75% of DB pension schemes on course to use contingent funding to manage scheme risks - LCP
23 March 2021
For many years, companies have dealt with shortfalls in their pension schemes by pumping in extra cash. This has often been appropriate. But it can sometimes divert capital - needed by the business now - to meet pension promises which will not have to be met until decades into the future.
In response to this, there is growing interest in “contingent” funding of DB pensions – coming up with alternatives which provide security for scheme members but without requiring employers to lock up cash that they need to keep the business going. Now a new report from LCP estimates that as many as 3 in 4 schemes could be going down this route in the near future.
In ‘LCP's Contingent funding handbook: Emerging trends and market practice’ LCP delves deeper into the topic and highlights that more schemes will turn to contingent funding approaches in the next two years as the impact of new regulation and the current economic environment mean that more schemes need greater long-term security that doesn’t demand up-front cash.
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.
While such arrangements have been used for a while because they can protect member benefits without causing an undue strain on corporate resources, LCP believes that there are several key factors that will account for a big rise in their popularity. 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. With sponsors needing to provide mitigation for a much wider range of events under the Pension Schemes Act 2021, there will be an increasing number of cases where non-cash mitigation may be appropriate.
- The Covid-19 pandemic led to around 10-15% of sponsors seeking to negotiate reduced Deficit Reduction Contributions in 2020. As part of these and similar negotiations, trustees may seek guarantees of future funding, which can be triggered on a contingent basis. PPF levies may also rise in the wake of Covid-19 and these approaches can lead to levy savings.
Changes to insolvency legislation could put pension schemes further down the queue of creditors if a company goes bust. Trustees may be looking for alternative guarantees to call on if the worst happened.
- Increased Regulator focus on dividends and other forms of “covenant leakage” – for example, contingent approaches can help a company maintain a progressive dividend policy without threatening scheme security, and can also be structured so that the scheme shares in certain upside scenarios.
The typical approaches include putting money in an escrow account, which holds funds that can be drawn on by a scheme, parent company guarantees, asset-backed funding or guarantees provided by banks or insurers. New and recent trends in this space include combinations of different approaches, cleverer structuring (for example, a parent company guarantee that only comes into existence if certain covenant or funding metrics fall below a pre-agreed level at some point in the future), Covid-specific agreements, and a more strategic use of these approaches within a dynamic journey planning framework that considers upsides as well as downsides.
Phil Cuddeford, Partner at LCP, commented:
“We are seeing a surge in interest in contingent funding arrangements, ranging from cost-efficient vanilla approaches to highly bespoke ones. This is being brought on by big changes in the economic and regulatory environment.
Contingent funding can be a win-win, giving members the security they need while not depriving businesses of the money they need to rebuild post-Covid-19 and to invest for the long term.”