In its recent annual funding statement, the Pensions Regulator’s attention appears to be directed towards corporate employers whose affordability has improved. Does this let charities and other not-for-profit organisations off the hook? Unlikely. So how will the regulator’s annual funding statement affect charities with defined-benefit pension schemes?
The regulator re-emphasises the importance of the integrated management of three key areas of risk that affect pension schemes: covenant, investment risk and funding plans. The regulator highlights the scheme’s cash-flow demands, which will be affected by its maturity, and the risks that a scheme’s deficit could increase.
For a scheme sponsored by a charitable employer, the integrated risk-management processes should be the same as for profit-making enterprises, helping trustees to focus on what is most important for their scheme. One of the first steps is to consider the risk areas.
Where do the risks lie in a charity’s finances and how does this affect the employer covenant – its ability to afford contributions to a scheme now and in the future? Some of the key risks include: loss of income from donations; loss of other income, for example through cuts to grants and contracts; increased costs; and poor management-information systems and governance.
So how can trustees of pension schemes with charities consider those organisations’ 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 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 incomes of the top 50 charities identified that unrestricted incomes were up by 20 per cent in the past two years, suggesting that the affordability of pension deficit reduction contributions for larger charities might be improved. However, an increase in unrestricted income will have competing priorities for funding. In light of growing financial risks, charity trustees might have plans to increase reserves, could 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 is spent on charitable activities. They might 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 might 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 might therefore influence and enable deficit reduction contributions to be negotiated into budgets to be agreed by providers.
In some cases, the grants will cover only the incremental costs of running a particular project and, in extremis, the reliance on restricted funding can jeopardise the survival of a charity if it is unable to source sufficient funding to cover underlying costs. Charities that rely overly on restricted funds or see a trend moving from generating unrestricted income to restricted income might have limited scope to absorb unforeseen costs.
Endowment funds are capital donations to the charity that are intended to be invested by the charity in perpetuity, with only the income earned on the capital expensed. Some endowment funds grant charity trustees the power to convert some or all of an endowment into unrestricted income, which may therefore be used to fund pension scheme obligations.
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 that might influence funding decisions. For example, to what extent can charitable expenditure be curtailed or deferred, or expansion delayed, to allow a higher level of agreed deficit reduction contributions? The conversations needed between the scheme trustees and charity management might be uncomfortable but should not be avoided, in order for the scheme trustees to fulfil the regulator’s expectations. Often it is the potential capacity to reduce discretionary expenditure that the trustees might 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 that might restrict the charity’s ability to make contributions, such as maintaining a certain level of unrestricted reserves.
For schemes whose employer covenants are at the weaker end of the spectrum, the regulator 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.
Many real and pressing issues affect the sector. These need to be properly considered as part of an assessment of the strength of the employer covenant that 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 that have already been accrued, and the fact that a pension scheme might be closed to future accrual means only 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 make only a relatively small dent in the funding shortfall.
One thing for certain is that the regulator’s increased scrutiny will encompass not-for-profit employers and, in particular, schemes that 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.
Ruth Bromley is a senior manager in the pensions advisory team at BDO