01/11/2013

Charity relief

Terry Saeedi on the great definied benefits crisis charities are facing.

Click here for coverage of the article on Pensions World.

The Wedgwood Museum pottery collection under threat. The Royal Geographical Society auctioning painting and sketches from a Victorian expedition to Australia.  A Northern Irish cross-community charity has been wound-up.  The common thread behind the difficulties these charities face is the defined benefit pension scheme deficit.

CHARITIES: SOME BACKGROUND INFORMATION

There are over 180,000 charities registered with the Charity Commission.  Of these about 30,000 employ around 857,000 people.  Many charities participate in defined benefit pension schemes.  For example, according to Charity Finance Group figures, there are about 1700 charities in The Pensions Trust Growth Plan, 800 in the schemes for registered social landlords and around 2,000 – 3,000 participating in the Local Government Pension Scheme.

A charity has unique characteristics.  In order to be a charity it must be able to demonstrate that its purposes are charitable and for the public benefit.  Typically charities are funded through a combination of voluntary donations, income from contracts for delivering services and commercial income from trading and investment.

Charities generally manage their finances in order to ensure the maximum benefit for charitable purposes.  Donations are given on the basis that they will be used only for charitable purposes. Many charities have limited reserves and are reliant on fundraising each year to meet planned spending.  A significant number of charities have restricted funds which can only be used for the purpose for which they were intended – those funds cannot be used to meet the charity’s overheads.

The continuing economic difficulties have presented charities with particular issues.  At a time when costs for the sector have generally risen, donations are down in real terms, investments have under-performed and grant-giving bodies have less money to distribute.  Charities, therefore, are facing financial pressure which is being exacerbated by the particular issues relating to defined benefit pension schemes.

OVERVIEW OF THE PROBLEM

Historically charities have tended to provide defined benefit pension schemes for employees.  For a number of years the combination of increased longevity, increased regulation and economic difficulties have led to significant defined benefit scheme funding deficits. These in turn have led to many affected charities being put under severe financial pressure or, in some cases, being wound-up.

It is not only funding deficits which pose problems for charities.  An exit debt arises when a charity ceases to have any active members in (or eligible to join) a multi-employer scheme which is calculated on the buy-out basis.  The buy-out basis is the most expensive method of valuing pension scheme liabilities and is the cost of securing those liabilities with an insurance company.  The Charity Finance Group has commented that the cost of buying-out pension liabilities for the top 50 UK charities would be £4.7bn.    More detail

The defined benefit scheme funding regime requires a scheme to have sufficient and appropriate assets to cover its liabilities (technical provisions).  A key part of the funding process is the pension trustees’ ongoing assessment of the strength of the sponsoring employer covenant.

Covenant strength and affordability of deficit reduction contributions are major issues for charities.  These challenges have been recognised by the Charity Commission which has noted that pension deficit reduction contributions are likely to “increase at a faster rate than charitable income”.  In addition, some charities are technically insolvent because the size of the pension scheme deficit is larger than the amount held in the general reserve.

The Pension Regulator’s 2013 annual funding statement may help charities to some extent.  The statement requires an integrated approach to funding, investment and employer covenant risks.  The level of risk taken by the pension trustees should be “neither overly prudent nor overly optimistic”.  In relation to contributions, pension trustees should consider whether contributions are reasonably affordable for the employer.  However, the statement does not address the particular challenges faced by charities.

The ways in which a charity can address the funding deficit varies depending on whether or not the charity has its own scheme (or a fully segregated scheme) or participates in a multi-employer scheme.  Those with their own scheme have more options available to them to address deficits.  The most popular option has been to close the scheme both to new members and to future accruals.  Other options available are the reduction in the rate of benefit accrual and/or increasing member contribution rates.

It is important to note that closure to accrual does not eliminate the funding challenge.  The scheme is still subject to the funding regime.  Whilst no further liabilities will accrue, their value (and as such the extent of the deficit) will be affected by such matters as longevity and investment return.

Charities have a narrower range of funding options available to them than private sector scheme employers.  One of the most common tools for private sector employers to assist with covenant strength has been the provision of contingent assets the value of which become available to the scheme at a specified time, for example, employer insolvency.  Examples of contingent assets include charges over real property, parent company guarantees or letters of credit.  The nature of a charity means that only the largest may be able to consider contingent assets and then perhaps only a charge over property.

Charities which participate in a multi-employer (non-segregated) scheme, for example The Pensions Trust, have fewer options available to them.  In a non-segregated scheme the assets and liabilities for all employers are pooled together for funding and investment purposes.  This means that funding assumptions are set for the whole scheme rather than for each participating employer.

It is difficult for a charity to stop participating in a multi-employer scheme without triggering an exit debt.  The debt legislation applies where an employer stops having active members in the scheme at a time when another employer continues to have active members.  The only way to prevent triggering the debt would be for all participating employers to cease accrual at the same time.  This is going to be difficult to achieve in practice where employers have no connection to each other.  Participating charities are caught in a catch 22 situation, therefore.

When a participating charity becomes insolvent the liability to fund any deficit relating to that charity’s members often falls on the remaining participating employers.  This type of scheme is referred to as a “last man standing scheme” because effectively it is the strongest employers which end up standing behind the funding obligations of weaker employers.

A charity is only able to provide a guarantee if it furthers its charitable purposes and it has the express power to do so, so it is unlikely that it would be able to guarantee the liabilities of an unconnected charity. However, this cross-subsidy is just what occurs in a non-segregated multi-employer scheme.

LOCAL GOVERNMENT PENSION SCHEME

A large number of charities participate in the Local Government Pension Scheme (LGPS).  This may be because they have tendered and won local government contracts and a condition of that contract is participation in the scheme.  It may also be because the charity was established as a result of local government outsourcing.  Whatever the reason for participation, the LGPS creates particular issues for charities.

The LGPS is a funded public sector pension scheme made up of a number of separate funds across the country.  When a charity is admitted as an employer to the LGPS it is required to fund both the future accrual of benefit for its members and also any deficit in respect of members’ past service in the LGPS.  Regardless of any deficit in respect of future service, there is likely to be a deficit on the past service basis because the amount transferred to the charity in respect of past is calculated on the ongoing funding basis rather than the exit basis.

IMPACT ON CHARITIES?

The existence of defined benefit schemes (and their associated difficulties) has had a major impact on the charities sector.  Charity mergers and restructurings often founder because of defined benefit scheme issues.  Affected charities may also find that the additional cost of defined benefit liabilities may result in them being less competitive on tenders.  They may also be turned down for grant funding on the basis that too much of the grant might be directed into the pension scheme.

WHERE NEXT?

The Charity Finance Group has been lobbying for a change in pensions legislation both in relation to private sector scheme and also the LGPS to recognise the unique challenge which charities face.  In response the Government has set up a working party to consider the issues.  Only time will tell whether or not a solution acceptable to both sides can be found.