Defined Benefit Pension Scheme Deficits and Directors’ Duties

Thu 20 Oct 2016

There has been much talk recently about the rising costs of defined benefit pension schemes, with figures close to £1 trillion being quoted by some media agencies.

Indeed, many companies who still have a Defined Benefit (“DB”) pension scheme will soon be feeling the effect of what appears to be a three-point problem:

• DB scheme members are living longer meaning that the cost of the pension schemes continue to rise,
• The implementation of the new accounting standard for accounting periods commencing in January 2015 (FRS 102) has meant that the pension liability is now accounted for differently in the profit and loss, and,
• The impact of Brexit has led to a fall in interest rates and gilt yields, potentially resulting in an increase in pension scheme liabilities.

The impact of the new accounting standard

There are many companies where the DB scheme has not adversely affected their balance sheet in the past. However, the introduction of FRS 102 in January 2015 together with the other factors noted above are having wide-ranging implications for many business.

Group companies will probably find their balance sheets affected more than others, as under the old UK accounting standard FRS17, multi-employer schemes did not necessarily have to be accounted for as a DB scheme in the individual entity accounts, where each company in the group could not determine their share of assets for the group scheme.  Many group companies thereby avoided recognition of a DB liability and instead simply charged employer contributions in the year incurred.

The changes to UK accounting now mean that where companies in a group can identify their share of the assets and liabilities or allocate between group companies on an appropriate basis, these must be recognised in each company’s balance sheet, or failing that, recognised in full in the group entity that is the sponsoring entity.

How would that affect my client?

If a company is party to a DB multi-employer scheme that includes other employers not part of the same group as the company and the company is unable to identify its share of the assets and liabilities but there is an agreement in place to reduce the deficit, the balance sheet now has to show a liability equivalent to the net present value of the future deficit reduction payments (albeit discounted to present value using market yield on high quality corporate bonds) and a finance cost in the profit and loss equivalent to the unwinding of the discount rate, which would usually equate to the annual deficit payment.

As the markets fluctuate whilst the UK Government decides what “Brexit” means, this will have a further impact on the company’s balance sheet as the market yield could be adversely affected.

Even for companies that previously accounted for DB schemes as DB schemes under FRS17, whilst for many the net defined benefit liability (or, increasingly rarely, asset) would not be expected to change purely because of transition, FRS 102 has tightened rules such that some costs that were previously allowed to be spread over several periods now have to be recognised immediately such that any impact is likely to increase pension liabilities to be recognised on transition.

The impact on Directors’ duties

The effect of the pension liability on the balance sheet raises further issues for directors. Whilst a company is solvent, the Board of Directors’ fiduciary duty is to the shareholders, with a view to increasing the profit and distributing dividends. Once the company becomes insolvent, the fiduciary duty of the Board turns to all stakeholders, including creditors, and it is important to ensure that the position of creditors is not worsened by the actions of the directors – the Board cannot take any action that may be to the detriment of the creditors, otherwise they can lay themselves open to claims of misfeasance at a later date.

In many businesses, a conflict of interest will arise; the Board and the shareholders will want to continue to invest in the business, but this could come at the expense of the DB scheme members. In this scenario, it is of paramount importance that you engage with the scheme trustees to keep them up to date with the company’s financial position so that they can obtain their own independent advice.

Other impacts

This issue has potentially other implications down the line, especially for those businesses where they are reliant on bank loans and overdrafts, or an invoice discounting facility. The effect on the financial statements could lead to covenants being breached in due course. For those businesses seeking investment to develop their business, they might struggle to obtain the additional funding they need to progress, resulting in a “check mate” position whilst a resolution is sought.

However, the purpose of this article is not to bring a thunder cloud on the horizon; indeed there are many solutions and an insolvent balance sheet does not necessarily mean that the business is going to fail if the company can still pay its debts as and when they fall due. But notwithstanding that, if you have clients who may be facing difficulties as a result of these changes, seeking advice from a restructuring professional as soon as possible is key to finding a sensible solution for all involved; the longer you delay, the chances are the liability will increase, making it more difficult to find an effective solution.

Should you have any clients that are facing these pressures, please do not hesitate to contact Patrick Lannagan or Heather Bamforth of our Restructuring Services team.