A corporate client with a well-funded scheme (already having a surplus on a “gilts+0.5% pa” discount rate measure) was considering putting forward a proposal to the trustees regarding their journey plan to buyout.
The sponsor proposed that the scheme aimed to achieve buyout via investment returns, preferably avoiding the need for further cash contributions. However, the trustees were concerned about the downside covenant risk of the sponsor.
The sponsor had previously been regarded as having a “tending to strong” covenant, but the trustees had become concerned about possible material detriment to the covenant arising from the general economic uncertainty due to Covid-19 and Brexit. Also, the employer operates in the energy sector, and is impacted by volatile oil prices and large decommissioning liabilities falling due in the next few years.
Because of those covenant risks the trustees requested a full buyout guarantee from a ‘strong’ overseas group entity. However, the group was reluctant to commit this support when it may not be required.
This prompted the group to consider a different and contingent support structure, in which additional support is only provided if the UK sponsor covenant weakens beyond a certain point that is linked to the funding level at that time.
In this contingent structure some financial metrics were agreed to test the strength of the UK sponsor. If any of these metrics are breached, the group would provide additional support. The group has options for the form this support could take including one or a combination of:
- Additional funding to the UK sponsor to bring the metrics back within the agreed parameters, so repairing the direct covenant to previous levels
- Additional funding to the scheme to reduce its reliance on the direct covenant
- A guarantee from a group entity of suitable financial strength
This agreement enabled the trustees to take comfort that additional support would be provided if required, and the group retained flexibility to provide that support in a manner that best suited its operational and financial position at that time, avoiding pre-committing to cash contributions or guarantees that may turn out not to be required.
How we can help
Contingent funding approaches are rapidly becoming more widespread. They can be a great way to protect member benefits as well as the shareholders and other creditors of the sponsoring employer.
We help sponsors of pension schemes understand and manage the costs and risks associated with supporting their current and legacy pension schemes as well as other employee benefits.
We help trustees understand and monitor the employer covenant.
Whether to enter a DB Consolidator is a complex decision. Sponsors and Trustees must be sure it is the right decision for their scheme and its members. We can help.
We help pension scheme trustees and sponsors to determine the ultimate destination for their scheme and help them put together a plan to get there, including how to effectively manage the risks they face along the way.
We help trustees achieve their strategic goals, with solution-led, appropriate advice.