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Four solutions for higher education pension deficits

Tim Birkett Tim Birkett

Higher education employers and pension scheme trustees face substantial challenges in completing scheme valuations in today’s environment. 

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Tim Birkett has worked with Nick Stones of Pinsent Masons to come up with four creative solutions to funding higher education pension deficits.

Falling gilt yields are pushing liabilities ever higher, while the COVID-19 situation is causing widespread disruption in financial markets and the wider economy. Questions are also being raised over the covenant strength of universities, with a wide ‘fan of doubt’ around future university cash flows and therefore the affordability of deficit contributions. How can the affordability of contributions be assessed when there is uncertainty over student numbers and research grant income?

  • What about losses arising from student accommodation lying empty and conferences not being held?
  • Will there be long-term impacts from the Augar review?
  • What might happen to contributions to other schemes, such as the University Superannuation Scheme, Local Government Pension Scheme, Teachers Pension Scheme and others?

Many employers are seeking to preserve cash to protect against potential downside scenarios. Pension scheme trustees, meanwhile, may want to increase funding and security, but without damaging the sustainability of their employers. Structures are needed to accommodate these uncertainties, and to bridge gaps between the needs of the employer and of the scheme.

TPR guidance

The Pensions Regulator (TPR) has issued coronavirus guidance that trustees should engage with employers constructively. They should understand constraints to funding a pension scheme, but also weigh any requests for concessions against the potential risks to the scheme and, where possible, seek appropriate protections.

As such, performance-based or alternative 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 or where payment above a certain level as a contractual obligation would risk 'choking' the employer.

There is a wide range of alternative funding structures available, some of which are well understood, but some less so. We identified four of them:

1 Performance based contributions

One relatively straightforward option is performance-based contributions.

There is an agreed 'baseline' level of deficit reduction contributions, with further payments made depending on university performance - say, an adjusted net income metric exceeding a threshold - or other events, such as asset disposals.

Such agreements, while ostensibly simple, need to be extremely carefully designed in order to avoid unintended consequences or disputes over measurement.

TPR’s coronavirus guidance observes that such structures should be considered alongside “appropriate protections for the scheme”. This may, for example, include prohibitions on the use of cash for purposes other than funding the scheme - a complex area to evaluate when tuition fees and research grants can be ‘lumpy’ and received in advance.

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.

2 Alternative scheme funding structures in a higher education context

Perhaps the most common contingent support is security over an asset.

While this may be well understood, it is important to be sure that the asset security is enforceable and of value, taking into account the likely circumstances at the time and the nature of the asset in question. For example, a student accommodation building might have a materially reduced value if an institution were to default, while purpose-built properties may not easily lend themselves to being repurposed for alternative use.

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, however, 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, or funds are placed in trust, but otherwise act in substantially the same way as an escrow account.

While these sorts of solutions can effectively manage risk, they do need to be considered carefully in terms of implications for accounting, tax and investment of assets.

3 Surety bonds and letters of credit

Less common collateral to provide additional security can come from other instruments, such as surety bonds or bank letters of credit.

These are similar to asset security, but have some differences, 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, in order to avoid unexpected 'cliff-edge' effects from the early expiry of the arrangement before it is called upon.

4 Asset-backed contribution

Another, quite complex, arrangement to consider is an asset-backed contribution.

This may offer multiple benefits for both the scheme and sponsor, but can be costly and time-consuming to implement and usually requires a critical mass to justify the expense of implementation and ongoing ‘maintenance’ costs. Also, one of the key advantages of an asset-backed contribution is that it can deliver tax savings to a UK tax-payer, but this will not apply to universities.

Competing creditors

All the above structures need to be considered in light of other creditors, such as lenders or other stakeholders with security or negative pledge arrangements.

A conscious assessment would be needed on whether a contingent funding structure for the scheme might trigger actions by others. This is particularly relevant to higher education schemes given that the USS is effectively pursuing pari-passu security where any new structures would impact on its current priority position.

Associated legal issues need careful consideration

Whatever arrangement is ultimately agreed, it will need to be documented clearly in a legally binding document. Often these agreements are designed to last many years, so need to be able to adapt and cope with changes in circumstances and key people.

Regardless of the funding agreement reached between the parties, the trustee and sponsor will need to sign off actuarial valuations and associated schedules of contributions and recovery plans in the usual way under the Pensions Act 2004 regime. The parties will need to be clear as to how the statutory regime and any separate funding arrangements interact.

Long-term funding commitments

An employer making long-term funding commitments, often much in excess of the statutory commitment, may expect the trustee to commit to certain behaviours in return. For example, agreeing and maintaining a particular investment strategy, agreeing to certain apportionments and the restructuring of scheme liabilities or liability management exercises, or the maintenance of particular actuarial factors used for benefit calculations.

While in most cases this should be possible with suitable release or escape triggers, the willingness of both parties to agree to formal legal commitments should be explored early. It serves little point in agreeing these funding matters if one stakeholder declines to commit to the full terms. Specialist legal and covenant advice may be needed for trustees and employers to feel comfortable with proposed structures.

Evergreen commitments may not be feasible

The lifetime of the funding or guarantee arrangement will also be an important factor in the negotiations.

A blanket 'evergreen' commitment may not be ideal for a variety of reasons and consideration should be given as to where it may be desirable for the funding commitments to fall away. For example, in the context of a guarantee, the employer would need to be mindful about the trustees taking certain actions that could accelerate a payment commitment under the guarantee, such as triggering wind-up.

Wider legal obligations

Finally, consideration should be given to wider legal obligations, such as the university’s fiduciary obligation through its charitable status. Both the Office for Students and the Education and Skills Funding Agency may need to be considered.

Still, in our view, such agreements usually represent a good long-term outcome for the university.

A win/win scenario

Stability is key for both employers and schemes, especially in a volatile economic climate. Long-term funding structures have the potential to take one issue off the table even though other issues will undoubtedly remain.

The best outcomes are likely to be achieved for both parties if funding, investment and covenant are considered holistically. Scheme funding structures using alternative or contingent assets can help to bridge gaps and reconcile different valuation and funding objectives between trustees and employers.

Care is needed to choose the right method and to set the right terms, but if you choose the right one for your circumstances, they can be a powerful tool when facing the level of uncertainty that higher education employers currently face.

Written by Tim Birkett and Nick Stones of Pinsent Masons.

For support in understanding alternative pension scheme funding arrangements in a higher education context, contact Tim Birkett.

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