WHAT ARE SPONSORS AND TRUSTEES DOING?
Below we set out the emerging trends and best practice in this fast-evolving area, as well as discussing how sponsors and/or trustees can avoid contingent solutions that they may subsequently wish to unwind but can't.
More strategic use of contingent approaches
For example, to form an integral part of an agreed journey plan within a clear IRM framework, with both upside and downside contingencies. This gives the right mix of security and cash to address overfunding concerns on one hand and covenant/underfunding concerns on the other.
More sophisticated structures
For example, a contingent asset itself can be contingent. In other words, the sponsor might not need to provide it on day one – instead, they agree to give it IF a specific trigger occurs – that can still give the protection the trustees need while being more palatable for the sponsor or its parent or group companies and other stakeholders. One example is a parent company guarantee that is not granted immediately but comes into existence if certain covenant metrics fall below a pre-agreed level at some point in the future.
Innovative approaches i.e. combining two or more contingent solutions
Several combinations are being developed that combine some of the key benefits of traditional contingent approaches in a tax, legal and accounting efficient way; for example letters of credit combined with investment management of the collateral put aside to back them.
Emphasis on future-proofing
Covid-19 has taught us that events perceived as extremely remote do actually happen, with some pre-existing contingent assets having triggered at a time when they were least affordable. Many trustees and sponsors also have pre-existing contingent assets that are no longer in line with their initial objectives, which have evolved since they were first put in place. Avoiding single-date market “snapshot” triggers for these vehicles, having an eye on how objectives are likely to evolve, and stress-testing the likelihood of triggers occurring (and their affordability) are all ways to address this crucial point at an early stage of the design process.
Increased leverage for schemes
We’re seeing this particularly where there’s M&A or restructuring activity, due to the new regulator powers introduced in the Pension Schemes Act 2021. This leverage might enable trustees to more easily negotiate certain protections.
Framework agreements
There’s an increasing use of framework agreements in which various aspects of managing a scheme are pre-agreed so the trustees get the benefit of locking in increased funding or security, or dividend sharing, but the employer has the benefit of knowing that the situations where the trustees could come and ask for more support are limited.
Pre-transaction agreements
We’ve seen benefits for both trustees and employers of pre-agreeing mitigation where transactions are planned. As just one example, an LCP covenant review recently picked up that a business disposal was planned, which led to the sponsor pre-agreeing to share a given proportion of the proceeds as part of the valuation discussions.
Fair treatment and sharing upside
Fair treatment has been a big focus of the Regulator in its recent Annual Funding Statements, leading to an increasing number of dividend sharing agreements. These range from matching 50:50 to much smaller percentages, depending on scheme size mainly (but also on funding level and covenant). Dividend sharing is popular as it enables schemes to share in the upside of employer performance and also addresses some trustee concerns over covenant leakage.
Tangibles vs guarantees
We’ve observed a trend away from simple guarantees to more tangible forms of support, such as contingent contributions or asset security. Trustees are viewing related party guarantees more critically and thinking about how and when these will result in value flowing to a scheme.
Covid-19 contribution switch-offs and switch-ons
Covid-19 has shown that things can very quickly go wrong, so it’s a good idea to have some locked-in contingency arrangements to cover downside events. Even if these can’t be realised in the short term, (eg property security), it does at least give the scheme a better position to negotiate from. It’s also important to think about improving the scheme’s position when things start to recover and linking increasing contributions to improving performance to get the scheme back on track, where appropriate. All this can help sponsor focus on getting the business focus on business recovery in the meantime.
"Contingent funding approaches are increasingly an important element of a holistic plan for a pension scheme’s future journey. They can be tailored to a scheme’s and employer’s specific circumstances and as a trustee give me confidence that we are hitting the right balance between short-term benefit security and sustainable long-term support. LCP provide invaluable support on assessing the options and designing outcomes including a range of contingent funding mechanisms that work for both the scheme and the sponsor."
Kate Hardingham
Trustee Director, Ross Trustees Services Ltd