Author: Ruth Bromley, BDO Pensions Specialist
In its recent annual funding statement, the Pension Regulator’s (“tPR’s”) attention appears to be directed towards corporate employers whose affordability has improved, evidenced by a policy of increasing dividend payments and other returns to shareholders. Does this let charities and other not-for-profit organisations off the hook? Unlikely!
So what are some of the ways in which tPR’s annual funding statement affects charities with defined benefit pension schemes?
tPR re-emphasises the importance of the integrated management of the three key areas of risk which affect pension schemes – covenant (or an employer’s ability to support the scheme, now and in the future), investment risk, and funding plans. tPR highlights the scheme’s cash flow demands, which will be affected by its maturity, and the risks that a scheme’s deficit could increase e.g. as the result of an investment strategy downside scenario crystallising.
For a scheme sponsored by a charitable employer, the integrated risk management processes should be the same as for profit making enterprises, with the aim of helping trustees focus on what is most important for their scheme. One of the first steps is to consider the risk areas individually – and covenant risk is a good place to start.
Where do the risks lie in a charity’s finances, and how does this affect the employer covenant, i.e. its ability to afford contributions to a scheme now, and in the future?
Some of the key risks include:
- loss of income from donations, for example, through the loss of donor contacts as a result of the General Data Protection Regulation (GDPR), through reputational damage (whether in the charity itself or by association with others in the same sector), and through concerns over the level of pension scheme funding reducing the cash which actually ‘hits the ground’
- loss of other income, for example, through government austerity measures continuing to cut grants and contracts
- increased costs, for example, people costs as a result of the ruling regarding overnight sleep-in staff, the shortage of qualified nurses driving salary pressures, the strengthening of a dedicated compliance and risk team, and the introduction of the living wage, as well as increased fundraising costs and other overhead cost measures
- poor management information systems and governance, resulting in, for example, loss-making contracts, statutory or otherwise, and an inadequate level of reserves to stand unexpected financial shocks.
So how can trustees of pension schemes consider their employer’s ability to afford contributions to repair deficits? We consider some of the sources of income for charities below, and the extent to which they may be used to fund a scheme.
A charity’s trustees have discretion to use unrestricted funds to further any of the charity’s purposes. Unrestricted income includes:
- donations in the form of regular committed giving, fundraising, legacies, and corporate giving
- income from trading activities and contracts
- investment income
and, more rarely,
- unrestricted grants from public sector or other grant making bodies.
Unrestricted funds are those that the charity can most easily use to fund pension deficits, so an increase in unrestricted income is generally good news for the affordability of pension scheme deficits. Unrestricted funds are especially useful for scheme funding if it is predictable income, such as regular donations or committed grants. Contracts to provide services are also unrestricted, if the charity is able to use any surplus generated on a contract to fund its activities, rather than being returned to the source.
Our recent analysis of the top 50 charities’ income identified that unrestricted incomes were up by 20 per cent in the last two years, suggesting that the affordability of pension deficit reduction contributions for larger charities may be improved.
However, an increase in unrestricted income will have competing priorities for funding. In light of growing financial risks, charity trustees may have plans to increase reserves, or may see an increase in staff costs on the horizon, and will undoubtedly be conscious of the need to ensure that a high proportion of income be spent on charitable activities. They may also be required to supplement shortfalls in respect of any loss-making contracts. The pension scheme will be competing against these demands for access to limited cash, as well as any requirement the charity has to service and/or repay any external debt.
Restricted income funds must be used for a particular purpose, as specified by the donor or in the charity’s particular fundraising drive. In England these are known as Special Trusts. Careful consideration needs to be given to the precise nature of the restrictions, and the extent to which, if at all, such funds may be used to fund a pension deficit.
Diversity in funding sources is generally a positive thing for an organisation. However, budgets for the expenditure of restricted grants are usually agreed in advance with the funding providers, and therefore new sources of restricted grant funding in particular may not allow legacy pensions costs to be expensed on that funding. The extent to which scheme members work, or have worked on particular projects funded by restricted grants may, therefore, influence and enable deficit reduction contributions to be negotiated into budgets to be agreed by providers.
In some cases, the grants will only cover the incremental costs of running a particular project, and, in extremis, the reliance on restricted funding can jeopardise the survival of a charity if the charity is unable to source sufficient funding to cover its underlying costs. Charities that overly rely on restricted funds or see a trend over time moving from generating unrestricted income to restricted income may have limited scope to absorb unforeseen costs, including volatility in the scheme funding position.
Endowment funds are capital donations to the charity which are intended to be invested by the charity in perpetuity, with only the income earned on the capital able to be expensed. Some endowment funds grant trustees of the charity the power to convert some or all of an endowment into income, at which point this should then be treated as unrestricted, and may, therefore, be used to fund pension scheme obligations.
In addition to considering the sources and quantum of income into a charity, scheme trustees will need to be mindful of the interplay of the affordability of scheme contributions with expenditure.
It will not usually be possible to identify from a scheme’s accounts the qualitative factors which might influence funding decisions. For example, to what extent charitable expenditure may be curtailed, deferred, or expansion delayed to allow a higher level of agreed deficit reduction contributions? The conversations needed between the scheme trustees and charity management may be uncomfortable but should not be avoided in order for the scheme trustees to fulfil tPR’s expectations. Often it is the potential capacity to reduce discretionary expenditure which the trustees may need to rely upon to deal with cash demands arising from volatility in the scheme’s funding position.
Scheme trustees will already be conscious of the charity’s need to service any external debt, but should also take into account whether there are any financial covenants on the debt which might restrict the charity’s ability to make contributions, for example, by needing to maintain a certain level of unrestricted reserves.
For schemes whose employer covenants are at the weaker end of the spectrum, tPR expects trustees to secure proportionate reward for the scheme arising from employer growth and/or to maximise other forms of support, including contingent assets. For charities, this might mean that in addition to basic deficit repair contributions in the recovery plan, scheme trustees should consider obtaining a formal agreement to additional, contingent contributions when opportunities arise from unexpected income, and efficiencies in expenditure materialise (compared to a pre-agreed budget).
There are many real and pressing issues affecting the sector. These need to be properly considered as part of an assessment of the strength of the employer covenant which a charity provides to its pension scheme, particularly in the underlying affordability of contributions to meet a pension scheme’s funding gap. These funding gaps are in relation to pension benefits which have already been accrued, and the fact that a pension scheme may be closed to future accrual only means that sponsoring employers have stopped digging the hole any deeper. For those schemes that are currently open to future accrual, for many closing to future accrual will only make a relatively small dent in the funding shortfall.
One thing is for certain: tPR’s increased scrutiny will encompass not-for-profit employers and, in particular, schemes which have a higher risk profile in any one of the three integrated risk management areas. Trustees should, therefore, ensure that they have documented the work they have undertaken to be able to demonstrate their integrated risk management approach and their contingency plans.