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Lending to Pension Schemes

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United Kingdom

Andrew Evans and David Gallagher discuss lending to and the variations of Pension Schemes
 

Types of Pension Schemes in the UK

There are several different types of pension scheme found in the United Kingdom. The main categorisation is between Occupational Pension Schemes which must be sponsored by an employer and Personal Pension Schemes which are, in effect, individual insurance contracts between the scheme member and the financial services provider. Master trusts have developed in the last 5 years and they contain features of both occupational and personal pension schemes.

Occupational Pension Schemes

Occupational Pension Schemes in the private sector have to be under trust. In the public sector they can have managers instead of trustees and the managers can have an investment fund for the scheme. This briefing paper only deals with private sector occupational schemes.

Occupational Pension Schemes are often further categorised by the type of benefit which they supply being either Defined Benefit Schemes or Money Purchase Schemes.

Defined Benefit Schemes

Defined Benefit Schemes use a pension formula that is set out in the rules of the scheme. This formula often uses the employee's salary at the date of retirement and such schemes are called "Final Salary Schemes" (which are being phased out in practice), but there are other types of benefit formulae which can be used in a Defined Benefit Scheme.

Money Purchase Schemes

Money Purchase Schemes are schemes where the individual members get a benefit in retirement which is based solely on fund performance. Often these schemes have a set contribution level and they are often called "Defined Contribution Schemes", but in legal terms it is the money purchase definition which is important. It is possible for a scheme to have a defined benefit section and a money purchase section under the same trust.

Small Self-Administered Schemes ("SSAS")

There is a sub-category of occupational scheme which used to be known as a SSAS - Small Self-Administered Scheme. These schemes usually have a maximum of 12 members, all their members are trustees and formerly had a number of exemptions from pensions investment rules. Since 2005, most of these exemptions have either been expanded to be available for all schemes with fewer than 100 members or withdrawn.

The current main exemptions for small schemes provide that they do not need:

  • To prepare and revise a Statement of Investment Principles

  • to comply with the statutory requirements to invest to ensure security, quality, liquidity and profitability of the portfolio; or

  • to comply with the statutory test that borrowing is only for temporary liquidity

(but they are still subject to less specific trust law obligations to act in the best interests of their members).

A SSAS is usually constructed in a similar way to an occupational pension scheme with a Trust Deed and Rules and trustees appointed who have connections with the sponsoring employer.  The members will be senior employees or directors or will have been in the past – it is not permitted for this type of scheme to have members who were not in receipt of earnings from the sponsoring employer at some point.  The trustees are often all the members.

A SSAS will often have a corporate trustee, although the legal requirement to have this was abolished in 2004.  In some schemes the corporate trustee has additional powers (for instance certain decisions can only be taken with the consent of the corporate trustee), in others it would be specifically excluded from some decisions. 

SSASs will typically have more than one member although this is not a legal requirement and a SSAS could exist for a single member.  Where there is more than one member it is possible to have separate investment accounts and for the members to agree between themselves that they will only exercise trustee powers in relation to the account of which they are the beneficiary.  Where there is such an agreement it is not normally in the Trust Deed and Rules, but will be in a separate document and additional due diligence and warranties/representations may be required.

Self Invested Personal Pensions ("SIPP")

A SIPP is a type of personal pension scheme and therefore by definition in legal structure will only have one member who is building up benefits and entitled to draw a pension (or other retirement benefits) from the scheme.  But note that it is possible for a SIPP provider to create an umbrella trust structure which sits above a series of separate SIPP policies and sub-trusts.  In this regard there may be a single trust deed document relating to a large number of SIPPS each of which has the same boilerplate rules.  Technically they are separate pension schemes.  Additional drafting or revision of defined terms may be necessary to cater for such a structure.

An Occupational Pension Scheme that is "defined benefit" or "money purchase" could borrow from a bank.

Can pension scheme trustees borrow?

