INTRODUCTION

Contingent funding solutions for DB pension schemes can be a great way to protect member benefits, as well as other stakeholders of the sponsoring employer. It is therefore very important for both sponsors and trustees to understand the range of options available.

“Contingent funding arrangements are set to become far more mainstream, and should be considered by every trustee board and sponsor.”
Phil Cuddeford

LCP Partner

This report will explain how these arrangements are rapidly moving from niche to mainstream because of a wide range of regulatory, financial and macroeconomic drivers.

Contingent solutions can take a variety of forms, but they generally involve the sponsor agreeing to contribute more to its pension scheme if certain triggers are reached in return for less upfront cash into a Scheme.

Some of the more common arrangements include:

  • Contingent contributions, based on funding and/or covenant triggers;
  • Escrow-type accounts, which hold funds that can be drawn on by the pension scheme and the sponsor in certain circumstances, but are not actually held within the scheme;
  • Parent or related company guarantees, where additional funding is provided by the parent if the immediate sponsor is unable to pay;
  • Asset-backed funding, where the scheme has a claim over an asset if needed;
  • "Guarantees” provided by banks or insurers; and
  • Upside profit sharing, dividend sharing, and negative pledges.

Types of contingent funding

The traditional benefits of such arrangements are well known. They can provide valuable additional security for pension schemes, helping make the case for a longer deficit recovery plan; for well funded schemes they can help avoid “trapped surpluses” where a scheme has more than it needs but the excess cannot easily be withdrawn; and they can help to underpin a more growth-orientated investment strategy because of the downside protection that they provide.

We believe that current regulatory, financial and macroeconomic factors mean the use of contingent strategies will grow.

These include:

  • Significant improvements in scheme funding levels mean that “surplus management” is becoming a real strategic driver. These involve contingent approaches with “switch-off” mechanisms, reducing the chances of a taxable refund on wind-up, and enabling sponsor resources to be deployed optimally.
  • The 2021 Pension Schemes Act has made a big difference to the dynamics of transactions and other sponsor actions that could involve “covenant leakage”. In cases where immediate cash injection is not the preferred solution, contingent approaches are coming into their own.
  • A tougher line on scheme funding from the Pensions Regulator, potentially leading to shorter recovery periods and more “prudent” funding targets and investment strategies. Sponsors who can bring contingent funding deals to the table are likely to come under less pressure to de-risk or increase contributions; this may be particularly relevant to schemes that expect to use the “Bespoke” funding framework under the new funding code.
  • A number of other drivers, including pandemic pressures on sponsors, covenant pressures due to rising inflation and interest rates, corporation tax rate changes, changes to insolvency legislation affecting the scheme’s standing in the creditor pecking order, and higher expected PPF levies for some.

Whilst the “vanilla” approaches, such as simply putting money in escrow, have much to commend them, we are increasingly seeing new and innovative ways in which companies are providing security to their pension schemes enabling them to invest much-needed short-term capital in their businesses.

Contingent funding approaches have now moved from a niche area of pensions management to the mainstream, and should be considered by every trustee board and sponsor.

In this handbook we:

  • Explain why these approaches are becoming so much more mainstream;
  • Discuss emerging innovations and best practice in this fast-evolving area;
  • Introduce LCP’s Streamlined Escrow solution to help sponsors and trustees get the most out of escrows in the most time-efficient and cost-effective way;
  • Provide a number of case studies to illustrate the solutions that are being applied to a surprisingly wide range of different situations;
  • Discuss the “nitty gritty” issues that are needed to avoid regret risk of a contingent solution that the sponsor and/or trustees subsequently wish to unwind but can’t;
  • Summarise the “basics” of the most common contingent mechanisms, in a reference section;
  • Provide our key predictions throughout this handbook for this fascinating and growing area over the next five years; and
  • Help you understand what content might be most relevant to you in What's best for me?
"Contingent funding arrangements have been around for a long time, but they are now far more mainstream. Many sponsors are under considerable pressure to use their available funds to keep their business going following the pandemic crisis and during the rising inflationary and interest rate environment, but are under growing pressure from the Pensions Regulator to deal with the shortfall in their pension scheme. Contingent funding is a way of squaring this circle. Trustees can get the assurances they need about future funding of the scheme while sponsors are able to concentrate their available resources on making sure the business is still there in the future. This is an approach whose time has come.​"

Phil Cuddeford

LCP Partner

Why is contingent funding such a growing area?

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