20 April 2022
Contingent funding has become an integral part of many large schemes’ self-sufficiency strategies.
This article was first published in our Leading the Way report.
Contingent funding has become an integral part of many schemes’ pension strategies and can help to protect both the sponsor and trustees over the long-term against both upside and downside risks, often providing a win-win solution for all parties.
Examples of downside protection include:
- A letter of credit or surety bond to provide support to the scheme in the catastrophic scenario where a sponsor becomes insolvent. This can be particularly useful if the journey plan is long and covenant visibility is unclear over that time.
- Contingent contributions to protect against significant covenant deterioration. Many different covenant metrics could be considered as triggers, but it is important that they are designed relative to the quantum of scheme risk – one example being the ratio of free cash flow to the buyout deficit.
- An escrow account or reservoir trust could be set up for future contributions to tip funds into the scheme, should investment returns prove to be worse than expected, or returned to the sponsor if not needed by the Scheme. Our Streamlined Escrow has recently been used by a billion-pound scheme wanting a cost-effective and time-efficient set-up for this exact purpose.
For protection against upside risks and to mitigate overfunding concerns, Asset Backed Funding (ABF) arrangements with a built-in switch-off mechanism can be used. The additional security can help support a longer recovery plan, while providing upfront deficit reduction and tax relief. We recently supported BT in connection with the triennial valuation of its pension scheme, where such an arrangement was set up alongside a suite of other contingent funding mechanisms which achieved a number of focussed objectives. You can read more about this here.
As with many pension solutions, getting the practicalities right is critical. Examples of this include futureproofing and flexibility. Avoiding trigger payments that are based on a single date can protect the sponsor against spurious effects of volatility. Upfront stress testing is imperative: the pandemic has shown that extreme events can and do happen and it’s important to understand the impact of these on any contingent funding mechanisms before they are put in place.
The pandemic has also shone a spotlight on significant uncertainties in assumptions around future improvements to life expectancy, in particular whether we can expect this to resume to pre-pandemic trajectories (click here for more details). Use of contingency mechanisms could allow these uncertainties to be navigated without “trapping” contributions if they are not ultimately needed.
“Contingent contingent” mechanisms could also be considered, for example a contingent letter of credit, which is only put in place if another trigger is hit, such as a covenant metric deteriorating. This means that the sponsor doesn’t need to waste funds on premiums when the covenant is strong, but the trustees have the knowledge that enhanced security would be put in place should things worsen.
Additional flexibility can be achieved via a framework agreement. This could, for example, give the sponsor the option to choose between putting in place a letter of credit, paying a contingent contribution or taking some other action, such as de-risking the scheme’s investment strategy or providing a group company guarantee, when a trigger is reached. In this way, the sponsor can choose the course of action that best suits its business needs at that time, helping to reduce future regret risk.
Superfunds and other third-party capital solutions are all entering the market to make returns by providing external capital to underwrite the risks on the journey plan to a scheme’s longer-term target. Sponsors of larger schemes may be able to design similar “DIY” strategies, using wider corporate assets secured in contingent funding arrangements, instead of external capital, to underpin a scheme’s journey plan. The advantage being a possible reduction in sponsor contributions and the potential for any surplus to be returned to the sponsor and its shareholders over time. With careful design, futureproofing and the flexibility to modify arrangements, contingent funding solutions can be tailored to suit many different circumstances, and will be key to the self-sufficiency strategies for many larger schemes.
- Escrow account - Funds are held by a third party but ringfenced for the pension scheme. Funds are transferred into the scheme or back to the sponsor based on pre-determined triggers.
- Contingent contributions - Funds are transferred from the sponsor to the scheme based on pre-determined triggers.
- Letter of credit - A guarantee from a bank with a strong credit rating to make a payment to the scheme on certain pre-agreed trigger events, in return for a premium from the sponsor.
- Surety bond - Similar to letters of credit, however the guarantee is provided by an insurer instead of a bank.
- Group company guarantee - The parent, or another group company, makes a legally binding commitment to provide support to the pension scheme in certain circumstances.
- Asset Backed Funding - The sponsor either funds the purchase of assets or transfers assets to a Special Purpose Vehicle (SPV) that is jointly owned by the sponsor and the trustee. The sponsor may make payments to the SPV for use of the asset, which supports a contractual income stream to the pension scheme.