Regulatory Restrictions

In exercising their powers of investment, trustees of an Occupational Pension Scheme must comply with the Occupational Pension Schemes (Investment) Regulations 2005. For schemes with one hundred members or more Regulation 5 prescribes that they may only borrow money for the purposes of providing liquidity to the scheme and on a temporary basis. Pension schemes can have unexpected liabilities (as many of them provide lump sum death benefits) and may have cash flow issues (if, for instance, pensions are paid to the members monthly but employer contributions are paid annually or quarterly). An Occupational Pension Scheme with less than one hundred members does not have any regulatory restrictions on borrowing, but can only borrow (and give security for such borrowing) if the Trust Deed and Rules relating to the Scheme permit it to do so.

Scheme Trust Deed and Rules

Every pension scheme must have its own governing documentation. For a trust-based scheme this will normally be a Trust Deed and Rules which, despite its name, is usually a single document. This document will almost always have an investment power in it. That may:

  • permit borrowing by the Trustees,

  • expressly provide that they must not borrow, or

  • provide that borrowing is permitted, but only subject to certain conditions.

Every scheme has its own Trust Deed and Rules – there is no prescribed form such as Table A which exists for company articles of association. A Trust Deed and Rules can be amended, but the trustees would need their own legal advice from their own legal advisors on whether they could amend the Trust Deed and Rules to remove restrictions on borrowing. Note that while borrowing is not strictly speaking an "investment" in many definitions of the word, as a matter of drafting practice, powers for Trustees to borrow are often included in the investment provisions of a pension scheme Trust Deed and Rules.

Security

If security is being taken from the trustees it is equally important to ensure that the scheme Trust Deed and Rules permit the trustees to give such security.

Large Schemes and their SIPs

The trustees of an Occupational Pension Scheme with one hundred or more members must have in place a Statement of Investment Principles ("SIP"). The SIP must be prepared in consultation with the employer and reviewed every three years. It must also be reviewed without delay after any significant change in investment policy. Before preparing or revising a SIP the trustees must obtain and consider the written advice of a professional advisor with appropriate knowledge and experience of pension scheme investment. The SIP contains the trustees' policies in relation to a number of matters including the kind of investments to be held, the balance between them, risk and return and realisation of investments.

If a SIP for a particular scheme did not cover the use of borrowing we would advise a lender not to lend until the SIP had been amended expressly to permit borrowing by the trustees either generally or from a type of organisation which included the lender. It is arguable that a SIP would not need to cover borrowing because borrowing is not in itself an "investment". However, our view is that for an Occupational Pension Scheme where a SIP is required, as borrowing can only be used for temporary liquidity, the retention of assets that is facilitated by borrowing is a trustee policy on risk and realisation and therefore it is appropriate for the lender to expect to see it referred to in the SIP. Note also if dealing with such an argument that the restriction on borrowing by trustees is included in the Investment Regulations which are the same regulations which prescribe the contents of the SIP.

No SIP is required for an Occupational Pension Scheme with fewer than one hundred members.

Tax law limits on the value of scheme borrowing

Schemes are limited in the amount that they can borrow. Broadly speaking, the maximum that can be borrowed (in all borrowing not just the immediate loan being made) is 50% of the assets of the scheme measured on the day the loan is taken out. Note that it is 50% of net assets so, for example, if the scheme wants to invest all its assets in a £30m property it needs to fund £20m of the purchase price, and the most that can be borrowed is £10m (50% of £20m).  Liabilities to pay pensions are not deducted from net assets – only existing borrowing. The 50% is not periodically tested – if the asset value falls that does not cause a breach.  It is re-tested at any new lending, so re-mortgaging would catch an asset fall. Where a borrowing facility is created by a loan agreement but the borrowing is drawn in instalments, the borrowing test must be met at each draw-down.  But there are complications in the calculation of assets if members have started taking out their benefits. Because of this, and because the immediate loan may not be the scheme's only  borrowing, we advise that the lender requires that the trustees of the scheme warrant that the borrowing is "within the limits set out in the Finance Act 2004, sections 182-185".

Note that breaching these limits has tax consequences for the trustees – it does not necessarily make the loan illegal or unenforceable, but the tax charge may affect the trustees' ability to repay the loan. If the Trust Deed and Rules incorporate the limits of Finance Act 2004, sections 182-185 however, breach could be ultra vires the trustees and make the loan unenforceable. In practice, the 50% limit only really affects small schemes because the temporary liquidity rule and the best interests of members mean that large schemes' borrowing will always be much lower than 50% of assets.

