Patrick Kennedy and Caoimhe O’Neill If you sign a contract with a firm that has an underfunded final salary pension scheme, it could drag you into the mire too

Construction firms operate sophisticated vetting and pre-qualification schemes for their supply chain but an important, often overlooked, issue for parties entering into contracts is whether the solvency of the other contracting parties could be threatened by an underfunded final salary pension scheme.

Final salary pension schemes differ from other pension schemes in that the employer promises a particular level of pension to its employees calculated with reference to their final salaries. The employer is then responsible for ensuring that the funding in the pension scheme is sufficient to meet these promised benefits.

Over a decade ago, there would have been no issue: a company’s pension fund would probably have been fully-funded and capable of meeting the projected benefits. However, the recent performance of the stock market has caused a dramatic change in the solvency of pension schemes. People are also living longer, which means that the annuities purchased at retirement are costing the pension scheme more. The result of this is that the capital values of final salary pension schemes are frequently higher than those of their “sponsoring” companies.

Up until last year, the problems facing final salary schemes had caused a sharp rise in the number of final salary schemes being wound up by companies. However, in June 2003, the government introduced legislation making it prohibitively expensive for any solvent employer to wind up an underfunded final salary scheme. As a result, it appears that these schemes are here to stay. Consequently, all contracting parties must be alive to the fact that a company with a final salary pension schemes might carry an increased risk of insolvency, and adapt their vetting and qualification procedures accordingly.

A troubled fund might not be revealed on the company accounts. The obligation of a company to make good any pension deficit will only arise if a valuation shows that the scheme is underfunded. Such valuations generally only take place every three years, and take a further year to prepare and agree future contribution levels. This means that the company accounts might reflect a schedule of contributions to a pension scheme that is up to four years out of date. Indeed, most pension schemes had healthy valuations prior to 2000/2001. It is the subsequent valuations that have shown large declines in funding.

The recent Pensions Bill introduces a host of complicated concepts and provisions that may, in time, grant further protection for the pensions schemes. But that’s a subject for another day.

A further danger to the solvency of a company is the power of the pension scheme trustees. In some cases, the trustees may have a power to wind up the pension scheme if they believe that the funding of the scheme is in jeopardy and they are unlikely to receive further contributions from the company. If the trustees use this power while the company is still solvent, given the June 2003 changes in the law, the company might be unable to meet its obligations and therefore become insolvent.

If the company becomes insolvent, although the pension scheme is an unsecured creditor, the size of the pension debt will dwarf any other unsecured claim, effectively scooping the pool when it comes to any recovery in insolvency. The Pensions Protection Fund due to commence in April 2005 may in time dilute this effect, but in the meantime it remains a significant concern.

Another thing: where a company does encounter financial difficulties as a result of an underfunded scheme, financial strength elsewhere in the company’s group can not necessarily be relied on. Only a company that formally participates in a pension scheme has any obligation to contribute. Any other solvent group member or a solvent parent that did not participate in the scheme has no liability to make good any pensions deficit.

What, if anything, can be done to guard against these risks? Those involved in the vetting of potential contractual parties must not make the mistake of focusing only on company accounts. Instead, enquiries need to be made of the most recent pension scheme accounts and actuarial valuation. Simply putting a tick in the solvency box may increasingly give rise to serious consequences.