by regulators, advisers and many trustees. Credit ratings exist on essentially all private sector sponsors to schemes and will play a dynamic role in the future determination of scheme funding from both the trustees’ perspective, to restore adequate solvency, and from the sponsor’s desire to enhance prospective earnings through reduced PPF risk premiums and a lower cost of capital.

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