Article

DB scheme funding in uncertain times

Paul Brice Paul Brice

Many DB pension scheme sponsors and trustees are facing funding challenges. Paul Brice and Tim Birkett explain how utilising alternative funding structures can help find an appropriate balance between the respective needs of both scheme and sponsor.

Many DB pension scheme sponsors and trustees are facing funding challenges. Paul Brice and Tim Birkett explain how utilising alternative funding and covenant support structures can help find an appropriate balance between the respective needs of both scheme and sponsor.

As we continue to deal with COVID-19 related restrictions, both sponsors and trustees of DB schemes have been navigating through the deep uncertainties presented by the pandemic. When considering DB scheme funding, there is a balance to be found between delivering the funding and support needs of the scheme, consistent with the fiduciary duties of the trustees, while at the same time seeking where appropriate to preserve the financial health of the employer.

When trying to find this balance, we find it helpful for trustees to think of the acronym ‘ICEP’:

  • Information - getting the right information from sponsor to trustee to facilitate appropriate monitoring and decision making
  • Contributions - understanding the right level of cash contributions to go into a scheme, and how these should be structured
  • Enhancements - how the covenant can be enhanced during this uncertain period
  • Protections - how the covenant can be protected from leakage, such as material transactions or material dividends

There are several alternative funding structures and mechanisms available for trustees and sponsors to consider. Some address scheme funding, some relate to security, while some address a combination of the two. When combined with the elements outlined in ICEP, it is often possible to put together a package of measures that can help a sponsor through a period of uncertainty. We acknowledge that these funding structures are not new, but their use in such uncertain times is increasingly widespread. We highlight a number of key structures and considerations below.

Guarantees

One of the most common structures used to support covenant strength are guarantees, either from a parent or sister company. Guarantees often provide 'backstop' security, but no cash unless the terms of the guarantee are triggered (typically being payment default or insolvency). Guarantees may be an attractive option to sponsors and trustees where they bring substantial additional covenant strength in the context of scheme funding discussions.

However, it is particularly important to consider the strength of any guarantor in a scenario in which a claim might arise. It could be materially different from the position it is in today, and this is especially relevant given the uncertainties faced by many sponsors and sectors today. This might seem obvious, but needs to be considered.

To consider the likelihood of a recovery under a guarantee, scenario planning is key – what are the sector dynamics? What is the company’s market position? What value would flow to a guarantor given its position in the group? Trustees should also consider whether it is better to have a guarantee from a subsidiary with operating assets, or a parent with access to value from the whole group, but where there may be structural subordination issues.

Jurisdiction and the enforceability of guarantees is another consideration that has come to the fore after Brexit. Trustees will need to obtain sound legal advice around all aspects of guarantee structure and enforceability.

Group contingent funding arrangements

Rather than producing cash solely in the event of default, contingent funding arrangements involve a group agreeing to provide additional cash funding in pre-determined situations. This could include, for example, when scheme funding moves outside a pre-agreed ‘corridor’ – not just on payment default or insolvency. These arrangements add the strength of the parent to support the funding covenant, ensuring that a scheme can receive cash funding from a stronger counterparty upon the defined trigger events in case the employer itself is unable to make the payments.   

As with a plain guarantee, the strength of the counterparty is key here, as is checking jurisdiction issues and enforceability issues with legal advisers. Triggers and limitations need to be carefully defined, and there may be tax implications to be mindful of. As with all of the structures discussed in this note, these arrangements require careful tax, legal, actuarial and covenant advice.

Employer-led conditional contribution arrangements

At a time when many businesses are facing uncertainty, employer-led conditional contribution arrangements could provide an appropriate level of flexibility, giving the employer the best chance of survival.

Under these structures, a baseline level of contributions is agreed, with further payments being made depending on employer performance. In this way, the interests of the scheme and employer can be aligned, so that when the employer does well, the scheme does well.

In these arrangements it is essential that the parameters are defined closely to avoid unintended consequences or disputes over measurement. A sensible base level of contributions needs to be agreed, as does the measure of performance-based contributions going forward. While agreements like this can seem simple at the outset, without careful planning, complications can arise. Alongside these arrangements, trustees also need to consider additional undertakings, such as negative pledges around the use of cash for dividends or other purposes.

Escrow account or reservoir trust

An escrow account or reservoir trust is where assets are set aside, thereby ring-fencing funds to be paid out if certain conditions are met. The essential difference between the two is that broadly an escrow remains an employer asset, whereas a reservoir trust is legally separate and therefore might be more appropriate where there is a perceived risk of insolvency. Both require specialist legal and other advice.

These instruments can be helpful tools where there is an uncertain outcome. For example, an employer might be confident in the renewal of a material contract, whereas the trustees may focus on the risk should the contract not renew.  Funds set aside can support the scheme if the contract is not renewed or be released back to the employer in the event of renewal.

It is essential to carefully define the triggers for release to avoid subsequent misunderstandings or disputes.

However, while an escrow account or reservoir trust can provide additional certainty to trustees, they do require cash or assets to be committed, so at a time when resources are at a premium these options will not be appropriate for everyone.

Asset security and Asset Backed Contributions

A relatively straightforward alternative funding structure is for a scheme to take security over an asset. This can benefit the employer and provide covenant support to a scheme to be taken into account in valuation discussions.

However, these arrangements require availability of unpledged assets – which may be a scarce resource at a time of high borrowings. It is also necessary to think about competing creditor claims, or whether an employer has borrowings which carry a negative pledge preventing the company from giving additional security to third parties such as pension schemes.

The valuation of assets can also be problematic, and trustees need to consider what the asset value may be in an insolvency scenario, being realistic about recoverability in downside scenarios.

For employers who do have unpledged assets of value, this arrangement can provide support to the covenant for the purposes of scheme funding and contribution discussions.

Asset backed contributions (ABC) are a mechanism to use a business asset to generate cash flows to support a pension scheme. A range of assets can be used. We have seen examples ranging from whisky to Heathrow landing slots. There is time and cost involved in implementing ABCs but they can deliver substantial financing benefits and scheme security in the right circumstances.

Letters of credit or surety bonds

Letters of credit or surety bonds can provide additional security upon default. The key difference between these two financial products is that a letter of credit may count against a credit facility, whereas a surety bond is an insurance product. Otherwise, these are instruments with similar commercial effects – albeit that their detailed terms and operation vary.

Given their typical duration, letters of credit or surety bonds may be appropriate where there is a need to support a medium-term risk.

Careful consideration is required around amount, duration and triggers in these instruments in order to avoid ‘cliff edge’ effects from the early expiry of the arrangement before it is called upon. In the current environment, increased risk may lead to tighter pricing, or reduced duration, but for those with collateral, these instruments may still offer attractive options.

If you would like to have an informal conversation about any of these alternative funding structures, contact Paul Brice or Tim Birkett.

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