Insolvency and Accounting
Formally, insolvency is the inability to pay one’s debts in full as they come due, but in practice may be characterised in a number of ways. The failure to meet obligations as they fall due is known as equitable insolvency, while the condition that liabilities exceed assets is known as balance sheet insolvency. The circumstance may also arise that due debts cannot be met as available assets cannot be sold at prices which maintain either or both equitable or balance sheet solvency.
There are important differences between these – notably with respect to future income and expense. The equitable balance sheet of a pension scheme includes the present values of future expenses and future contributions and is sometimes referred to as the comprehensive balance sheet; this is the inter-temporal budget constraint. The ordinary balance sheet approach does not include these items; this is the conventional financial balance sheet of the institution.
The current accounting and regulatory regimes are problematic in that they are of the ordinary balance sheet type rather than the comprehensive, equitable, income and expense form.
However, it can be seen that schemes regularly continue to operate while in a state of deficit. In other words, they are reliant upon the existence, but not the exercise, of the balance of cost guarantee, the provision of future contributions by the sponsor. The relevant form of insolvency for a UK pension scheme is equitable insolvency.
Prior to sponsor insolvency, though the scheme only benefits from future contributions when they are made, it may operate soundly while in deficit. Whether a scheme which is in deficit is insolvent prior to formal sponsor insolvency depends upon the answer to the question: can the sponsor be expected to make payments sufficient to repair this deficit prior to the sponsor’s insolvency? This is a standard guarantee evaluation.
This raises the issue of when a guarantee can and should be called upon. With a standard conditional guarantee it is necessary for the trigger event to have occurred for any call under the guarantee to be enforceable. In this pensions case that would imply that the scheme should be unable to make the next payments to pensioners. The pension sponsor balance of cost guarantee may be called upon recurrently by the scheme, which eliminates some potential complications as to timing.
Calls under the pension guarantee can only weaken the sponsor’s financial condition. This implies that Trustees should evaluate the position of the scheme with and without the call. It is notable that the Pensions Regulator bases its deficit repair calls on the sponsor upon the premature balance sheet deficit. Indeed, European regulation, in setting a 100% funding objective at all times, is taking these calls to their extreme and most expensive limit.
While these balance sheet and equitable insolvencies are necessary conditions, they are not usually sufficient for a scheme to begin insolvency action against its sponsor. There may be further issues to be considered, such as whether the situation after recoveries from the sponsor’s insolvent estate is better than may be achieved by the scheme exercising forbearance. The concern here is that allowing the firm to continue may result in higher recoveries for the scheme than liquidation, with all of its attendant costs. In other words, it may even be in a scheme’s best interests to allow the sponsor to cure equitable insolvencies as they arise, rather than recapitalise the scheme. In the case that the insolvency arises from an inability to realise assets even though the scheme may be in balance sheet surplus, it is clearly usually in the interests of all to show forbearance.