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Companies should plan now to minimise their pension protection levy
The amount that pension schemes have to pay to the Pension Protection Fund (PPF) for the year 2006/07 may have increased by as much as five times the previous year's levy. Employers who ultimately bear the cost of many pension schemes will need to make plans now to ensure the levy payable for the year 2008/09 is kept to a minimum.
The PPF was set up under the Pensions Act 2004 and came into existence on 6 April 2005. Its principal purpose is to pay compensation to pension scheme members whose employers have been made insolvent and who have occupational defined benefit or hybrid pension schemes that the employer can no longer support.
There are various ways by which the PPF ensures that it has enough money to make compensation payments. These include:
- collecting the annual pension protection levy from all eligible pension schemes (an eligible pension scheme is one that has a deficit, is a defined benefit or hybrid pension scheme, and potentially may need to draw on the PPF should the employer become insolvent);
- making its own investments and maximising the returns;
- if a pension scheme enters the PPF as a result of sponsoring employer insolvency, transferring the assets of that pension scheme to the PPF; and
- if possible, during the insolvency process, recovering further assets from the insolvent employer as a major creditor.
There are two parts to the levy that pension schemes have to pay. First, there is a scheme-based levy, which is based on the scheme's PPF liabilities. Secondly, there is a risk-based levy which takes into account the following three factors:
- the likelihood of the employer becoming insolvent;
- a measure of how much the scheme is underfunded, but taking into consideration any recent contributions made to alleviate the scheme deficit; and
- the existence of any contingent assets that have been put in place by a scheme (for more information, see below and also our article, 'Contingent asset agreements - start getting ready for levy year 2007/08', IHL146, p81).
The Levy Scaling Factor
The PPF estimated in December 2006 that it would need to collect £675m through the pension protection levy in 2007. This represents an increase of potentially five times the levy paid for 2006/07.
It will be achieved through the new levy scaling factor, which was revealed at the end of April 2007. The role that the levy scaling factor plays in the levy calculation is to measure the insolvency and underfunding risk for each pension scheme so that the total levy amount closely matches the PPF's original levy estimate of £675m. The chief executive of the PPF, Partha Dasgupta, has explained that the levy scaling factor is crucial to the levy calculations because it allows the PPF to distribute the levy proportionately among eligible schemes. This strengthens the financial security of the PPF and provides levy payers with greater certainty about the amount they will have to pay.
The scaling factor calculations for 2007/08 have been based on a larger sample of schemes and better data than last year. However, the PPF has said that the quality of data will improve further next year.
Levy invoices based on the new scaling factor will be issued to schemes from summer 2007. One-fifth (20%) will be based on the scheme's PPF liabilities (the scheme-based levy), and four-fifths (80%) on the risk-based levy. The scheme-based levy is a measure of a scheme's assets compared with the liabilities that the PPF would be required to meet should PPF compensation be payable to the members. Such compensation includes 100% payment of the pensions already being received by pensioner members, and 90% of future pensions owed to deferred and active members (which have been capped at £26,925.70 for 2007/08). Schemes that are more than 125% funded on a PPF basis (this is the measure of the scheme's PPF liabilities as explained above) are exempt from the risk-based levy.
Methods by which companies may reduce the 2008/09 levy
There are methods that employers and schemes can use to reduce the amount of the levy that will be payable by the scheme in future. Outlined below are some of the more common options:
1) Additional contributions
Any additional contributions made by employers to reduce scheme deficits are taken into account by the PPF if the relevant certificate was returned to the PPF by 5 April 2007. There is no reason to believe that this will not be the case for 2008. The certificate must be given by the actuary appointed in relation to the scheme, and must state that a deficit reduction contribution has been made since the date of the last valuation. Consequently, the value of the assets of the scheme will be increased by the aggregate amount of contributions.
2) Contingent assets
A contingent asset is an asset over which the trustees of the pension scheme have been given a charge. The contingent event, which will release the assets to the trustees, is employer insolvency. The PPF has recognised the value of contingent assets in an insolvency situation, and will therefore reduce the levy paid by the pension scheme should a contingent asset be put into place using the PPF's standard documentation.
The board of the PPF recognised three forms of contingent assets when calculating the 2007/08 levy. These include:
- cash, property or securities granted by the sponsoring employer or associated company;
- a group company guarantee provided by any group company based in an Organisation for Economic Co-operation and Development (OECD) country; and
- bank guarantees and letters of credit provided by banks based in OECD countries and with a set credit rating.
However, any contingent asset for your pension scheme must be certified to the PPF board, using the relevant PPF standard form documentation, by 30 March of the relevant year (for 2008/09 this will be 30 March 2008).
3) Replacing principal employers with a more financially-robust company
Another method, which, if planned properly, may operate to reduce the risk-based levy, is to replace a financially weak principal employer with a financially stronger company that attracts a better rating from the PPF when assessing the risk-based element of the levy.
Given the sharp increase in the size of the levy payable to the PPF in 2006/07 and the predicted significant increase in the levy for next year, it is advisable for companies and schemes to plan ahead now to reduce the level of their future PPF levy. Both the trustees of pension schemes and their sponsoring employers have a common interest in reducing the cost of the levy. The use of, for example, contingent assets to reduce it can take a little time to organise, but once in place the benefits are available for years to come. Some companies are concerned that the size of the levy reduction is disproportionately less than the cost of putting in place measures to reduce it. The point to remember is that there will probably be significant increases in the size of the levy in the future and, once established, a contingent asset will reduce the levy for as long as it is in place.
By Philip Goodchild, partner, and Holly Thomson, associate, in the pensions team at Stephenson Harwood.