WHAT ARE SPONSORS AND TRUSTEES DOING?
Below we set out the latest 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.
The DB funding regime
The DB funding regime now places a lot more focus on contingent assets and formalises the Pension Regulator’s expectations for setting up, valuing, reviewing and monitoring these types of arrangements. Trustees and sponsors are taking steps to ensure that the contingent asset remains fit for purpose and is compliant with the requirements of the funding regime, including assessing whether there is good reason to elect for a Bespoke route to funding valuations.
More strategic use of contingent approaches
It is becoming more common to construct a suite of contingent funding mechanisms, as an integral part of an agreed journey plan within a clear IRM framework, addressing 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.
Off the shelf approaches
This is where materiality or simplicity mean that a standard product meets the objectives in the most cost-efficient way. We are seeing escrow accounts becoming increasingly popular as schemes become better funded and employers are keen to avoid a trapped surplus.
Learn more about LCP's Streamlined Escrow.
Emphasis on future-proofing
Many trustees and sponsors 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 are seeing this particularly where there’s M&A or restructuring activity, due to the new regulator powers introduced in the Pension Schemes Act 2021. In particular the new Contribution Notice tests have had a big impact and we’ve seen trustees and The Pensions Regulator putting much more emphasis on providing mitigation where there’s an adverse impact on the insolvency outcome for a scheme, even where the likelihood of insolvency is remote. This leverage is enabling trustees to more easily negotiate certain protections and means that employers need to think more carefully about what sort of mitigation they can provide without constraining their business activity, including financing options. Learn more by reading this case study.
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 Pensions 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 with trustees 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 towards more robust security that has a tangible value. In the new DB Funding Code, the Pensions Regulator references the value of guarantees where the guarantor has essentially the same obligations as the sponsor – called “look-through guarantees”. There is also a shift towards more tangible forms of support, such as contingent contributions or asset security. Under the new funding regime, trustees should be viewing related party guarantees more critically and thinking about how and when these will result in value flowing to a scheme.
Contribution switch-offs and switch-ons
In the current uncertain macroeconomic environment, a contingent asset should have the flexibility to meet the current needs of the pension scheme and sponsor. Therefore, it’s often 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 is also important to think about circumstances where the scheme’s position has improved and the need for the contingent asset isn’t as great as it once was. Paring back the contingent asset at pre-determined points can help sponsors to focus on business recovery and sustainable growth.
"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