Duty of trustees to act in the best interests of the members

The trustees of all sizes of scheme must be satisfied that they exercise their powers of investment in the best interests of the members and beneficiaries of the scheme. Again we leave aside arguments as to the definition of "investment" as the borrowing must necessarily be connected with retention of an investment. Trustees must be satisfied that any loan agreement they enter into is in the best interests of the members. "Best interests" in this context effectively means best financial interests rather than, for instance, preservation of future employment or protection of the industry in which the employer participates.

Duty of trustees to obtain investment advice

Trustees are required to determine at what intervals the circumstances make it desirable to obtain written investment advice when retaining an investment. In our view, the point at which they need to borrow to meet liabilities instead of liquidating an asset should be seen by the trustees as a circumstance in which they should take written advice on retaining the investment they are choosing not to dispose of. Therefore it would be appropriate for a lender deciding to lend to trustees in such a circumstance that they seek comfort that the trustees have obtained appropriate investment advice.

The role of the Pensions Regulator

The Pensions Regulator regulates UK occupational pension schemes with the purposes of protecting members' benefits and minimising claims on the Pension Protection Fund.  Most of its powers relate to trustees and sponsoring employers but under the Pension Schemes Act 2021 it also has a wider powers which could be used against those who lend to trustees or sponsoring employers of defined benefit schemes.

The 2021 Act creates a new criminal offence by introducing section 58B of the Pensions Act 2004 which will be of relevance to lenders to scheme trustees and is scheduled to be in force from 1 October 2021.  Under this section, it is an offence to do anything, without a reasonable excuse, which detrimentally affects in a material way the likelihood of accrued scheme benefits being paid to the scheme members where the person doing the act knew or ought to have known that the act would have that result.

Where a lender calls in a loan from and/or enforces security against trustees of a defined benefit pension scheme it is probable that this action would affect the likelihood of members receiving benefits and it would be reasonable for the lender to know that.  Where enforcement follows an event of default, the event of default in itself will probably increase the likelihood of benefits not being paid.  The lender therefore is left relying on the analysis that exercising its enforcement rights is a reasonable excuse.  The legislation applies to the enforcement event at the time of enforcement even if the loan agreement pre-dates 1 October 2021.

Comments from relevant ministers in Parliament during the passage of the legislation and from the Pensions Regulator looks to provide re-assurance.  In its draft policy on investigation and prosecution of the new offences (March 2021), the Regulator quotes ministers as saying "the offences were not intended to achieve a fundamental change in commercial norms or accepted standards of corporate behaviour in the UK".

In deciding whether a person has a reasonable excuse for their act(s) the Regulator will look at:

  • Whether the detrimental impact on the scheme/likelihood of full scheme benefits being received was an incidental consequence of the act or omission, as opposed to a fundamentally necessary step to achieve the person’s purpose; 

  • the adequacy of any mitigation provided to offset the detrimental impact; and

  • where no, or inadequate, mitigation was provided, whether there was a viable alternative which would have avoided or reduced the detrimental impact.

The reasonable excuse defence is set out in the legislation and the Regulator's policy is not a binding interpretation of it.  Further, the Regulator is only the prosecutor for England and Wales.  If a pension scheme is based in Scotland or Northern Ireland other public prosecutors will be involved.

Where a lender enforces repayment of a loan by pension scheme trustees it may well have a detrimental impact on the scheme's ability to pay benefits, especially those due in the short-term.  The impact on the scheme is not normally a fundamentally necessary step to achieving enforcement of repayment, but it is not always going to be an incidental consequence either.  It would normally be arguable that a loan is only providing temporary liquidity and the trustees must have expected to have access to other assets.

So, while it should be open to lenders to enforce contractual rights to repayment and/or enforce security, until clearer guidance is published, increased caution is required when lending to trustees of defined benefits schemes and when enforcing repayment or security.  Unless the lender is satisfied that the trustees will remain able to pay all members' benefits in full, lending may not be prudent.

Lender due diligence issues

Due diligence check-list

The due diligence issues to be considered by a lender are:

  1. Scheme Trust Deed & Rules and any amendments thereto. 

  2. Deeds of Appointment (or other instruments) showing appointment of each current trustee.

  3. Memorandum and articles for any corporate trustee.

  4. Certificate of Incorporation for any corporate trustee.

  5. Resolution appointing authorised signatories for any corporate trustee.

  6. Documentation demonstrating value of scheme assets, such as accounts, and proposed amount to borrow.  (If no appropriate accounts are available this will be certified by the Trustees.)

