The decision by the IFRS interpretations committee to re-examine its asset-ceiling guidance should serve to focus minds once again on how defined-benefit plan sponsors can address the danger of a trapped surplus. Stephen Bouvier explores the issues with two experts from Aon Hewitt’s UK practices

The latest accounting uncertainty to hit defined benefit (DB) pensions accounting under International Accounting Standard 19, Employee Benefits, (IAS19) is the decision by the International Financial Reporting Standards interpretations committee (IFRS IC) to look again at its guidance on the interaction between the IAS19 asset ceiling and a scheme’s minimum funding requirement.

The fear is that the committee, which is charged with interpreting IAS19, could be on the verge of restricting the ability of DB plan sponsors to recognise a plan surplus on their balance sheet. But convenient though it might be to see changes to IFRIC 14 as a reason to enter into an alternative financing transactions, it is unlikely that any sponsor either has gone, or will go ,down this route with that thought in mind. 

“To date, this question has not really been a driver because, certainly in the UK, we have been confident it has not been an issue,” says Simon Robinson a consultant actuary and IAS19 specialist with Aon Hewitt. But he does agree that a wider concern about the potential to access a refund of any surplus, and talk of changes to IFRIC14, have highlighted the issue. “It is not just about cash, it is also a balance sheet issue.”

So why do sponsors enter into alternative financing transactions, if not for accounting reasons? Generally speaking, says Lynda Whitney, a partner with Aon Hewitt, it is about solving a disagreement between the company and its trustees over issues such as how long the recovery plan should be, or managing the Pension Protection Fund levy. “Perhaps the company wants the trustees to agree to a higher-risk investment strategy than the trustees are willing to agree to,” she explains.

“We are seeing a lot of interest from companies and trustees on the question of how they might bridge the gap between their understandably different viewpoints,” Whitney continues. “So, if a company has concerns about the direction of travel at the IFRS IC, for example, or about a trapped surplus, and the company doesn’t want to put cash into the pension scheme, they need to work with the trustees to come up with a solution that offers the trustees a sense of security.”

A groundbreaking deal between the UK retailer Marks & Spencer (M&S) and its pension trustees (see box) is perhaps one of the best-known examples of how a DB plan sponsor could structure an alternative financing transaction. But, as M&S discovered, and as Whitney notes, actions by regulatory authorities have, in recent years, reduced the pull of these arrangements.

Equally, the solution that a sponsor opts for will invariably be highly situation specific. So, if a company is set against pouring more cash into its scheme, what could it do? “One option is to put funding into another vehicle such as an escrow with either with a charged account or with a reservoir trust-type arrangement,” says Whitney. 

“If they have assets, do you put a charge over the assets, or something more complex such as an asset-backed contribution structure? But, as we have seen since 2007, both tax authorities and pensions regulators have limited the advantages of those structures.

“Finally, it is possible that a business could make better use of the cash in its business and would prefer, therefore, to pay a third party to give the trustees security,” adds the Aon Hewitt partner. “And this is where you will see either a bank letter or credit or an insurer’s surety bond. This would basically say that if the company is unable to meet its obligations to its pensioners then someone else will.

As for the market for these transactions, Aon Hewitt estimates that more than 70% of clients with schemes with funding liabilities of more than £1bn (€1.25bn) have entered into some form of alternative financing arrangement –although a significant number of those are parent company guarantees. 

Further down the ladder, although fewer of the smaller schemes use these vehicles, around 20% of schemes with less than £100m of liabilities have taken the plunge – generally in addition to cash, rather than as a complete replacement.

Deciding on the most appropriate structure depends which problem the sponsor is trying to address. Although it would be a fiction to suggest that recent actions on IFRIC 14 are the sole driver of change, were a sponsor to address that issue in isolation, Lynda Whitney thinks that an escrow solution is the one to go for, simply because “you are not trying to solve any other problem alongside that”. 

But where, say, the PPF levy in the UK is an issue, or because you need to liberate cash for use within the business, an asset-backed contributions start might be an option because it puts the whole asset on the trustees’ balance sheet. “If you think about it, you have two elements,’ says Whitney. “You have an ongoing flow of contributions from the SPV and, if the worse were to happen, the fund could also take ownership of the asset.” 

Regulatory concerns mean, however, that sponsors must tread carefully and understand what the underlying asset in the vehicle is. 

But could the decision to enter into a deal with their trustees leave a sponsor worse off? On balance, Whitney thinks not: “If you are thinking about what might happen if you needed to unwind the escrow, the main disadvantage is that the sponsor will not have had the tax relief as early as if they had put the money into the scheme directly. Although this depends on whether the sponsor is actually paying tax in the UK. On the other hand, the company is in no worse position in relation to the trustees if they want to unwind the escrow.”

Marks & Spencer sticks to its obligations

Back in 2007, retailer Marks & Spencer became only the second major listed company in the UK to enter into a property lease-back transaction with its DB scheme. 

The deal used a Scottish limited liability partnership and saw M&S enter into a joint venture worth just shy of £500m with the trustees of its deficit-laden scheme. 

The pension scheme received a “limited interest in this partnership”, while M&S retained control of the properties in the partnership.

The properties were then leased back to M&S, creating an income stream to the pension fund of £50m per annum for 15 years from July 2008. M&S retained the right to buy out the trustee’s partnership interest at any point for an amount equal to the net present value of the remaining annual distributions due to the pension scheme.

Then, in March 2009, the trustees and M&S amended the terms of their deal partnership to reflect a discretionary right agreed between them. The deal meant that were M&S Group to make no dividend or other distribution to ordinary shareholders, it could also withhold its annual distribution from the partnership to the scheme’s trustees. 

But following publication of M&S’s 2009 annual report, the Financial Reporting Review Panel (FRRP) challenged M&S’s decision to classify its interest in the partnership as a component of equity. 

M&S eventually announced that it would continue to reflect the obligation as a liability and waived its discretionary right indefinitely. The outcome leaves M&S’s obligations to its pension scheme unchanged.