A rarely-used insurance product guarantees the payment of DRCs in the worst-case scenario. James Phillips asks if it is appropriate for DB schemes
Defined benefit (DB) scheme trustees are paying more and more attention to the risk to their sponsor covenant, especially in the wake of major company failures over the past few years.
In the event of insolvency, access to any pledged deficit recovery contributions (DRCs) is lost, and schemes are unlikely to receive much in the way of proceeds from the remaining assets in administration.
Yet, there are ways of ensuring these contributions are actually paid - surety bonds are a form of insurance, guaranteeing DRCs in the worst-case scenario. And, they also have the added benefit of reducing a scheme's levy payment to the Pension Protection Fund (PPF).
In the context of pension funding, the products are fairly niche but a handful of schemes do make use of them, and there are signs their consideration by trustees is creeping up.
How they work
Surety bonds can be offered by banks or insurers after a premium is paid for by the sponsor or from scheme assets. They can be used to guarantee DRCs for the period of a recovery plan and, for each payment that is made by the sponsor, the cover of the bond reduces accordingly.
In an employer insolvency, where the pledged DRCs are unrecoverable, the provider then pays out the full amount covered. This also occurs in the event of any general non-payment.
Several consultants have noted to PP that there is increasing talk among scheme trustees over their potential use, and there are a range of situations where they might be a potential solution.
In a brochure on the topic, Aon says these can be suitable in valuation negotiations, investment reviews, corporate restructures, scheme mergers, or during the writing of integrated risk management plans, for example.
More generally, surety bonds are most commonly used in the construction sector to smooth financing to permanent financing, ensuring support for contractors as well as project completion.
While it may not be an obvious sector to learn from, Employer Covenant Working Group (ECWG) chairman Donald Fleming does believe the products can be useful in DB pensions.
"They are two slightly different worlds," he says. "We're looking at something that is applying what is conventional in the construction sector to effectively insuring a financial downside risk for the benefit of a pension scheme where the corporate sponsor might be in distress.
"That requires pension trustees to feel comfortable about the legal structure, and to feel comfortable that they understand, to an extent, the covenant of a surety provider and their ability to service that obligation. Then, that's overlaid onto how comfortable they feel with the primary sponsor, and what that might do to the relationship with the primary sponsor."
While there may be a number of considerations for trustees seeking this route, the development of best practice over time, if they are more widely picked up, could help iron out the issues in the longer term.
The insurance products have further advantages. The PPF considers them as a form of ‘Type C2' contingent asset, sitting on a scheme's balance sheet.
This has the effect of improving the funding position as the DRCs are treated as paid, as they are guaranteed, and can therefore also be used to reduce the levy a scheme needs to pay to the lifeboat fund.
PPF head of policy Chris Collins explains: "They can be useful in particular circumstances, particularly where you've got a large corporate - possibly a foreign corporate - and a relatively small UK subsidiary with a pension scheme, and you want to manage that exposure. Perhaps there are particular reasons why the financial institution is already in a relationship with the potential surety bond provider."
In global terms, across various Type C2 contingent assets, the PPF sees levy reductions of around £250,000. Nevertheless, "for each [scheme] it can be considerable", he says.
The bespoke nature of the financial products means they can be tailored to each scheme situation.
In fact, if the size of a scheme's pledged DRCs is equivalent to the entire underfunding gap, it could reduce the levy amount to zero.
Collins says: "If what they've done is to cover the whole of their underfunding risk, then obviously it's a 100% reduction in levy."
But while there are situations where a surety bond may be attractive, Collins does not believe they are a "mechanism that we would expect to see being used enormously widely in the future".
While they may be rarely-used, Collins emphasises that the PPF does see them as appropriate - they should be considered within a range of contingent assets when a scheme is looking at other sources of funding.
But, while talk of them is increasing, there should be no expectation that they will become widely-adopted - their usage is best in very particular circumstances. Indeed, the surety bond providers may not actually want or be able to offer one.
Furthermore, those schemes with perhaps the highest need for such products will most likely be priced out. The risk that would be taken on by the provider would cause the cost to ramp up.
PwC partner Jonathon Land says: "for those schemes that really want one, because their company, for example, has a poor credit rating, they can be too expensive.
"In those cases where the surety provider is happy to provide one, those trustees often don't feel it is necessary; they'd rather just take the money into the scheme that would need to be paid as the premium."
For this reason, surety bonds are not a "panacea" but rather "part of a package of solutions", he adds.
"If you have a sub-investment employer grade, you may like this idea but the surety provider could well look at the employer and not be prepared to provide one or it can be expensive," he continues.
Furthermore, insuring employer contributions can be seen as a lack of trust in a scheme's sponsor, and could therefore damage the relationship between parties.
Fleming says: "It's quite a big thing to go out and say we're getting this third party in. That's not part of the whole general relationship the pension scheme typically has with its corporate sponsor."
For this reason, other forms of contingent assets can be more attractive, particularly those where the company provides a guarantee or security over any of its assets.
"The first port of call is, typically, trustees look for what might be available within the corporate sponsor's capabilities," Fleming explains. "They'll ask for a guarantee.
"But, parental guarantees, especially with big overseas companies, are often quite a difficult ask because usually that becomes a liability that they might not want to start a precedent with, or they might have to put that into their accounts and it becomes a market issue."
Nevertheless, if possible, company guarantees, either from the parent or another company in a large group, can be better for the trustee-sponsor relationship and, if all goes well, do not come at a cost to the sponsor while immediately improving the scheme's funding position - at least for PPF reasons.
Land says: "Intercompany guarantees - particularly parent company guarantees or guarantees from other group companies - can provide a dramatic improvement in the recovery in insolvency of an employer and are cheaper and often easier to obtain than a surety bond."
While little known and even less used, surety bonds are another tool for DB trustees seeking alternative ways of guaranteeing DRC payments in the future, removing some of the risk, and securing future benefits over a longer timeframe.
But they may not be suitable for all and, where a scheme is seeking better protection, other contingent asset types should be explored.
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