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.
This report will explain the most common arrangements, and how they’re being used in new ways due to regulatory, financial and market changes.
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 to the 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 related company 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 (letter of credit) or insurers (surety bond).
- Upside profit sharing, dividend sharing, and negative pledges.
“Contingent funding arrangements are set to become far more mainstream, and should be considered by every trustee board and sponsor.”
Phil Cuddeford
LCP Partner
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schemes they can help avoid “trapped surpluses” where a scheme has more than it needs but the excess cannot easily be withdrawn; and they can help to underpin a more growth-orientated investment strategy because of the downside protection that they provide.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:
- Surplus management is now a strategic driver for many sponsors and trustees. This includes full insurance transactions where an escrow-type approach can help avoid a trapped surplus.
- Alternative end-game solutions (e.g. delaying full insurance to generate surplus to pay DC contributions and/or to fund discretionary benefits) are increasingly being developed, with several contingent solutions providing protection against extreme tail risks and comfort to all stakeholders that the alternative end-game is appropriate.
- The 2024 Funding Code places increased emphasis on contingent approaches, and for example focuses on guarantees that are “look-through” in nature. The new funding requirements can also lead 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” approach.
- The 2021 Pension Schemes Act 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 have come into their own.
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 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.
- 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 more mainstream and are being used in a huge range of circumstances. These range from schemes in long-term run-on generating surplus, to schemes on the verge of full insurance, and those with large deficits combined with covenant or cashflow pressures. In all cases, trustees can get the assurances they need about future funding while sponsors are able to concentrate their available resources on making sure the business is still there in the future."
Phil Cuddeford
LCP Partner