  7. Confirmation that any assets to be purchased with the borrowing are not residential property, are not otherwise taxable property (such as cars, artwork etc) and that any transaction will be at arm's length for normal commercial value. 

  8. Any account opening forms and other existing banking agreements, including any collateral agreements.

  9. (For a SSAS) any agreement between or resolution of member trustees as to exercise of investment powers.

  10. For a defined benefits scheme, the latest actuarial valuation of the assets and liabilities of the scheme and advice to the trustees on the strength of the employer covenant supporting the scheme.

Check Scheme documents

Due diligence should be performed on the trustees of an Occupational Pension Scheme. However, there is no requirement to update Trust Deeds and Rules at any prescribed period nor is there a public registry of such documents. Therefore, in examining the trust documents, reliance is placed on the honesty and diligence of those supplying the documents.

Renewal of SIP

A SIP must be renewed at least every three years, but could be renewed more frequently, so, even if you have a SIP that is less than three years old, you cannot be entirely satisfied that it is the current document. As part of the due diligence process, the lender should ensure that it requests the up-to-date SIP from the trustees. As mentioned above, it should be noted that no SIP is required for an Occupational Pension Scheme with less than one hundred members.

Audited accounts and actuarial valuation reports

Pension scheme trustees must obtain audited accounts for the scheme within seven months of the scheme year to which they relate and defined benefit schemes must have an actuarial valuation report on the scheme every three years (although this can take up to fifteen months to produce following the valuation date).

Legal Opinion in favour of the bank

Because of the due diligence risks which arise when relying on the borrowers to supply information showing their own capability to borrow, we would often advise that a lender lending to pension scheme trustees should obtain a legal opinion from lawyers acting for the trustees (the "Opinion"). This would be, in normal practice, an Opinion addressed to the trustees but with an express extension of liability to the named lender lending to the trustees.

The Opinion would cover:

  • A confirmation either that (i) the scheme had fewer than one hundred members or (ii) that the scheme is borrowing only for the purpose of providing liquidity on a temporary basis.

  • That under the Trust Deed and Rules governing the scheme (as amended from time to time) the trustees have full power to enter into the loan agreement with the lender and (if applicable) grant security to such lender.

  • That there is no provision of the Trust Deed and Rules governing the scheme (as amended from time to time) that would allow the trustees to breach their obligations under the loan agreement (and, if applicable, the security documents) without the lender having a resultant right of redress in full against the scheme's assets.

  • That the individuals signing the loan agreement and any other loan documents to which the borrower is a party have full authority to bind the trustee body in full in the terms of the loan agreement and (if applicable) any security documents to which the borrower is a party. This is only necessary if the documents are not signed by all the trustees.

  • That, unless the confirmation has been given about having fewer than 100 members, entering into the loan agreement (and (if applicable) any security documents to which the borrower is a party) is expressly provided for in the current Statement of Investment Principles adopted by the trustees for the scheme.

  • That the trustees have considered that entering into the loan agreement and granting any security pursuant thereto is in the best interests of the members and beneficiaries of the scheme.

  • That the loan in question does not cause the scheme's total borrowing to breach the limits set out in sections 182-185 of the Finance Act 2004.

  • The trustees have obtained and considered independent written investment advice that retention of the trust assets which would otherwise be sold if the loan agreement were not entered into should be retained.

Other legal points to be aware of

Generally pension schemes can only borrow for short-term liquidity.  But small pension schemes (less than 100 members) which allow their members to direct their investment can borrow for more wide-ranging purposes such as purchasing an asset over which they give a mortgage/charge.

While small schemes are usually still called SSASs or SIPPs, the current technical term in the investment legislation is a "member-directed pension scheme" and in tax legislation an "investment regulated pension scheme"

There are restrictions on what a registered pension scheme can invest in so it is prudent when lending to one to provide that any investment of the scheme does not break these rules.  Residential property cannot be purchased so a mortgage over residential property would not be appropriate (and there are specific tax manual provisions on separating certain real estate such as a flat above a shop).

