What impact has Ofwat's final price determination had on the water sector's ability to fund company pension schemes? Jay Doraisamy explains.

Hardly a week goes by without something in the press about defined benefit schemes. It seems as if the situation has reached a critical stage. Legislative changes over the past decade, volatile markets, poor investment returns and the economic downturn have all contributed to this state of affairs. Pension law has never been more complex. The result is that a great many employers with defined benefit pension arrangements have, over the past few years, taken steps to carry out benefit and pension reviews.

Employers in the regulated water sector face the same cost pressures as those in non-­regulated industries. They have difficult business and financial decisions to make within the confines of spending budgets set by Ofwat. In addition, water company pension schemes face some issues that do not apply in the non-regulated sectors.

Ofwat's final price determination on water and sewerage charges for 2010-15 was issued on 26 November last year. Fortunately, the price cuts proposed in the draft determination were reined in, but the final determination is nevertheless tough for companies that will be looking at ways to achieve greater cost efficiencies as they cut spending.

*Appeal unlikely*

It is probably unlikely that pension costs would feature in any appeal to the Competition Commission. However, pensions have played a significant part in the run-up to the final determination, with various announcements made by Ofwat. We understand there have also been discussions between Ofwat and the Pensions Regulator.

Ofwat says two out of three companies raised the issue of the treatment of pension deficits after the draft determination was published, and a number of companies made specific representations about their pension arrangements. All this is reflective of general trends in the pensions industry and demonstrates the strain on water companies in managing their pension liabilities.

So what has Ofwat said about pensions? Ofwat's final determination, helpfully, takes into account updated actuarial information where this has been provided by the company. One of the issues for companies has been the length of the recovery period. There has been an inconsistency between the Pensions Regulator's ten-year recovery plan period trigger and Ofwat's earlier statement that longer recovery periods should be allowed.

This inconsistency has been somewhat tempered by a recognition from the Pensions Regulator that longer recovery periods might be appropriate in regulated industries. This is recognised in Ofwat's final determination, which takes into account minimum recovery periods of ten and 15 years.

The extent to which Ofwat's final determination affects pension schemes will depend on a number of factors. Some companies may take the view that pensions have been treated reasonably by Ofwat, although in the overall context many companies have a tough time ahead of them. Where updated actuarial valuations have been taken into account, this will certainly be an important factor. However, at the end of the day the companies will be looking at the deficits their schemes have been left with and their employer funding liabilities. This will determine a company's views on future pension provision and whether action needs to be taken to reduce liabilities.

In considering future pension liabilities after Ofwat's final determination, there is a myriad of issues that could be relevant. There are also specific water sector issues that must be taken into account, in particular the employer covenant and member protections.

*The employer covenant*

The employer covenant sets companies in regulated industries, including the water sector, apart from those in non-regulated industries. The very nature of the regulated water industry means that covenant issues should not be of great concern to trustees of water sector pension schemes. One of the many factors generally looked at when assessing the employer covenant is the likelihood of the sponsoring employer failing or going into insolvency. Water sector companies are not in this situation. The likelihood of a water company entering into an insolvency situation is slim given the way in which the legislation is drafted and the fact that they have captive customer bases. This seems to argue for greater flexibility in funding negotiations and in the length of recovery plans.

A strong covenant does not mean that companies should not be looking at managing their liabilities. There is a finite pot of money available to fund schemes and capital is required to fund the businesses. Amending pension scheme benefits is one way to reduce liabilities. Almost all water companies have closed their defined benefit schemes to new members. However, they remain open to future accrual. Many employers in the non-regulated sector have closed their schemes to future accrual or are in the process of doing so. As it happens, this course of action might not be the solution it seems to be, particularly if future service cost is not the major liability. Other ways of changing benefits may offer a more promising solution than the more drastic option of cessation of future accrual.

In considering any benefit changes, an important factor to bear in mind is the member protection in water sector defined-benefit schemes. This is relevant to the mirror image benefits, which reflect the benefits provided under the Local Government Superannuation Fund before privatisation in 1989. These benefits are subject to an individual trustee veto in respect of certain scheme changes and hence benefit changes would be subject to this protection (commonly referred to as the "Belstead Commitment") if a trustee chooses to exercise it.

The defined benefits provided outside the mirror image benefits are not generally subject to this type of restriction, although sometimes members might have expectations that their benefits are protected. The protections are generally seen as a stumbling block to making benefit changes and companies have, quite rightly, trod carefully.

*Pensions protection*

However, this is an untested area. Notably, the pensions protection was not enshrined in legislation. The protection was instead incorporated into the post-privatised mirror image schemes in the form of a discretionary trustee veto. There is no requirement for trustees to exercise the veto and as with all their directions they must consider factors relevant to the exercise of the veto. Factors would include not only the intention behind the safeguard at the time of privatisation but also, 20 years on, the position of the sponsoring employer. It really remains to be seen how companies and trustees will approach this issue in the face of increasing cost pressures.

Joining up the dots, Ofwat's final determination has gone some way in treating pensions reasonably, but the continued pressures faced by companies and the measures they need to take are likely to mean that pensions will continue to be a priority for company boards.

Jay Doraisamy is a partner with Eversheds. Email: jaydoraisamy@eversheds.com