How contingent funding can be used to manage overfunding and regulatory risks

More than half of the schemes we recently surveyed use contingent funding arrangements and we’re expecting this to increase. In this blog we look at the key drivers for this trend.

Our annual survey of the FTSE 100 shows that a quarter of those companies disclose contingent funding in their accounts. Based on our experience, this is likely to be quite an understatement of the actual number of companies with such arrangements in place, given there is no requirement to disclose many of these arrangements.

This is backed up by our recent Chart your own course publication, where we surveyed 130 of our clients and found that 64% already have contingent arrangements in place. This isn’t just limited to large schemes, as around half of those with assets below £500m have some form of contingent funding arrangement in place.

We expect the use of contingent funding for pension schemes to grow rapidly over the next few years, driven by a number of factors, as set out in our Contingent Funding Handbook. We discuss three of the most topical drivers below, along with how contingent funding can help you in each case, and some of the trends we are seeing.

Of course recent market turmoil following the September 'mini-budget' is yet another driver, which we will discuss in a separate blog.

1. The increasing likelihood of overfunding or trapped surplus

   Over recent months, many schemes have seen significant improvements in their funding levels, largely driven by a rapid rise in gilt yields. This, combined with attractive insurer pricing, means that schemes may now find themselves much closer to a potential insurer transaction than even just last year. The 'buy-out funding level' can change rapidly even for those with high levels of hedging, and more will be likely to find themselves in a surplus position on this basis.
   
   Once a scheme is in surplus on an insurer basis, the options available to the sponsor to access that surplus can be limited. Depending on the exact rules of the scheme, the trustees may have the power (or the requirement) to use the surplus to enhance member benefits. Even if it can be returned to the sponsor, this will usually be subject to a hefty tax charge.
   
   The level of over-funding risk will depend on the scheme’s strategic journey plan, and where it sits on that journey. For many, albeit not all, there will come a time when it makes sense to stop cash contributions into the scheme and think about alternative means of support.
   
   As a scheme approaches its target, if things go better than expected, the sponsor will not want to use more capital than is needed. If things go worse than expected, the trustees will want something to be available to get back on track and/or provide increased security for member benefits. This is where contingent funding solutions come in.
   
   Several different types of contingent funding can mitigate overfunding risk, but we have seen a significant increase in the use of escrow-type solutions this year, with many using LCP’s Streamlined Escrow service, allowing trustees and sponsors to benefit from a pre-negotiated contract with BNY Mellon acting as escrow agent. Some of our larger clients are looking to use Limited Partnership structures as a 'wrapper' for their escrow-type accounts (referred to as 'co-investment vehicles', see example the BT case study), in order to access wider investment flexibility and potentially more beneficial accounting, tax, funding and PPF treatment of the funds held.

2. The Pension Schemes Act 2021

   The criminal sanctions, fines and new Contribution Notice tests, which came into force in October 2021, are another key driver for the increasing use of contingent funding. Some of the activities that risk triggering either one, or both, of the new Contribution Notice tests may be familiar to sponsors, such as M&A activity or special dividends. But other business activities, such as business as usual dividends and refinancing, may come as a bit of a surprise. We’re also seeing group trading and lending arrangements come under much closer scrutiny now, with trustees really scrutinising what the implications could be if something went wrong.

   Contingent funding is becoming an increasingly popular tool to use as mitigation for when these tests might be triggered. Over the last year or so, we have seen an increasing use of letters of credit alongside M&A activity, which can provide a flexible alternative to cash mitigation.

   Dividend payments and other covenant leakage are also high on the agenda, where we’re seeing our clients use a wide range of contingent funding mechanisms including contingent contributions and matching mechanisms, escrow accounts, letters of credit and group guarantees.

3. The Pensions Regulator’s new funding code

   The DWP has recently published draft funding and investment regulations. These set out a requirement for schemes to reach a state of low dependency for both investment and funding strategy by a time of “significant maturity”, and for any deficit to be recovered “as soon as the employer can reasonably afford”. See our on-point paper for more details.

   Whilst we still await a lot of the detail from the Regulator in its new Code, and the new regime won’t apply to valuations until at least late in 2023, the draft regulations are potentially quite restrictive on investment allocations for schemes at or close to “significant maturity”. Indeed, one of the consultation questions asks if additional risk should be permitted, if supported by contingent assets. Depending on the responses to this, we may well see many such schemes turning to these arrangements.

   Crucially the DWP consultation does not include any references to 'fast track' or 'bespoke', as trailed in the Regulator’s first consultation on the new regime back in March 2020 (this flexibility, to the extent that it is retained, will presumably be covered in the Code, rather than in the Regulations). Given the option, many schemes and sponsors may be unable or unwilling to follow a 'fast track' approach and may turn to contingent funding approaches as justification for the 'bespoke' alternative where possible.

   In particular, we expect a variety of contingent funding approaches could be used to justify a higher risk investment strategy, a higher ultimate discount rate, or a longer recovery plan on a scheme’s journey to low dependency. We expect trustees will end up needing to report the details of their contingent funding to the Regulator, including how it’s been valued, how that value holds up in stressed scenarios, how it supports the risks taken, and how this fits into their strategic journey planning framework.

How can I find out more?

If you are interested in finding out more, please watch our recent webinar on demand, have a look at our website and either contact the person who normally advises you or one of our contingent funding experts.