Gary Cullen: Charities must tread warily in the final salary pensions minefield

Published on Thursday 28 January 2010 20:15

FINAL salary pension scheme deficits have long been a thorn in the side of many successful businesses – a thorn that has, in many cases, taken a great deal of time, pain and cost to extract.

As much of the private sector is getting to grips with its liabilities, there is concern over the situation in the third sector. With many charities only now beginning to address their own multi-million-pound pensions powder-keg, what will be the potential damage to their reputations and their prospects of long-term survival?

Over the past five to ten years, many employers have lost control over their final salary pension schemes. This has been as a result of the growth in very trustee-orientated legislation, as well as the advent of the Pensions Regulator, who has the power to take Draconian enforcement action against the sponsoring employers of inadequately funded schemes.

Alongside this, investment returns over the past ten years have been poor, with many schemes suffering losses. This has led to schemes having substantial deficits, which have been thrown into relief by changes in the way they are valued, and increasingly stringent funding requirements.

Employers also have the Sword of Damocles hanging over them, in the form of section 75 of the Pensions Act 1995 as amended. Section 75 states that, in certain circumstances, the employer has to meet any deficit on the "annuity buy-out" basis. This is the most expensive way of funding a scheme, calculated on the assumption that annuities are purchased by the trustees for all beneficiaries.

Private-sector companies have struggled with these issues for years, but many charities now find themselves in a uniquely challenging position. Members of the public donating money or other assets to charity do so in the reasonable hope that at least a large proportion of their donation will reach those who need it. Most donors would certainly be displeased to learn that a chunk of their money is simply going to fund past service deficit in the charity's pension scheme.

Accounting standards oblige companies to provide details in their annual accounts of any deficit within their schemes. If a member of the public making a donation to a charity were to see huge deficits in its accounts, they might reasonably conclude that their donation may not have as much impact on the ground as they hoped.

But charities considering shutting the door on their old final salary scheme face a practical dilemma. The third sector sometimes pays less well than money-making organisations, simply because there tend to be less available funds. Therefore, charities have historically offset lower salaries by offering employees accrual in a final salary pension scheme.

The damage caused by the loss of such an incentive clearly weighs heavily. A recent survey of the Charity Finance Directors' Group found 43 per cent of those charities which still have open final salary schemes have no plans to close them.

However, there is now real pressure to take a much tougher stance, as the longer such schemes are open to future accrual, the bigger the deficit will be.

Charities may consider following most private-sector employers, which have stopped future final salary accrual. In doing so, however, they must take great care not to trigger a winding-up of the scheme and, therefore, a very costly section 75 Pensions Act debt.

An employer cannot trade while insolvent, so if the pension scheme deficit cannot be contained, the company would have to go into liquidation or administration. The same principles would apply to a charity. Given the volatility of stock markets, it would be very easy for an employer suddenly to find itself trading while insolvent.

Those responsible for the running of charities must contain the risk and liability of the pension scheme, perhaps by stopping future accrual or offering incentives for members to transfer into alternative arrangements.

The lifeblood of all charities is donations, and all such donations are made with the aim of tackling poverty, promoting education and fulfilling other charitable purposes as required by the Office of the Scottish Charity Regulator.

It would be difficult for any charity to justify its existence where a substantial proportion of funds being received are going straight into the pension scheme.

&#149 Gary Cullen is a partner and head of the national pensions unit at Maclay Murray & Spens LLP