UK: Beyond the contingent
John O'Brien outlines alternatives to pension funding through contingent assets.
At a time of economic turmoil and cash scarcity in many organisations, it is not surprising that sponsors of defined-benefit (DB) pension schemes in the UK are turning more and more towards alternative finance. This non-cash type of financial support is typically deployed where direct cash contributions are not readily available from the sponsor, which is normally a corporate entity.
Among these alternative vehicles are contingent assets, so called because they only become plan assets under certain circumstances, for example if the sponsor defaults on agreed payments to the pension scheme. The forms of contingent assets typically employed by pension fund sponsors are parent company or third party guarantees of funding, charges on properties or other assets such as escrow accounts and letters of credit.
Indeed, sponsors are getting more creative in how they finance their pension funds' liabilities, and contingent assets have become a growing manifestation of that creativity. In Mercer's recent annual survey of valuation outcomes for more than 250 UK DB pension schemes, over a third of schemes surveyed (34%) now use contingent assets and other forms of security as part of their funding strategy, compared with 24% in 2009 and only 14% in 2007. Among those that use contingent assets, parent company guarantees are the most prevalent (71%), although charges on property or other assets have surged in popularity - with 22% of schemes using them compared to 10% in 2009.
Even so, a reliance on contingent assets is, typically, rather inefficient for employers for a number of reasons. Not only do they tend to encumber corporate resources, but they also:
The scheme has a significant deficit; There may be significant PPF levies;
Therefore, plan sponsors and trustees are wise to explore more innovative, efficient and employer-friendly solutions than the traditional - and perhaps overly familiar - contingent asset approach. We call these fresher approaches ‘conditional' because they take the form of plan assets from the outset, albeit with conditions attached. A growing number of established UK companies have announced conditional asset arrangements with trustees, and it is quite likely that several more such transactions will be announced and implemented over the course of 2010 and beyond - especially as funded public sector schemes are also starting to explore alternative finance.
Recently, a high-profile alternative arrangement by a global producer and distributor of alcoholic beverages has captured the imagination of pension professionals and observers. The company announced an agreement with its UK pension trustee to deploy barrels of its maturing whisky as collateral against its pension deficit, transferring its maturing whisky stock, with a book value of some £500m (€608m), into a new pension funding partnership that will immediately reduce the pension deficit, as these truly ‘liquid' assets are set against the scheme's liabilities.
It is easy to see how such an arrangement would be viewed as far more efficient than a traditional contingent asset structure that restricts a company's freedom by ring-fencing assets while the trustees can only access the assets under certain, often narrow, circumstances. A growing number of conditional asset arrangements have thereby benefited UK pension funds since 2007, the majority of them involving the sale and leaseback of property assets.
These arrangement are generally structured to avoid any over-funding of the schemes; the scheme receives the lease payments if it needs them, and the company retains all the upside of the property's value - as well as a substantial upfront tax rebate on the value of the asset transferred to the scheme.
There are several triggers which indicate that alternative finance should be considered. These include:
The company:has unencumbered assets on its balance sheet (such as real estate or intellectual property); has not given wholesale negative pledges; may be attracted by the possibility of accelerating the timing of a tax benefit; wishes to address the deficit but cannot afford the treasury strain associated with large cash contributions; may not wish to risk over-funding the scheme by contributing cash or valuable assets directly into the pension scheme.
Given these triggers, sponsors or trustees may want to explore a conditional asset arrangement.
These typically utilise special purpose vehicles (SPVs), legal entities created to fulfill a specific objective. SPVs are often used to own a single asset, such as a real estate portfolio or specified intellectual property. The SPV provides the legal structure to enable the cashflow generated by the asset to be transferred, in this case, to a pension scheme. The related documentation needs to address a host of questions such as control of the assets, how they are valued, what happens if they fall in value, how cashflow is distributed, etc.
SPVs are also typically structured so as to satisfy regulatory requirements with respect to employer-related investment, although they do still represent a concentration of investment in the employer's business, so trustees should consider their impact on the scheme's overall investment profile.
The arrangements work this way: the conditional asset, or SPV, channels cash flow generated by company assets into the pension scheme over a period of time but creates a scheme asset at the outset, at the present value of the cash flow. The company makes a contribution to the scheme to finance the acquisition of the conditional asset, and as a result there is a considerable reduction in the funding deficit. From the company's perspective, a tax rebate is sought on the upfront contribution and the associated strain on the cash flow is staggered over time - perhaps 15 or 20 years.
The SPV's obligations to the scheme are typically structured to cease once the scheme becomes fully funded on an agreed-upon basis; beyond this point, the assets may return to the corporate entity. The accounting treatments can vary, depending on the company's objectives and the underlying assets.
The benefits of such alternative financing arrangements are self-evident, not least of which is their greater efficiency when compared to the old-fashioned contingent asset approach.
All the same, trustees must consider some key issues, including, for example, the suitability of the SPV asset as a scheme investment; the impact on existing funding arrangements; the valuation of the asset; and the impact on employer covenant. Nevertheless, it may well be appropriate for trustees themselves to raise the possibility of conditional assets where they believe their scheme sponsor does not have the cash available to repair a pension deficit promptly.
The company itself must consider such issues as the availability of unencumbered assets; the agreement of other creditors and stakeholders; and the range of tax, accounting and cost considerations.
Ultimately, while conditional assets may be significantly more efficient and sophisticated than the one-dimensional contingent asset approach, they are also a more complex reflection of today's complex pension context. Proceed with care - and consultation.
John O'Brien is a senior consultant in Mercer's European financial strategy group