The new Pension Protection Fund (PPF) has been set up to provide compensation to members of underfunded pension schemes with insolvent employers. It will fall to the solvent employers of other pension schemes to provide the funds to make this possible through annual levies on their pension schemes.

The PPF has proposed a risk based formula for calculating up to 80% of the required levy. The current proposals penalise sponsoring employers with a weak credit rating harshly. With the same pension fund a poorly rated business could pay up to 115 times the levy paid by the most highly rated business.

Given the highly leveraged structure of most private equity owned businesses we suspect the proposed levy will hit private equity portfolios with defined benefit pension schemes badly. This is on top of the myriad of other issues created by defined benefit pension schemes.

The maximum risk based levy is to be capped at 3% of PPF liabilities of the scheme. However this may be little comfort to many companies (particularly those whose current operations are dwarfed by the size of their pension scheme) and a considerable drain on available cash.

The risk based levy is calculated by multiplying the assessed probability of insolvency in the next year (assessed by a rating agency for the PPF for all employers) by the level of underfunding in the pension scheme measured against a target of an insurance company buy-out of 105% of the level of benefits provided by the PPF. (The PPF provides only 90% of full benefits with limited pension increases and a cap on pensions of £25k per annum for members who have not passed their scheme’s normal retirement age.)

For example imagine a company rated with a 3% chance of insolvency in the coming year (broadly b+) with a pension scheme with a £20m assessed underfunding risk. The proposed risk based levy would be would be 3% x £20m = £0.6m per annum. This is all subject to a final unknown adjustment factor that could reduce or increase the levy. So the actual size of the levy for any company is still unknown but the burden of cost is likely to fall heavily on leveraged companies and others with poor credit ratings for whatever reason.

Whilst the principles are similar to those for any insurance - charge the higher risks more – this may backfire for the PPF. If levies are unaffordable for businesses with tight constraints on available cash this may force more schemes into the PPF requiring further funding from the remaining employers.

We also note that whilst connected or associated companies (e.g. private equity owners) face the possibility of being subject to a Contribution Notice or a Financial Support Directive in respect of a pension obligation within the wider group of companies, the scheme will not be given credit for this in the calculation of the risk based levy which will be assessed relative to the insolvency risk of the sponsoring employer alone.

Consultation is open until 4 October 2005. This may be a topic on which the private equity industry will wish to lobby in order to reduce the burden from these proposed levies. Please contact Paul Geeson (020 7533 1872) or Richard Jones (020 7533 6967) for further information.