Contingent assets have been used in scheme funding arrangements in the UK for some time, but how popular are they overseas? Chris Panteli finds out.
Brewer Diageo hit the headlines earlier this year following its announcement to fund an £862m ($1.3bn) pension deficit using maturing whisky spirit.
Under the deal, the firm - whose products include Guinness, Johnnie Walker and Baileys - established a pension funding partnership (PFP) with the trustee, which will hold the maturing whisky.
Once the whisky matures, it is hoped the trustee will be able to sell the matured whisky back to the company for an amount expected to be no greater than the deficit at that time, up to a maximum of £430m. Diageo said the structure will generate about £25m each year over the term of the PFP, which is expected to last 15 years.
Although the details of the Diageo PFP are unusual because of the type of asset used, UK sponsors and trustees have been making similar agreements for some time and, thanks to a combination of scheme-specific negotiations and trustee prudence requirements, are ahead of their European and American colleagues in the use of cash alternatives.
The use of PFPs began in earnest in 2007, when retailer M&S placed £1bn of property into its pension fund. The high street giant followed this up in May 2010 with a further contribution of £300m through the granting of a further interest in the property-backed partnership.
The financial crisis has only spurred on sponsors in the quest of offering alternatives to cash, and this year has already seen a number of deals emerge from big name companies such as Whitbread, Sainsbury, GKN and John Lewis using property to help fund their pension schemes.
Limited cash flow is the simple reason for many companies. Raising cash is considerably more difficult since the economic crisis and taking cash out of the company could harm its operations.
As Sainsbury's pension scheme trustee chairman John Adshead said following the announcement of a £750m property partnership deal with the retailer to tackle its £1.2bn pension deficit, the agreement offered "substantially increased security to the scheme while also supporting the continued growth in the covenant strength of its sponsor".
Once set upon this path, there are two key issues to consider. The first is the type of asset to use. The contingent assets offered by the employer usually consist of bricks and mortar, but can include intellectual property or ownership of a subsidiary.
The second consideration is whether to opt for direct funding or contingent funding. This is the difference between plugging the deficit and promising to do so following a trigger event. Typically, this could be an employer defaulting on a cash payment or a change of company ownership. In this situation, the assets offered could be cash, real estate, royalties or anything else of value the sponsor might own. The assets might not even be directly owned by the sponsor, but instead belong to another entity in the parent company's group.
PricewaterhouseCoopers partner Marc Hommel (pictured) says the UK is at the forefront of using contingent assets for a number of reasons, but he expects their use to eventually spread to other countries.
"In the UK these funding arrangements have always been allowed by law and trustees have been under increasing pressure to become more prudent and look at ways of shoring up liabilities," he said.
"As the number of cash-strapped employers unwilling or unable to pump money into their schemes is increasing, so to is the practice of using contingent assets. Property, letters of credit and parent company guarantees are all regarded by the regulator as acceptable security against employer default during the term of a recovery plan, and can often have the added benefit of reducing Pension Protection Fund risk-based levies too. These are most prevalent in the UK but it will spread to other countries. They are already used in Ireland and will become more common in the US and Canada."
Mercer principal John O'Brien said regulation gives schemes in both the UK and Ireland a greater incentive to try to arrange such deals, but those conditions may not exist elsewhere.
"Contingent assets are quite common in Ireland for very similar reasons to those in the UK," he said. "There is no insolvency protection fund, but otherwise the motivations are quite similar: the need to create security for scheme beneficiaries.
"My understanding is that in the US there is not much use of these kinds of structures at the moment and in Europe again I do not think there is as great a culture for structures like this, or maybe the incentives are not as great."
Joe McDonald, leader of Hewitt Associates' global risk services division, said the use of contingent assets in the US is rare and likely to remain so. He believed while employers such as retailer JC Penney have started contributing company stock into their pension plans as an alternative to cash, the types of deals witnessed in the UK will not travel across the Atlantic.
"It is fairly uncommon here in the US and we expect that to continue," McDonald said. "The Diageo announcement and the prevalence of similar deals in the UK have generated some discussion but it's mainly interest in how it could work and hasn't sparked much activity. There are a handful of sponsors looking at this seriously, and we would expect even fewer to go ahead and do so.
"The main reason for this is because it is cumbersome from a regulatory standpoint. Very often this type of deal would be considered a prohibitive transaction under the rules governing US pensions. A plan sponsor can solicit the Department of Labor for an exemption to those rules and you can get approval for such transactions, but it can be an onerous and time-consuming process and you ultimately have to demonstrate this move is in the best interests of plan participants.
"In the UK, funding requirements are more scheme-specific, so you can arrive at agreements which may not be natural for either side but are the result of negotiations. That doesn't exist in the US - the funding requirements are pretty explicit and very formulaic. With few exceptions they don't vary by organisation."
Such deals are also rare in Europe, again because of key differences in how pension plans are funded.
LCP Netherlands partner, Evert Van Ling said not only are Dutch trustees not contemplating the use of contingent assets they are unlikely to start doing so in future because of the country's strict funding regulations regarding pension schemes.
"There is not much use of contingent assets such as property because we have rules about how much money the company can owe the pension fund," Van Ling said.
Hommel said if such schemes do pick up in countries such as the Netherlands, they will most likely be carried out by sponsors with US or UK parent companies.
"In the Netherlands we are seeing a significant portion of employers saying ‘we absolutely have to do something to address the risks that our pension arrangement poses to us the sponsor and we are deeply concerned about the amount of cash we are having to put in to our pension funds'," he said.
"But when it comes to actually implementing a decision to address the risk and cash problem, many companies - particularly those which are Dutch-owned - are reluctant at the moment to make the decisions which are possible. There is a nervousness about being first mover. As in most countries, pensions there are very emotive and represent strong social contracts. I think it is going to be US and UK organisations with Dutch operations which are going to be the first to use these structures."
Another issue for trustees to consider is how the use of a particular type of asset could have a knock-on effect on a pension fund's portfolio, said O'Brien.
"The nature of the guarantee is something trustees should take into consideration," he says. "If it is property based, trustees might think if they already have material exposure to property, should they be taking into account this additional exposure and should they be diversifying away?"
Hommel agreed both trustees and sponsors ought to look closely at the implications of using contingent assets, but believes their use will evolve and thrive over time.
"Although property has been the most common asset to date and the organisations which have used these arrangements tend to be those with large property assets such as big retailers, we are seeing greater imagination and variety in the kinds of assets that companies and pension funds are looking at," Hommel said.
"These structures enable a win-win for scheme and sponsor but it is critical that the two parties to the deal - sponsor and trustee - understand the transaction.
"Neither side should rush in to these arrangements. They need the appropriate due diligence, discussions and understanding. For a sponsor they can impact favourably or unfavourably on your accounting position, your tax position and your agreements with other creditors."
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