Summary and implications
Asset-backed contribution arrangements (ABCs) have become an increasingly popular tool for reducing pension scheme deficits.
- The Pensions Regulator has had ABCs in its sights for some time. Its most recent guidance, issued in November 2013, warns trustees to evaluate the risks carefully on entering an ABC and to consider whether a similar advantage for the scheme could be achieved using a different, less risky, arrangement.
- Now the PPF is also treating ABCs with scrutiny. Schemes have up until now been able to use an ABC to achieve a reduction in the PPF levy; new proposals will mean that only those ABCs backed by a UK property investment can be taken into account and even then, only if strict certification requirements are met.
- Despite the concerns of the Regulator and the PPF and the legal complexities, an ABC has advantages for the employer in terms of retaining cash in the business, tax benefits and accounting treatment and can offer trustees a relatively secure income stream, sometimes with preferential rights over the asset itself.
Basic structure of an ABC
ABCs are used to improve the funding position of a pension scheme whilst allowing the employer to retain control of an underlying asset. Very simply, the employer transfers an income-producing asset to a separate entity. The trustee invests in that entity and its investment entitles it to a right to the income (or an agreed share of the income) produced by the asset. The employer retains ultimate control of the asset (with the trustee having step-in rights in certain circumstances) but the value of the trustee's investment, usually based on the capitalised value of the expected income payments, is recorded as an asset of the pension scheme, thus reducing the scheme deficit. The income to the scheme agreed under the ABC effectively replaces deficit repair contributions which the employer would otherwise have to make under a recovery plan.
The ABC has to be carefully structured to ensure that it does not breach restrictions on employer-related investments (ERI). Usually this involves the use of a Scottish Limited Partnership (SLP) as the entity holding the asset. The trustee invests in the SLP as a limited partner. For ERI, amongst other matters, trustees must ensure that the SLP will not be a "collective investment scheme" as, if it is, the underlying asset will be subject to the ERI test. An arrangement will not be a collective investment scheme if each of the participants is a corporate body within the same group - therefore in order for the SLP structure to work the trustee will need to be a corporate trustee within the same group as the general partner of the SLP (typically the employer).
Some of the first reported ABCs involved tangible assets (including whisky stocks) and intellectual property (including brand names). A recent report by KPMG indicates that the great majority of ABCs are backed by real property but that the use of intra-group loans is increasing in popularity. Where loan notes are used then the cashflow to the scheme is often provided by another stronger group company (e.g. the parent) promising to pay the SLP an agreed amount each year, effectively giving the scheme access to a stronger covenant.
Trustees would ideally want underlying assets which would maintain their value on the insolvency of the employer.
Potential problem with ABCs
Issues have been raised as to whether the UK legislation in relation to ERI might breach European Union law requirements, which in turn could make ABC arrangements using an SLP unlawful. For this reason the Pensions Regulator stresses the importance of using an "underpin" to protect the scheme's position if the ABC is found to be in breach of ERI or if there is a change of law affecting their legality. The underpin should be in a separate agreement so that it is not tainted by any illegality in the ABC.
The PPF levy issue
The PPF is concerned that ABCs are being recorded as assets in scheme valuations for levy purposes without any proper consideration being given to the value of the underlying asset nor how that value might be affected by employer insolvency. This means a scheme may be paying a substantially lower levy than the PPF considers appropriate based on the risk it actually poses. The PPF is proposing that only UK property-based ABCs will be recognised for levy purposes from 2015/2016.
Currently, the typical ABC will be valued based on assessment of the net present value (NPV) of the expected future cashflows from the asset. The PPF is proposing that the reduction in underfunding risk achieved by an ABC should be the lower of the NPV of the remaining payments under the arrangement and the value of the underlying asset on the basis that the employer is insolvent. Trustees will have to submit an ABC certificate certifying the lower of these two values. The PPF will not be producing standard form ABC documentation (as it has done for contingent assets).
The certification requirements proposed by the PPF for the recognition of ABCs are very stringent. In practice it may be very difficult for trustee's advisers to give them sufficient comfort to enable them to certify the ABC. This could mean that, in practice, very few ABCs will in future provide any advantage in relation to a reduction in the PPF levy.
Although this proposed change in practice by the PPF would not in most cases be a sufficient reason not to enter an ABC (if the trustees and employers are otherwise satisfied that an ABC is the best way forward) it does impact on the financial benefit to the scheme to be gained and this should be factored in to the considerations.
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.