WHY IS CONTINGENT FUNDING SUCH A GROWING AREA?
“I'm often being asked 'Why now?' and my first answer is: pensions regulatory change. This is one of the biggest drivers for the increased use of contingent funding options.”
Helen Abbott
LCP Partner
“Legal and tax changes outside of the pensions world are also driving the growth of contingent funding options.”
Peter Abrahams
LCP Investment Consultant
The significant growth we’re now seeing in this area is down to lots of factors all converging at the same time. Here are 12 such factors:
New funding regulation
The regulatory direction of travel is pointing to higher funding targets and shorter recovery plans. Under The Pensions Regulator’s planned “fast track” approach scheme funding will follow a narrower more prescribed route that won’t suit a number of schemes and their sponsors. Many of those will be assessing whether they can use contingent funding options to help justify alternative plans and following the "Bespoke" approach.
Learn more by reading our white paper: Fast Track to problems? Why TPR’s new DB funding code needs to be flexible
The pandemic and high inflation crises
The effects of the pandemic have led a number of sponsors to request contribution deferrals or stretch out recovery plans. In some cases, trustees will seek contingent support for this.
The highest inflation for over 40 years – related to macroeconomic policies, pent-up demand, huge energy price increases, and supply chain disruption – has a wide range of effects on pension schemes and on the covenants of their sponsors. Rising interest rates are also making borrowing more expensive and/or restricted for some as well. These are similar drivers for contingent funding as the pandemic itself.
The March 2021 Budget announcing higher corporation tax rates from 2023 provides an opportunity for contingent funding to help companies optimise their tax deductibility as well.
Learn more by reading our blog: Corporation tax is increasing – what does that mean for pension schemes?
Pension Schemes Act 2021
One of the many implications of this wide-ranging legislation is the need for sponsors to provide mitigation for a wider range of events leading to negative covenant changes – in an increasing number of cases, non-cash mitigation may be appropriate. It also places more focus on agreeing and reaching a long-term funding target, where contingent approaches can be very helpful.
Learn more by accessing our Pension Schemes Act 2021 insight hub
Over-funding risk
With recent significant increases in gilt yields and improved insurer pricing, more and more schemes are at risk of over-funding, and escrow type solutions are one of several ways to provide comfort to the scheme and give the sponsor the ability to recoup contributions without a 35% refund tax hit if those contributions ultimately prove not to have been needed.
Learn more by reading the latest LCP Accounting for Pensions report which shows record funding levels for the FTSE 100.
Learn more by reading the latest LCP Chart your own course report.
Dividends and other “covenant leakage”
The Pensions Regulator’s increased focus on dividends (and other sources of “covenant leakage”) is a continuing driver for contingent funding for some sponsors for example, where a parent company guarantee helps to safeguard an existing dividend policy.
Increasing focus on member outcomes
This includes recent statements by the Pensions Regulator, as well as the recent paper on journey planning issued by the Institute and Faculty of Actuaries. More focus on member outcomes means that contingent funding solutions can “plug the gap”; for example in new outcome metrics such as “expected % of benefits paid” and “probability of all benefits being paid” (traditional risk metrics like “value at risk” do not quantify covenant risk).
Learn more about our new Integrated Risk Modelling tool, LCP Triangulate.
Full scheme buy-ins
The increasing number of full buy-ins, followed by a data-cleanse period leading to buy-out, gives rise to a risk of tax charges on a final scheme surplus (e.g. due to positive data cleanse adjustments). Escrow-type approaches combined with flexibilities on insurer premium structures are being increasingly used to manage this risk.
Learn more by reading the latest LCP Buy-out report.
Pressure on regulatory capital
In the financial sector, contingent funding solutions can sometimes improve the efficiency of capital resources and thus reduce the pensions burden on regulatory capital requirements.
Consolidators and other capital-backed solutions
These new and emerging solutions are setting high profile examples on the use of contingent funding to achieve enhanced outcomes. These solutions can also be deployed themselves in a contingent way; for example by pre-agreeing to transfer to a consolidator in certain future negative covenant scenarios.
Sponsors of larger schemes may be able to design similar “DIY” strategies, using wider corporate assets secured in contingent funding arrangements, instead of external capital, to underpin a scheme’s journey plan. The advantage being a possible reduction in sponsor contributions and the potential for any surplus to be returned to the sponsor and its shareholders over time.
Learn more by reading the latest Leading the Way report.
Pressure to merge schemes
This pressure comes from the ever increasing need to reduce cost and complexity, and contingent funding can be used when it would otherwise be difficult to merge schemes with different funding levels.
PPF levies
In the light of Covid and macroeconomic related market and covenant effects, some schemes may face materially higher PPF in the future, so certain PPF-approved contingent assets may be an important way to generate levy savings.
Learn more by reading our white paper: The PPF and Covid-19 – Can the lifeboat sail to calmer waters?
"I predict that, within the next 2 years, 75% of companies with significant DB pension schemes will use contingent funding as an integral part of their governance processes to manage their legal, liability and reputational risks from the Pension Schemes Act 2021 regulator powers."
Helen Abbott
LCP Partner