WHY IS CONTINGENT FUNDING SUCH A GROWING AREA?
“Ensuring that any contingent assets are consistent with the investment and funding strategy of the scheme and are funding code compliant should be a key priority.”
Dev Gandhi
LCP Principal
“Where a scheme is well funded, contingent assets can protect the scheme on its journey to its long-term goal, whether that is a buy-out, transfer to a consolidator or to run on.”
Jack Tellyn
LCP Senior 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 11 such factors:
New funding regulation
The regulatory direction of travel and the new DB Funding Code in particular, are 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. There may be valid reasons why a scheme’s recovery plan is longer than the Fast Track benchmark or that more investment risk is taken on than Fast Track allows. Many of those schemes will be assessing whether they can use contingent funding options to help justify alternative plans and follow the "Bespoke" approach.
Learn more by watching our 2024 contingent funding webinar.
Over-funding risk
With recent significant increases in gilt yields and improved insurer pricing, more and more schemes are much closer to their end-games and are at risk of over-funding the scheme, with those funds being stuck in the scheme as “trapped surplus”. Escrow type solutions are one of several ways to provide comfort to the scheme and give the sponsor the ability to recoup contributions without the potentially time-consuming and onerous process to return them, 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 about end-game considerations by reading the latest LCP Chart your own course report.
Schemes targeting a useable surplus
As many schemes are moving into surplus positions, pension schemes can become an asset of the company and a way to generate returns using their significant asset base. This can be used to enhance member benefits, cover scheme costs, fund ongoing accrual or DC benefits or simply returned to the sponsor if the scheme rules allow. In order to not jeopardise the security of member benefits, trustees will be keen to ensure that risks continue to be appropriately managed along the journey. Contingent funding options can be a real advantage as they provide a way to keep a scheme on track on its journey plan and get things back on course if the funding position starts to deviate from this.
Read more about how we are supporting clients with this.
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
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.
Full scheme buy-ins
The increasing number of full scheme buy-ins, followed by a data-cleanse period leading to buy-out, gives rise to a risk of trapped surplus (e.g. due to positive data cleanse adjustments). In addition, the price of a buy-in is only known when the insurance market is approached for a quote. In many instances, the price of a buy-in is lower than the estimate meaning that schemes can have more assets than they need to transact. Escrow-type approaches combined with flexibilities on insurer premium structures are being increasingly used to manage these risks.
Learn more by reading the latest LCP Pension risk transfer 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 getting the interest of many corporates and trustees. However, given their relatively untested nature, many trustees are looking to sponsors to provide some additional comfort whilst these options are explored. The solutions themselves 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.
Learn more about DB pension scheme end-game strategy here:
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.
“Contingent funding solutions have a potential place for all DB pension schemes; for schemes with a deficit, those who are fully-funded and thinking about the future and those with a surplus.”
Dev Gandhi
LCP Principal