UK: Contingent Assets

Last Updated: 9 November 2007
Article by Wendy Hunter and Fraser Sparks

There has been steadily increasing talk in the pensions industry recently of surpluses. What is more, this talk has not been romantic reminiscing of a bygone age but has been considering the current or readily anticipated funding situation of many occupational schemes. Indeed, it has been claimed that the FTSE 100 no longer has a pensions deficit (although, of course, much depends on which method of valuing liabilities one is comparing funding against).

Wonderful news, you might think. A fantastic opportunity to make pension schemes solvent to such an extent that deficits could only arise again in the most extreme circumstances. It would not appear so. Understandably, employers are rather reluctant to keep pumping millions, if not billions, of pounds into a benefit arrangement that might have little relevance to current employees who are busy finding out how their money purchase pots are performing. So how are employers balancing the requirements of trustees against their concern to avoid what they see as the threat of overfunding and trapped surpluses? The answer is, quite overwhelmingly, contingent assets.

There is another aspect to this. The Pension Protection Fund (PPF) is, so some people say, taking money from those employers that are doing well in order to pay for the pension promises other employers have made but which they cannot afford. Again, one can ask what have employers been doing to reduce the annual premium they must pay to the PPF and, again, the answer is contingent assets.

There are now a range of contingent assets that are commonly used in relation to occupational pension schemes. As the name suggests, these are assets which are not placed within the pension scheme immediately but which will be placed within the scheme on the occurrence of certain, pre-defined events.

Escrow Accounts

Pension scheme trustees would probably like to receive cash from their sponsoring employers more than anything else. However, if that is not possible, placing the cash in a designated account, an escrow account, on the basis that it will be paid to the trustees in the future should they need it comes a pretty close runner-up. Unlike most other types of contingent asset, escrow accounts can be used as part of the general funding programme for a pension scheme and need not simply come into play on the insolvency of the sponsoring employer. That said, typically, the trustees will be given security over the escrow account so that they will have first call on the cash should the employer become insolvent.

Employers will be attracted to this approach if they take the view that any deficit in the pension scheme is likely to be funded by investments outperforming liabilities. The arrangement will define certain trigger events that would result in money from the escrow account being paid into the scheme provided that, at that time, the scheme is underfunded on whatever basis has been agreed. That said, for this to be a viable option, the employer must normally have a significant amount of spare cash available which it can lock away in an escrow account for a number of years. In addition, the employer will receive no tax relief on the cash it places in the account unless and until that money goes into the pension scheme.

Security Over Assets

If the employer does not have the spare cash necessary to make it commercially worthwhile setting up an escrow account, it may have other assets, typically land or buildings, which can be charged to the pension scheme. Normally, such arrangements are set up on the basis that the asset would only be transferred to the trustees if the employer becomes insolvent. After all, a successful business is unlikely to want to be evicted from its premises by its pension scheme trustees simply because the pension scheme is not fully funded. For this reason, this type of contingent asset is generally used, primarily, in order to reduce the pension scheme’s levy to the PPF. However, charges could be used by an employer in order to justify a longer recovery period under the scheme’s funding arrangement than might otherwise be acceptable to the trustees.

Of course, if the asset over which a charge is granted is property or some other non-cash asset the value of which will vary from time to time, the trustees will need to value it regularly. A mechanism could be put in place whereby the employer will have to pay additional contributions or provide additional security if the value of the charged asset falls below a particular level. Another point for the trustees to consider is the cash flow of the pension scheme as, clearly, this will not be assisted by a charge over the employer’s assets.

From an employer’s point of view, if it has available an asset which can be charged to the trustees, this can be a relatively pain-free method of reducing its contributions to the scheme while at the same time reducing the pension scheme’s PPF levy.

Letters Of Credit

A letter of credit is an arrangement whereby an employer can purchase protection against the risk of its insolvency for the benefit of the pension scheme trustees. The employer will enter into a contract with a bank or insurance company whereby, for a fee, the bank or insurance company will pay an agreed sum of money to the pension scheme trustees on the employer’s insolvency.

This can be a relatively cheap method of the employer deferring the payment of cash into the pension scheme and reducing the pension scheme’s PPF levy. The fee should also be tax deductible. However, the letter of credit will generally be treated as borrowing by the employer and so it could increase the cost of any subsequent debt the employer wishes to take on.

Trustees are generally receptive to funding arrangements involving a letter of credit. However, as with charges over assets, the trustees must ensure that the pension scheme has sufficient cash flow to meet its liabilities as they fall due.

Group Guarantees

Group guarantees have proved a very popular method of reducing pension schemes’ PPF levies. A sponsoring employer which is part of a wider corporate group and which does not have a particularly favourable failure score may be able to reduce the levy by the relatively simple process of obtaining a guarantee from another group company which has a more favourable failure score. This has been seen by many corporate groups as an obvious way of saving money but the would-be guarantor should first ensure that providing the guarantee will not have any adverse financial and/or accounting implications.

Such guarantees may not, however, have a material effect on the trustees’ approach to the statutory funding objective. This is mainly because the trustees might already be taking into account the financial strength of the wider corporate group on the basis that, if the sponsoring employer became insolvent, the Pensions Regulator could issue a financial support direction in order to make the wider group directly liable to fund the pension scheme’s liabilities. As such, this type of guarantee may not convince the trustees to accept a longer recovery period than would otherwise be the case.

Impact Of PPF Levy Documents

In order for a contingent asset arrangement to be taken into account by the PPF when calculating the levy, it must be entered into on the PPF’s standard form documentation. Even if an employer’s primary reason for offering a contingent asset arrangement to the pension scheme trustees is funding rather than to save on the levy, the employer is still likely to want the arrangement to be taken into account by the PPF so that it gets maximum value from the arrangement.

The PPF’s approach has, therefore, assisted pension scheme trustees no end as it has taken away much of the scope for negotiating these arrangements. Employers should take particular care, however, with the PPF standard documents as, once put in place, they can be very difficult to bring to an end.

Investment Strategy

Another issue that is becoming increasingly common when an employer suggests a contingent asset arrangement is the trustees’ investment strategy. Legislation makes it clear that a pension scheme’s investment strategy is solely in the hands of the trustees but a contingent asset arrangement can be used by employers to exert some control over the trustees’ decision. For instance, an escrow arrangement might be made subject to the trustees continuing to invest, say, 80% of the pension scheme’s assets in equities. The decision to maintain that investment strategy continues to rest solely with the trustees but they would have to bear in mind that, should they decide to move away from that strategy, they will lose the benefit of the escrow arrangement.

Any such conditions which are proposed by the employer will have to be considered carefully by the trustees in order to ensure they are not fettering their discretion or granting the employer control over the pension scheme’s investments.

In summary then, contingent assets can be very useful for employers who either do not wish to pay large sums of money directly into their pension schemes or cannot do so. Contingent assets can also be used very effectively to reduce a pension scheme’s PPF levy. Whatever the primary reason for a contingent asset arrangement, both employers and trustees should consider carefully how it fits into the wider arrangements for funding the pension scheme and also the pension scheme’s investment strategy.

Key issues:

  • What is the main purpose for putting the contingent asset in place?
  • Would it be better simply to pay contributions into the pension scheme?
  • Which type of contingent asset is most appropriate?
  • Can the contingent asset arrangement be used by the employer to exert some control over the pension scheme trustees’ investment strategy?

This article first appeared in the August edition of Pensions World. The article has been reproduced by kind permission of the publishers.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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