A pension scheme member cannot borrow from his or her scheme and, if the scheme guarantees a loan to the member, that is deemed to be the member borrowing from the scheme.  A member can lend to his or her scheme.

Transactions with connected parties are permitted, but must be at arm's length and on commercial terms.

Who can sign?

Where there is a board of individual trustees appointed to run a pension scheme, the default position is that all of the trustees have to be the signatories to any agreement if they are to be bound as trustees of the scheme. This applies to all binding documents relating to the transaction. The Trust Deed and Rules can provide for a departure from this basic position and provide, for instance, that an investment sub-committee could enter into a loan agreement or a defined sub-set of trustees could enter into an agreement.

As with any capacity issues relating to a counter-party, the lender should approach these with extreme caution. If it is proposed that signatories are anything other than the full board of individual trustees then we would advise seeking due diligence information such as trustee meeting minutes or a resolution signed by all trustees to show that the full board had considered and approved entering into the loan agreement and authorised named trustees to execute the loan documents to which the borrower is a party on its behalf.

Corporate trustees

Some pension scheme trustees are actually corporate entities and so their ability to enter into loan agreements are governed by the standard company law position and they have articles of association which will be available from Companies House if the relevant entities are incorporated in England and Wales. All the standard due diligence which the lender would carry out in respect of corporate entities would need to be carried out in respect of the corporate trustees in these circumstances,

Documents only bind Trustees in their role as Trustees

It is standard practice that trustees of an Occupational Pension Scheme will only enter into any financial transaction on a basis that limits their capacity to that as trustees of the scheme. So if an individual stopped being a trustee he would no longer be bound by the documents and any successor would automatically become bound by the documents. It is important, therefore, to include appropriate drafting for continuity through such a circumstance.

Limited recourse

Combined with the above, it is standard practice that any liability of trustees is limited to the assets of the scheme in question – trustees do not normally take on personal obligations and their advisers would strongly advise that they included limited recourse language in the loan documentation.  For a trustee who is trustee of more than one scheme it would also be vital for to avoid "cross-contamination" between the schemes which could break tax laws.  Having said that, a lender would normally wish to exclude the limited recourse in the case of fraud or wilful default on the part of the trustees.

Risk management tools

The possible risk management tools here for a lender are:

  • Taking security or collateral – the correct form of security varies with the assets being secured rather than the fact that the owner is a trustee; and/or

  • obtaining a guarantee from a relevant third party – in the pension scheme context this will be one of the sponsoring employers or their parent company; and/ or

  • taking into account the risk in setting the amount available for lending.

Pension scheme funding

Ascertaining a fund's assets and liabilities

Defined Benefit Pension Schemes have a fluctuating level of assets versus liabilities measured on certain actuarial principles. There are several different actuarial measures used for different purposes and at any one point in time a scheme could have a wide variance of funding levels on these different bases.

Actuarial surpluses and deficits

Funding levels are usually expressed as percentage of assets over liabilities. So a 110% funded scheme has £110 of assets for every £100 of liability.  Having more than 100% is an actuarial surplus, having less is an actuarial deficit. A deficit is not necessarily a serious concern – it is not the same as insolvency.

Insolvency issues

With this background it is important that default or termination events for a loan agreement to a pension scheme have some specialist review and do not just use the normal corporate insolvency tests. A serious issue would be if the scheme has a deficit and an insolvent employer. Since 2006 this has triggered an assessment for whether the scheme might pass to the Pension Protection Fund ("PPF"). The PPF only pays a reduced value of benefits so a scheme may come out of assessment and wind up rather than pass to the PPF (although in practice this is rare).

Default events

We would advise a lender lending to a defined benefit scheme to include termination or default events as follows:

  • The winding up of the scheme is commenced pursuant to any power in the Trust Deed, an order of a court or any competent regulatory body.

  • The scheme enters an assessment period as defined in section 132 of the Pensions Act 2004.

Drafting Points

Some schemes will have a combination of a corporate trustee and individual trustees.  Within the individual trustees there may be an agreement between them as to whose consent is required for investments regarding an individual's account. It becomes important therefore to separate in the drafting the different categories of trustee to cover:

  • "Scheme Trustee" - any trustee whose legal status may be relevant to representations and warranties as to the proper administration of the Scheme.

