14 August 2020
Contingent funding approaches are rapidly becoming more widespread, partly thanks to big changes in regulation. They can be a great way to protect member benefits as well as the shareholders and other creditors of the sponsoring employer.
Contingent funding solutions have been around for several years. They include parent company guarantees, asset backed funding (ABFs), escrow, letters of credit, surety bonds and other approaches. They have served a wide range of objectives – such as providing security in exchange for a longer recovery plan, less prudent technical provisions, or a riskier investment strategy; or justifying lower PPF levies; or giving protection against poor funding or covenant outcomes; or reducing the risk for the sponsor of overfunding.
So what’s changed?
The significant growth we’re now seeing is down to lots of factors all happening at the same time, including:
- Funding regulation: The regulatory direction of travel is pointing to higher funding targets and shorter recovery plans. Under the regulator’s planned “fast track” approach many sponsors will need to pay additional contributions, and many of those sponsors will be assessing whether they can use contingent funding approaches to help justify lower cash contributions by following the “Bespoke” approach.
- The Covid crisis has led a number of sponsors to request contribution deferrals. In some cases, particularly where the deferral is longer than 3 months, contingent support will be requested for this. More and more schemes are at risk of over-funding, and escrow type solutions are one of several ways to give the sponsor the ability to recoup contributions without a 35% refund tax hit if those contributions ultimately prove not to have been needed.
- The 2020 Insolvency Bill could weaken the position of unsecured creditors like pension trustees in certain circumstances. This means two things: firstly, the security provided by some existing contingent assets may deteriorate as it will be lower down the “pecking order” on insolvency (e.g. any assets with attaching floating charges); and secondly trustees may ask their sponsoring employers for new or enhanced “insolvency remote” protection.
- The Pensions Regulator’s increased focus on dividends is a new driver for contingent funding for some sponsors (for example, where a parent company guarantee helps to safeguard an existing dividend policy).
- In the light of Covid-related market and covenant effects, there is a renewed expectation of materially higher PPF levies for some (but not all) sponsors, so certain PPF-approved contingent assets may now yield bigger levy savings than before.
- Pensions Bill: One of the many implications of the Pensions Bill will be the need for sponsors to provide mitigation for a wider range of events leading to negative covenant changes – in an increasing number of cases linked to the above factors, non-cash mitigation may be appropriate.
- The increasing number of full scheme buy-ins followed by a data-cleanse period leading to buy-out gives rise to a risk of tax charges on a final scheme surplus (e.g. due to positive data cleanse adjustments) – escrow-type approaches combined with flexibilities on insurer premium structures are being increasingly used to manage this risk.
So what’s happening in response to all this?
In addition to the actions described within the above, some of the other practical consequences include:
- More strategic use of contingent approaches: for example to form an integral part of an agreed journey plan within a clear IRM framework, with both upside and downside contingencies. This gives the right mix of security and cash to address overfunding concerns on one hand and covenant/underfunding concerns on the other.
- More sophisticated structures: for example, a contingent asset itself can be contingent. In other words, the sponsor might not need to provide it on day one – instead, they agree to give it IF a specific trigger occurs – that can still give the protection the trustees need while being more palatable for the sponsor or its parent or group companies and other stakeholders. One example is a parent company guarantee that is not granted immediately but comes into existence if the free cashflow of the sponsoring company falls below a pre-agreed level at some point in the future.
- Off the shelf approaches: where materiality or simplicity mean that a vanilla product meets the objectives in the most cost efficient way (LCP’s off the shelf escrow is an example of this).
- Innovative approaches: several are being developed that combine some of the key benefits of traditional contingent approaches in a tax, legal and accounting efficient way.
- Covenant-related contribution “switch-on” mechanisms as we come out of Covid.
- Using different contingent vehicles in conjunction with each other: for example letters of credit combined with investment management of the collateral put aside to back them.
- Future proofing: Covid has taught us that events perceived as extremely remote do actually happen, with some pre-existing contingent assets having triggered at a time when they were least affordable. Many trustees and sponsors also have pre-existing contingent assets that are no longer in line with their objectives which have evolved since they were first put in place. Avoiding single-date market “snapshot” triggers for these vehicles, having an eye on how objectives are likely to evolve, and stress-testing the likelihood of triggers occurring (and their affordability) are all ways to address this crucial point at an early stage of the design process.
- Based on where we are today, it seems likely that a lot of sponsors are going to prefer the Bespoke approach rather than Fast Track. Contingent funding approaches will play an important role in helping achieve this.
- It’s good to have clear objectives but that needs to factor in how those objectives might evolve over time. That means you need to think hard about a flexible contingent funding design and future-proof it to the extent possible, including the need for it to be able to be implemented in difficult times and whether to make it a contingent-contingent asset.
- And last but not least: keep it simple if you can! Don’t tie yourself into a complex ABF if a simple charge over the same asset could do the job; don’t over-engineer the monitoring and governance processes around letter of credit renewability; only go for a reservoir trust if the extra governance and complexity delivers the extra value, being just a few examples.
Contingent funding approaches have now moved from a niche area of pensions management to the mainstream, and should be considered by every trustee board and sponsor.
If you are interested in finding out more, contact the person who normally advises you or one of our contingent funding experts.