As companies look for different ways to preserve cash, the option of deferring deficit repair contributions (DRCs) to defined benefit (DB) schemes is being considered by many organisations. It has been widely reported that, to date, around 10% of companies with DB schemes have approached their scheme’s trustees to seek a deferral. This number can be expected to increase as the constraints on cash flow resulting from the outbreak of COVID-19 and the resulting lockdown measures continue.
We have advised several companies and trustee boards on the scope for reaching an agreement to defer DRCs. We discuss below some of the key steps that companies can take to facilitate agreement being reached.
We also consider additional funding issues relating to actuarial valuations, recovery plans and PPF levies that companies with DB schemes should be aware of.
1. Providing information
Any company seeking to defer DRCs should engage with its scheme’s trustees, clearly explaining the rationale for its request and providing as much information as it can to support this. As a minimum, trustees are being encouraged to ask for thirteen week cash flow projections, which will likely have been prepared by a company in any event to support board decisions and discussions with banks and other creditors.
Trustees should recognise that any information provided is liable to change as events unfold. However, as a result, there may be an expectation for greater transparency and information sharing during the period of any deferral than might ordinarily be the case.
2. Ensure equitable treatment
The Pensions Regulator has signalled its support for trustees agreeing to defer DRCs for a limited period provided the pension scheme is appropriately safeguarded and treated equitably alongside a company’s lenders, other creditors and shareholders. Therefore, before they agree to defer DRCs, trustees will likely want to know:
- that the company’s banks and other lenders are continuing to support the business and will share in the pain;
- that dividend payments have stopped and will not resume until the DRCs have been made up;
- that intra-group transfers will be limited to those that are essential to the survival of the business or group; and
- what other steps the company has taken/is taking to preserve cash (such as furloughing staff and/or implementing pay freezes or cuts for senior management).
Trustees may also seek a legally binding commitment regarding the suspension of dividend payments and the restrictions on intra-group transfers.
3. Consider ‘switch-on’ mechanisms
The Regulator has said that trustees should initially only agree to a short suspension (for example, up to three months), particularly where information is limited. However, trustees may be open to agreeing a longer period where other creditors, such as banks, are agreeing to longer deferrals and where it is appropriate for the scheme to mirror this.
Although any agreement to defer will be time limited, trustees may seek to include a mechanism in any deferral agreement for DRCs to resume should cash flows improve more quickly than anticipated. Consideration should be given to how this might operate. For example, the agreement could provide that DRCs will resume early if EBITDA targets are exceeded in two consecutive months.
4. Seek advice
Before approaching their scheme’s trustees to request a deferral of DRCs, a company should seek legal advice because the approach in itself could constitute a default event for the purposes of the company’s banking and finance facilities and any other security arrangements. Therefore, this will need to be considered before any approach is made.
Legal and actuarial advice will also be needed on how any deferral should be implemented. It is likely that any deferral will require the scheme’s schedule of contributions to be amended to prevent the scheme from breaching legal restrictions which prohibit trustees from making any form of employer-related loans (which include deferring sums that have become due and payable to the scheme).
Checks will also need to be made to ensure that any deferral will not have any unintended consequences under the scheme’s winding-up powers, or any contingent funding or security arrangements that may have previously been put in place.
5. Contingent security
Depending on the circumstances, a company may need to consider whether any form of contingent security could be offered to the scheme (either temporarily or over a longer period) in order to get a request for a deferral across the line. This may be necessary where a company is in severe distress, where the proposed deferral period is longer than three months or where an annual or particularly large contribution is due during the deferral period.
The types of contingent security that may be appropriate include parent company guarantees and charges over property or other assets.
6. Don’t forget scheme expenses
Alongside (or as an alternative to) deferring DRCs, a company may also seek to defer payments that will become due to cover scheme expenses or to shift the obligation to pay expenses to the scheme (either temporarily or indefinitely). The same issues as those set out above will need to be considered where this option is proposed.
Where it is proposed that a scheme will assume the obligation to pay scheme expenses trustees may have additional concerns about the impact on the scheme’s funding position and/or cash flows and the scheme rules may need to be amended to enable this.
Actuarial valuations and PPF levies
Companies that are in the process of concluding negotiations over the terms of the scheme’s funding arrangements (including any recovery plan) as part of their scheme’s triennial actuarial valuation process should consider whether those negotiations should be extended to allow time for any agreement that may have been reached to be adjusted take account of recent events. The Regulator has said that where schemes are approaching the 15 month deadline for preparing their valuation and agreeing the terms of any recovery plan, they can have up to three months longer to finalise these without the Regulator taking action.
The Regulator is due to issue guidance for schemes and sponsors that are in the middle of or about to embark upon a valuation process in its Annual Funding Statement which is due to be issued by the end of this week. It is hoped that this will make clear how recent events and the corresponding impact on companies’ financial positions should be reflected in the actuarial valuations and recovery plans for such schemes.
Finally, over the medium term, companies should also assess how any reduction in their covenant strength may impact the amount of their scheme’s annual PPF levy and consider how any additional liability will be met.
For further information on the scope for companies with DB schemes to defer contributions to their scheme, please contact:
The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2021