Toolbox gets bigger

Contingent funding has gained significant publicity following announcements from the Pension Protection Fund and The Pensions Regulator.

While contingent funding may appear novel in a pensions context, the concept is well established in the banking and insurance markets where regulators have historically demanded higher levels of funding for liabilities.

Contingent funding encompasses a range of approaches aimed at improving benefit security for members without directly funding pension liabilities through cash contributions; this may include insurance-type arrangements such as letters of credit, or contractual arrangements backed by assets outside the fund such as escrow accounts.

The number of cases in the UK where pension funds are using these vehicles is increasing rapidly.

Recent changes to the UK legislation governing the funding of pension liabilities and the recognition of pension liabilities using corporate-bond based accounting standards are leading to higher funding targets and shorter timescales for removing deficits.

Companies are increasingly looking at alternatives to directly funding pension liabilities through contributions from free cashflow.

Trustees have a natural preference for direct funding, but often find that contingent funding can help them obtain additional security over and above what the employer is able or willing to contribute both in the short and long term.

Another factor to consider is the surprising result that the new legislation, which in the short term is resulting in pension schemes recognising higher deficits due to more conservative assumptions, will ultimately result in better funded schemes that are more likely to be in a surplus position.

Many companies are naturally concerned about the risk of such “trapped surpluses”, particularly where their pension schemes are closed to new members or future accrual, since the scope to use surplus assets to offset future contribution requirements is limited in such instances.

Taxation creates further incentives for the use of contingent funding.

While the current regulations governing refunds of surplus assets are in the process of being relaxed, refunds are still subject to a higher level of taxation than the relief provided on contributions, and will only be permitted once a scheme is in surplus on an insurance company “buyout” basis.

Therefore contingent funding vehicles could enable surpluses to be measured on a more realistic basis and returned to the employer sooner.

It is also worth noting that companies may be unable to obtain tax relief immediately on their pension contri-butions, either because of the spreading of tax relief or, in some cases, due to the employer having insufficient taxable profits or a deferred tax asset on its balance sheet.

Companies may also find that contingent funding can give them more options when negotiating funding and investment strategy with the trustee body.

A recent example included a company agreeing to fund an escrow account and invest it in bonds, subject to the trustees holding a mix of equities and bonds within the pension scheme, rather than simply investing all of the scheme’s assets in bonds as the trustees had originally intended.

In another situation a company wanted to adopt a low-risk investment strategy using bonds and swaps, whereas the trustees wanted to hold a mixture of equities and bonds in the hope of financing future discretionary benefits.

In order to come to an agreement the company introduced a contingent funding option whereby it offered to hold a sum in an escrow account that would improve benefit security for guaranteed benefits and finance a modest level of discretionary pension increases in the future. This approach was acceptable to the trustees as it met their need for additional security in the event of the sponsor failure.

In late 2005 contingent funding received another boost.

The Pension Protection Fund announced that companies could reduce their annual levy by acceler-ating deficit repayments or by implementing a contingent funding arrangement.

While this can provide a helpful additional benefit for most companies, some of the other benefits described in this article would probably rank higher than any reductions in levy achieved in this way.

In addition to escrow accounts and letters of credit, there are other approaches which are likely to be of interest in future, including intra-company guarantees and charges over assets, as these are potentially low cost and have strong application for multi-nationals where a UK subsidiary may have significantly weaker covenant or fewer assets than its overseas parent.

Thus, in the brave new pensions landscape, contingent funding is likely to become a key part of the toolbox for trustees and companies alike, especially in providing win-win options where conversations between companies and trustees may become adversarial.

Hemal Popat is a senior investment consultant at Watson Wyatt