A growing number of companies in the UK are discovering that they can repair the deficits of their defined benefit pension
schemes without having to put any money on the table. They are doing this with the use of contingent assets.

A contingent asset produces cash for a pension scheme contingent on a specified event - for example employer insolvency or failure to achieve a specified scheme funding level. They become available to the pension scheme only when the ‘contingent event' occurs, and therefore cannot be included as scheme assets to assess whether the statutory funding objective is met.

Contingent assets are effectively a charge against specified assets in a company. Assets can include cash in a bank account, or escrow, which is released to a pension scheme when a key event, such as the sponsoring company's insolvency, takes place; security over assets, where the assets are transferred to the pension fund when a key event happens; and a letter of credit or third party guarantee which is activated if an employer defaults on contribution payments.

The use of contingent assets by UK companies in respect of their pension funds is growing. A survey by Aon Consulting of 150 UK companies operating defined benefit pension schemes earlier this year found that a sixth (17%) of schemes are already using such assets in their portfolios, with another 20% considering such assets.

Parent companies and group guarantees are the most popular form of contingent funding being implemented or considered, with escrow accounts, charge over assets, and letters of credit, being the next most popular.

In its report ‘Accounting For Pensions UK and Europe 2006' consultants Lane Clark & Peacock note that few FTSE 100 companies disclose contingent assets in their accounts.

Last year UK supermarket chain Sainsburys used company properties as collateral to raise debt, part of which went to pay £350m (€516m) towards its pension deficit of £658m.

National Grid, the company that provides the network for the UK's electricity generation, has given its pension scheme letters of credit, which will be triggered should the company become insolvent or agreed payments to the scheme not be made.

Ericsson, which acquired the bulk of Marconi, paid £490m into an escrow account in as well as a cash payment of £185m to the pension fund. Companies are using contingent assets to support the recovery plans of their pension funds in two ways: to provide security against the risk of a default against their obligations, and to underpin ‘back-end loaded' recovery plans, where the companies pay in less cash in the early years and more in the later years.

The use of contingent assets also enables pension funds themselves to invest in riskier assets within the recovery plan. The Pensions Regulator may accept an ‘optimistic' asset return assumption over the period of the plan if contingent assets are in place.

However, companies cannot use contingent assets for both recovery and funding purposes. The Pensions Regulator has warned companies about double-counting. If a company uses contingent assets to support a back-end loaded recovery plan, the PPF says, it cannot also use them to support the scheme's funding strategy.

Contingent assets are seen as a solution to the problem of increasing contributions to conform with the funding requirements of the Pension Regulator. The Church of England's funded pension scheme for clergy is currently considering using contingent assets to reduce the impact of higher contributions. A strong attraction of contingent assets for companies is that they can be used to reduce the levy that they are required to pay to the Pension Protection Fund (PPF), the new body that has been set up in the UK to provide a safety net for members of failed pension plans.

The PPF reports that more than 100 companies used contingent assets to reduce their 2006/07 annual levy and they expect the number to increase for the 2007/08 levy.

The recognition of contingent assets by the PPF follows intensive lobbying by the Confederation of British industry (CBI), the UK employers' organisation, which was worried about the cost to companies of the PPF levy.

Last year the PPF agreed to take account of contingent assets in the risk-based levy calculation by reducing the level of a scheme's underfunding in line with the value of the arrangement. But they warned that contingent assets could take only specific forms and would be used only when a pension sponsor became insolvent.

Currently, the PPF will consider a guarantee by a company in the same group as a scheme's sponsoring employer, obtaining security over particular assets and paying a premium to provide insurance-style cover.