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19th June 2014

Pensions: Charities reminded to explain pensions shortfalls

A Charity Commission (“Commission”) review has found that some charities are not doing enough to show the public how they are dealing with pension scheme shortfalls.

A recent report by BDO found that forty of the largest fifty charities have a combined pension shortfall of around £5 billion. They said that it would not be uncommon for more than 10p in every £1 donated to some charities to be going to support pension obligations.

The Commission’s Review

Despite the SORP requiring charities to include a review of their financial position within their annual reports, only 31 of the 97 charities that the Commission reviewed had explained in their annual report the financial implications of their pension scheme shortfall and how they planned to deal with it.

Seven of the 31 charities reported shortfalls in excess of both their total unrestricted funds and 20% of their annual income. Those seven charities, in common with many of the others, were members of the local government pension scheme (“LGPS”). We considered some of the issues that pension shortfalls create for charities participating in private sector pension schemes here. We explore some of the issues in relation to the LGPS below.

Pension shortfalls

A pension shortfall arises when the actuarial estimate of the liability that employers need to fund in order to provide the promised benefits exceeds the value of the assets of the fund. Broadly, contributions in the LGPS comprise two elements: contributions to fund the future service benefits and contributions designed to eliminate any funding shortfall. Contributions are revised following each triennial valuation. Under the LGPS regulations, a charity has no opportunity to influence the level of contributions that they are required to pay.

In addition, a charity’s pension shortfall is due in full as an exit payment when its admission to the LGPS comes to an end. This will usually be when it stops providing services that are funded by the local authority or when its employees who are members of the LGPS stop spending the majority of their time working on the services funded by the local authority (unless they remain employed in another role alongside staff employed to work on those services).

The size of an exit payment can be significant and the time given to pay it is often short (e.g. 30 days). The actuarial assumptions that the LGPS actuary uses to calculate the exit payment are not prescribed. The assumptions used may well be more prudent than those used when calculating ongoing contributions, resulting in a larger shortfall on exit than on an ongoing basis.

Risk management

Before a charity joins the LGPS, a risk assessment is carried out to the satisfaction of the local authority (and is subsequently kept under review), as a result of which the charity may be asked to provide a bond, indemnity or, if neither is desirable, a guarantee to protect the LGPS fund against the risk of the charity’s insolvency.

The statutory mechanisms that allow charities participating in private sector pension schemes to, for example, apportion their exit payment or pension liabilities to other employers in the scheme are not available in the LGPS. To manage the risk of a large exit payment making a charity insolvent, a charity participating in the LGPS may choose to pre-fund for termination by changing their funding approach to a least risk methodology and set of actuarial assumptions. This will reduce the risk of a potentially large exit payment being due to the LGPS fund at termination. However, adopting such an approach is also likely give rise to a substantial increase in contributions.

Other approaches to managing the risks associated with pension provision include agreeing fixed or capped employer contribution rates. Any such approaches should be agreed between the local authority and the charity during contract negotiations and included within the outsourcing agreement.

Next Steps

The Commission’s review highlights the need for charity trustees to have a clear, up to date, picture of their pension obligations and a plan to manage contribution increases. Trustees should use their charity’s annual report to explain how they are tackling the risk of a pension shortfall.

If a charity is participating in the LGPS, its annual report ought to record any risk management mechanisms agreed with the local authority, details of any bonds, indemnities or guarantees in place and any plans to set aside future income and/or unrestricted funds to meet any shortfall. Doing so will help to show the public that pension issues are being tackled appropriately.

If you have any questions on pension shortfalls in the LGPS or in private sector pension schemes, please contact Christopher Nuttall on 01604 463134 or christophernuttall@hewitsons.com. For more information regarding our Pensions services click here.

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