Unfortunately, in a low interest rate/low investment return/low gilt yield world, many final salary defined benefit (DB) schemes have become a dangerous drag on the financial performance of the employers that sponsor them. Charities may find themselves in a particularly difficult position – and those that are part of multi-employer DB schemes carrying very large deficits could find themselves caught in a particularly tricky, potentially ruinous predicament.

Most single employer DB pension schemes run by charities are in a similar state to schemes sponsored by private sector employers of a similar size: they are relatively small, but likely to be closed to new entrants. Many will also have been closed to future accrual of benefits from members, with employees encouraged to join a defined contribution (DC) pension instead. Further impetus to join DC schemes is being provided by auto-enrolment.

Almost all single employer DB schemes in the sector are likely to be in deficit. The most recent annual funding statement issued by The Pensions Regulator (TPR) showed that although many investment asset classes have performed relatively well over the past year, most schemes are still likely to have a larger than expected deficit on their valuation dates. That means trustees and employers will need to adjust deficit recovery plans – which may mean higher employer contributions.

When that employer is a charity this becomes even more difficult, because the way the organisation can spend income from specific sources may be restricted. Anjelica Finnegan, senior policy advisor at the Charity Finance Group (CFG) is currently researching the methods charities are using to reduce these deficits. She suspects they must be using unrestricted reserves, or other assets held by the organisation to do so.

The 2016 UK Civil Society Almanac, produced by NCVO, calculates the voluntary sector has a collective pension deficit of £1.7 billion. About £1.5 billion of this is accounted for by charities with incomes of over £10 million. But far smaller sums may be very dangerous for smaller organisations.

Charities also now have to report these deficits on balance sheets, following the introduction of Financial Reporting Standard (FRS) 102, which applies to all but the smallest organisations.

“We’re operating in an environment where charities are being told to cut back on back office spending,” Finnegan points out. “When people see money going somewhere other than to the beneficiaries they may think that’s a bad thing. So it is important that charities highlight in annual reports what they’re going to do to bring down the deficits.”

Sarah Woodfield, policy advisor at the Pensions and Lifetime Savings Association (PLSA), fears there may also be implications for Pension Protection Fund (PPF) levy calculations. PLSA is working with the PPF to find a way to ensure charities are not hit by unreasonable demands as a result.

David Davison, director and owner at pensions consultancy Spence & Partners suggests that organisations carrying DB liabilities may also find this restricts their ability to merge with other organisations, to benefit both organisations and their beneficiaries.

Multi-employer schemes

Charities in multi-employer schemes in deficit are likely to have the least room to manoeuvre. In many cases the organisations joined these schemes because they offered a way to share risks associated with pension schemes. In other cases charities may have joined local authority schemes, or absorbed pension liabilities on behalf of former local authority employees, as a result of them being contracted to deliver public services.

Those charities are now unable to escape the spiralling liabilities associated with these schemes without having to pay substantial exit costs: Section 75 debts based on the potential costs of buying annuities for their employees in the scheme.

“The exit debt is calculated on a buy-out basis, so it’s very costly – for charities more often than not it’s just unaffordable,” says Gareth Hopkins, director at GJH Pensions. “Even if the charity has the funds to cover this exit debt, trustees are likely to be resistant to using charitable donations for a non-charitable use, so charities may find themselves handcuffed to the scheme. Worse, they’re tied to a scheme where the deficit will increase.”

Hopkins suggests the freedom of choice rules for defined contribution pensions may help, in some circumstances, where it is in the interests of both member and scheme for benefits to be transferred to a DC pension. But with serious concerns having been raised about individuals transferring out of final salary schemes to access pension pots, this would need to be an informed decision by the individual. Ideally, they would take financial advice before making a decision.

“We’re not suggesting everybody should transfer their final salary benefits – but members with smaller pots may want to do that,” says Hopkins. “It’s about employee or member engagement: many schemes will not have made it clear to members that they have that option. In some circumstances a transfer of benefits is a good idea for both member and employer – but caveats do apply.”

CFG, PLSA and other organisations continue to work with the Government to try to find a way to reduce the Section 75 exit costs for charities. A Department of Work and Pensions (DWP) consultation gathered submissions from the pensions industry and the charity sector regarding this issue in the summer of 2015, but there is no word yet from the DWP on when or what kind of further action might be taken.

Hopkins is a member of the PLSA Charities Working Group, which is working with the DWP to address the problem and which has made some suggestions as to how legislation could be changed. “The reason it’s tough is that if and when you ease the issue for charities regarding exiting multi-employer schemes you open the door for other employers too,” he says. “It would be hard to treat charities differently.”

In response to a query from Charity Times as to when further announcements might be forthcoming, a spokesperson for the DWP said: “We continue to fully assess the detailed views and evidence submitted to our Call for Evidence and are looking at how existing measures are used by employers and schemes to manage the debt”.

Local Government Pension Scheme

Meanwhile, the PLSA is also addressing the issue of the growing number of employers joining the Local Government Pension Scheme (LGPS), including some charities providing public services.

There is some concern that charities may lack a full understanding of the financial obligations associated with the scheme. Other public sector schemes have a fair deal arrangement in place which restricts a charity’s pension liabilities to the term of the contract for delivering a service, but the LGPS does not yet have such an arrangement. Employers seeking to leave the scheme will be liable for an exit payment likely to be calculated on the same basis as Section 75 debt. The PLSA is producing new guidance to assist employers in the LGPS.

The PLSA is also gathering evidence to inform the work of its DB Taskforce, launched in March 2016 to find ways to make DB pensions more sustainable. It will issue initial findings in the summer, then put recommendations to the Government in the autumn. “If there are representatives out there from charities who would like to tell us how DB pensions are affecting them, we’d like to hear from them,” says Woodfield.

All these issues should be considered in the context of the other financial challenges charities face, including reduced donor, grant and/or public service contract income; and the impact both of auto-enrolment and of the introduction of the National Living Wage.

“It is a bit of a perfect storm,” says Finnegan. “CFG and other partners have asked before the Budget for charities to get greater payback from National Insurance to be able to match the package of support provided for private business through corporation tax cuts.” But there is no indication this will happen anytime soon.

It seems a terrible shame that pension schemes, designed to help employees enjoy a more comfortable retirement, are causing so many problems.

The hope must be that continued efforts from within the charity sector and Government action will bring some comfort to organisations trying to do the right thing by employees, beneficiaries, donors, funders and society.

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