18 August 2020
Analysis by consultants LCP suggests that ‘contingent’ funding arrangements for DB pension schemes are likely to move ‘from the niche to the mainstream’ because of a range of regulatory and economic pressures.
Contingent funding arrangements can take a variety of forms but generally involve a company agreeing to contribute more to its pension scheme if certain triggers are reached.
In addition to a ‘plain vanilla’ escrow account (where the sponsor holds funds which can be drawn on by the pension scheme in certain circumstances, but which are not actually held within the scheme), arrangements can include:
- Parent company guarantees, where additional funding is forthcoming from the parent if the immediate sponsor is unable to pay;
- Asset backed funding, where the scheme has a claim over an asset if needed;
- Guarantees provided by banks or insurers.
LCP points out that contingent arrangements have always had a number of benefits. They can help make the case for a longer recovery plan because they provide additional security, they can help to avoid ‘trapped surpluses’ where a scheme has more than it needs but the excess cannot easily be withdrawn, and they can help to underpin a more growth-orientated investment strategy because of the downside protection that they provide.
But LCP believes that a number of current regulatory and economic factors mean interest in use of contingent strategies will grow. These include:
- A tougher line on scheme funding from the Pensions Regulator, potentially leading to shorter recovery periods and more ‘prudent’ funding targets and investment strategies. Sponsors who can bring contingent funding deals to the table may come under less pressure to de-risk or increase contributions: this may be particularly relevant to schemes which expect to use the ‘Bespoke’ funding framework under TPR’s new funding code;
- The risk of materially higher PPF levies, especially where the current crisis has led to higher deficits and/or weaker sponsor covenant. Pound for pound, a contingent asset can potentially lead to greater levy savings than in the past;
- Around 10% of employers have sought to negotiate reduced Deficit Reduction Contributions and as part of these negotiations trustees may seek guarantees of future funding, which can be triggered on a contingent basis;
- Changes to insolvency legislation could put the pension scheme further down the queue of creditors if the company goes bust; trustees may be looking for alternative guarantees which they could call on if the worst happened.
Whilst LCP stresses that ‘vanilla’ approaches such as simply putting money in Escrow have much to commend them, it also expects to see new and innovative ways in which companies can provide security to their pension schemes without having to divert much-needed short-term capital away from the business.
Commenting, LCP partner Phil Cuddeford said:
“Contingent funding arrangements have been around for a long time, but they are set to become far more mainstream. Many firms will be under considerable pressure to use their available funds to keep their business going during the current crisis, but will also be under growing pressure from the Pensions Regulator to deal with the shortfall in their pension scheme. Contingent funding is a way of squaring this circle. Trustees can get the assurances they need about future funding of the scheme while sponsors are able to concentrate their available resources on making sure the firm is still there in the future. This is an approach whose time has come”.
A longer article on this subject is available on request.