11 March 2021
In our view, the big headline from the Budget on Wednesday was from the changes to corporation tax, with the headline rate increasing from 2023. What does that mean for funding DB pension schemes?
All else equal, for a company making profits, a higher corporation tax rate means the company gets a bigger tax deduction for making a given DB pension contribution. So finance directors may justifiably ask whether deficit contributions can wait until 2023 (or more precisely, the company’s accounting year that contains 6 April 2023 – for example, that could affect contributions paid from 1 May 2022 for a company with a 30 April year-end).
On top of this, you have the eye-catching “super deduction” which allows businesses to claim tax relief of up to 130% on investment spending over the next two years (i.e. before the corporation tax increase comes into effect). Intended to fuel a post-Covid economic recovery, this creates a further incentive for companies to prioritise investing in their businesses over the next two years.
Proposing to defer pension contributions may not be well received by trustees, and with c.10% of schemes having already agreed a deferral during 2020 some trustees may be expecting contributions to start up again soon. But if it’s clear that prioritising investment now and making good use of the tax advantages from the Budget improves the long term covenant, this can bring benefits for everyone involved.
Where companies do wish over the next two years to prioritise investment and defer pension contributions, there are ways of providing security for the pension scheme during the deferral period, including:
- a letter of credit or surety bond, providing a route to third party funding if required (a surety bond is similar to a letter of credit but provided by an insurer rather than a bank)
- negative pledges or commitments around the funds being used for covenant enhancing investment purposes (rather than e.g. dividends)
- ‘switch on’ triggers so that if company performance exceeds expectations then cash contributions to the plan could restart.
This is by no means an exhaustive list, but all could help employers to keep cash on hand for investment and growth within the business, while still providing additional security to pension schemes until 2023, when it becomes more tax efficient to resume deficit funding.
Alternatively, and if tax efficiency is a key objective, a sponsor willing and able to pay cash contributions may be able to agree with the trustees that they pay these into an escrow account rather than to the pension scheme, with the intention of passing them on to the pension scheme in 2023. Our Streamlined Escrow service is perfect for this: a quick and simple to set up arrangement that is cost effective for sponsors and schemes (and also allowing investment returns where that’s appropriate).
Furthermore, escrow funds can flow back to the company if they are not subsequently needed. For some pension schemes, funding positions have improved over 2021 so far and, should that trend continue, the deferred contributions may even turn out not to be required in 2023, depending on what is agreed as part of the long term strategy for the pension scheme.
Of course, the Budget changes are only one reason to use contingent funding approaches; we will explore many more in our upcoming publication ‘Contingent Funding Handbook: Emerging trends and market practice’.