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Contingent funding structures: get creative

Paul Brice Paul Brice

The business uncertainties arising from COVID-19 are far from resolved, with numerous sectors affected and the commercial impact for many companies remaining uncertain.

Given the current uncertainties, defined benefit (DB) pension scheme sponsors may want to set lower contribution levels or to restructure existing funding agreements to preserve cash in the business, perhaps simply to survive.

In turn, many DB pension schemes may be going through valuations. A key question arises as to how best to determine affordability when there may be a massive 'fan of doubt' about the employer’s future and cashflow generation.

TPR guidance

The Pensions Regulator (TPR) COVID-19 guidance is clear that trustees should engage with employers constructively to understand funding constraints, but equally that they should weigh any requests for concessions against the potential risks to the scheme and, where possible, seek appropriate protections for the scheme.

In such uncertain times, contingent funding structures can be more valuable than ever, providing for payments to a scheme when an employer can afford them, but not where the employer’s financial capacity is excessively constrained; and where payment above a certain level as a contractual obligation would risk 'choking' the business.

There is a wide range of contingent funding structures, some of which are well understood but some less so. In many cases, contingent funding and other scheme liabilities can be underpinned by contingent assets.

Contingent funding structures: possible options

One relatively straightforward option for contingent funding structures is performance-based contributions. Under this option, there may be an agreed 'baseline' level of DRC’s, with further payments made depending on employer performance or other events (such as asset disposals).

Such agreements, while ostensibly simple, need to be extremely carefully designed so as to avoid unintended consequences or disputes over measurement. Trustees considering such agreements also need to consider additional undertakings, such as negative pledges on distributions, or other prohibitions on the use of cash for purposes other than funding the scheme. The Scheme Actuary is unlikely to be able to give credit for DRC’s above the baseline in setting the scheme recovery plan.

Contingent funding structures linked to metrics

Performance-based structures can also be linked to metrics of scheme performance, with, perhaps, further cash payable if a scheme’s funding position falls outside an agreed 'corridor' for a period of time.

A development of contingent funding structures that are based on employer financial performance can be group contribution underpinning, whereby additional cash sums may be payable to a scheme on the basis of an underpin from another group company in circumstances where specific performance or other targets, such as the renewal of a key contract by the employer, are not met. These arrangements ensure that a scheme receives cash funding underpinned by a stronger counterparty in circumstances where the employer is financially weak. Clearly, there are tax and other considerations that need to be considered in structuring these types of arrangement.

Collateralising contingent funding structures and scheme funding generally

While trustees are likely to wish to see certain negative pledges supporting performance-based contributions, other contingent funding structures can collateralise these arrangements and scheme funding generally.

Indeed, while performance-related contingent funding structures can be useful when the outlook for an employer is uncertain, they should, as TPR’s coronavirus guidance observes, be considered alongside 'appropriate protections for the scheme'.

Contingent asset structures

Perhaps the most-common contingent assets are parent company guarantees and security over assets. While these may be well understood, it is surprising how many trustees have not fully thought through the value to them in a scenario of default. For example:

  • What value would flow to a guarantor given its position in the group and how the insolvency process works?
  • Is it better to have a guarantee from a subsidiary with operating assets, or a parent with access to the entire group’s value but with structural subordination to creditors in subsidiaries?
  • Particularly where there are prior ranking debts or multiple jurisdictions, is asset security enforceable and of value?

Depending on how a guarantee or asset charge are implemented, they can also help to reduce PPF levies.

An escrow account effectively ring-fences funds to be paid out if specified conditions are met. This can provide additional certainty to trustees, but great care is needed in defining the payment conditions. Even an escrow account is not without risk, and a variant to manage those risks is a reservoir trust whereby a particular income stream over time is pledged to the scheme if needed. There can be important differences in terms of accounting, tax and investment of assets.

Contingent funding structures from surety bonds and letters of credit

Slightly less common collateral to provide additional security can come from other instruments, such as a surety bond or bank letter of credit. These are similar, but different, both being financial products with a cost attached, but having a different impact on credit facilities. Careful thought around quantum, duration and triggers is needed when giving credit for either arrangement in scheme funding, so as to avoid unexpected 'cliff-edge' effects from the early expiry of the arrangement before it is called upon.

Finally, another, quite complex, arrangement to consider is an Asset-Backed Contribution structure (ABC), which may offer multiple benefits for scheme and sponsor, but can be costly and time-consuming to implement and usually requires a critical mass to justify the time and expense of implementing, and maintaining, the structure.

If you would like to have an informal conversation about these and other contingent funding structures, including their benefits and potential pitfalls, contact Paul Brice.

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