  • "Signing Trustee" - each trustee who is required under the Deed and Rules to be a party to the loan agreement.

  • "Member/Individual Trustee" - to mean each individual living person who is a trustee.

  • "Corporate Trustee" - to mean the entity which is a corporate trustee.

Where there is a facility agreement with the capacity to draw down on the borrowing in the future it is necessary to ensure that representations are repeated, in particular representations that the draw-down does not breach the "Arrangement Borrowing Condition" within the meaning of section 182 of the Finance Act 2004. This is the 50% asset value test referred to above.

A standard assumption (backed up with a standard representation and warranty) is that any pension scheme involved is a registered pension scheme with HMRC as that gives it the tax benefits we associate with pension schemes.

Where comfort is taken from the existence of a corporate trustee (e.g. a charge is to be registered against it) it will normally be appropriate to provide that it will be an event of default for the Corporate Trustee to cease to be in office and not be replaced by another corporate trustee.  It would be legally possible (unless the deed and rules said otherwise) for a corporate trustee to be replaced by an individual or, where there are already more than two trustees, to not be replaced on removal.  This would place the lender at risk if a term such as this were not included.

We would normally expect to seek standard form representations from pension scheme trustees that the trust is not in the process of being wound-up, that no steps have been taken by any person to trigger such a winding-up, that the execution and performance of the package of finance documents does not violate any terms of the Trust Deeds, that the trustees were validly appointed, that all the trustees are party to the agreement (subject to the signing trustee point above), that the scheme trustees have full power and authority to enter into the documents and have valid rights of indemnity against the assets of the fund.

As previously mentioned it is normal, especially for a corporate trustee, to provide that the trustees' liability is and the bank's recourse is limited to the assets of the pension scheme in question, absent fraud or wilful default on the part of the trustees.

When lending to trustees who are or include individuals it is necessary to consider consumer credit legislation. In this situation the two possible exemptions from the bank having to be regulated under the Financial Services and Markets Act 2000 and having to lend on a regulated agreement pursuant to that Act are either that: (a) each individual trustee gives a declaration of high net worth in the required form supported by independent verification in the form of a statement of high net worth from an accountant OR (b) the business purpose exemption is used. It is worth noting, however, that the individual trustees can only use their personal income and assets (i.e. not trust income or assets) to qualify for the high net worth exemption and that the business purpose exemption is of limited application and, for example, is unlikely to cover a loan to enable the trustees to make distributions.

If the borrowing is to purchase specific assets it is extremely important to ensure that none of the assets are "taxable property" for the purposes of Schedule 29A of the Finance Act 2004.  A starting point would be to exclude residential property entirely from the assets that can be purchased with a loan.  Strictly speaking there is a narrow exemption for residential property which was already owned by the pension scheme prior to 6 April 2006 but there are further tests that have to be met including an assessment of the value of any improvement work which has occurred since that date.  Taxable property also includes certain assets for which there is "pride in possession" such as racing cars, artwork or fine wine. 

Where there is a single individual trustee/member of the scheme it might be necessary to add additional drafting to protect the lender in the event of the death of that individual.  Trust law and inheritance law does provide for replacement trustees to take office but in a contested estate the appointment of a replacement trustee could become a contested issue which may damage the bank's ability to enforce promptly.  If these circumstances create a risk then we would suggest an event of default being the death of the individual and a failure to replace him/her as a trustee within, say, 28 days.  We would not normally advise that the bank itself become a trustee or become the person with power to appoint a trustee as this can create liability on the part of the bank that it does not need. 

Conclusions

Pension schemes can borrow and banks can lend to them, but pension scheme trustees have a series of tests to comply with before they can borrow. Whether these tests will be met in any particular transaction will depend on the scheme documents, the trustees' decision-making, the size of the loan and the value of the scheme assets. If lending to individual trustees, the consumer credit protection under the Financial Services and Markets Act 2000 needs to be considered and complied with. 

If you would like assistance in reviewing any proposed specific transaction we would of course be happy to be instructed.



Contacts
 
Andrew Evans | Partner David Gallagher | Partner
Jeremy Harris | Partner Oliver Abel Smith | Partner

 

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