In a rapidly changing landscape, contingent funding is becoming an increasingly important area in DB pensions, with both trustees and employers looking to take advantage of the benefits it offers over traditional cash funding.
In this blog, we explore the new ways that contingent funding solutions are being used and examine the key factors that are driving this innovation.
The recent uptick in contingent funding activity can largely be attributed to one or more of these three important factors:
- Improved funding levels
- The new DB funding regime
- The need to make changes to existing solutions.
We discussed these issues and highlighted a number of case studies pertaining to each in our recent webinar: The future of contingent funding: Developing solutions for the new DB pensions landscape This blog summarises some of the key themes from our discussion.
Improved funding levels
Gilt yields have risen significantly over the last two years, contributing to a notable improvement in funding levels for most schemes (which measure the value of their funding liabilities with reference to gilt yields). The most dramatic rises came in late 2022 in the wake of the gilts crisis, but yields have remained high and have indeed been creeping up again over 2023 to date.
An improvement in funding levels is usually good news for pension schemes, but such a rapid change in position can carry risks to sponsors. When a company is still on the hook for recovery plan contributions agreed at the previous triennial valuation, despite now having a much-reduced deficit, there is a risk of ‘overshooting’ the agreed funding target. This can leave surplus cash trapped in the pension scheme with no way for the employer to access it without paying a hefty 35% tax charge on any cash recovered – and that’s if the scheme’s rules permit a refund of surplus at all (in many cases, trustees will be able to use any surplus to secure additional benefits for members).
One way to mitigate this risk is through contingent funding solutions such as an escrow. These arrangements can be designed with suitable triggers for returning superfluous contribution monies to the company (eg upon the scheme reaching a certain funding level, or when a scheme secures its liabilities with an insurer via a buy-in). This allows sponsors to make the cash available to trustees when needed (e.g. if adverse experience develops and a larger deficit emerges) without running the risk of the cash becoming trapped. As overfunding risk has become an increasingly prominent concern, we are seeing an increased interest in escrows and similar solutions from schemes of all sizes.
LCP’s Streamlined Escrow service has been designed to enable trustees and sponsors to set up escrows quickly and efficiently – if you think an escrow could be the right solution for your schemes, you can read more here: Streamlined Escrow.
The new DB funding regime
A new, albeit delayed, DB funding code is edging ever closer, and trustees and sponsors are starting to think hard about how their existing funding arrangements fit into the new world.
A key tenet of the expected new regime is the twin-track approach, comprising ‘fast-track’ and ‘bespoke’ routes for valuation scrutiny from the Regulator. To satisfy the fast-track requirements, which will invite minimal Regulator scrutiny, a valuation must meet a number of prescribed parameters in relation to the technical provisions, recovery plan length and level of investment risk.
However, there are many reasons that sponsors and trustees may prefer not to be constrained by the fast-track parameters, and instead go down the bespoke route. For example, one case study discussed in our webinar relates to a sponsor that wished to invest cash in its own business in the short term in order to navigate the climate transition effectively and protect its future prospects. This would temporarily limit its ability to pay cash contributions to fund the deficit in its pension scheme, but the trustees of the scheme were appreciative of the benefits to the long-term covenant of the company’s proposed strategy.
Therefore, a longer recovery plan (in excess of the six-year limit currently expected under fast-track) was agreed, but this slower pace of funding needed to be justified to the Regulator. The solution was for the sponsor to provide security over its property to the trustees on a temporary basis as a means to underwrite a specific risk over a known period and ensure that in the event that the internal investment programme was unsuccessful, the scheme would be no worse off than it would have been under fast-track.
Although significant uncertainty remains around the implementation of the new funding regime, we are still expecting valuations in late 2024 to fall under the new code, so it is important for trustees and sponsors to start thinking about how their arrangements could sit in the context of the regulations now. We expect contingent funding solutions to play a significant role in helping schemes ensure they make the most appropriate choices in the new world.
Changing existing solutions
While the changing financial and regulatory landscape is leading many to introduce new contingent funding solutions, others will already have an existing solution which will now need to be reviewed, adapted or changed entirely in light of recent developments.
In some cases, the aim is to ‘beef up’ existing solutions to make sure they are still robust and fit for purpose. For example, the Pensions Regulator’s increasing scrutiny of parent company guarantees is leading trustees to revisit these agreements and look to give them more ‘teeth’ or supplement them with additional contingent funding mechanisms.
Elsewhere, existing contingent funding arrangements have become disproportionate as the risks that they were intended to mitigate have diminished. As schemes’ liability profiles mature, funding levels improve and investment and longevity exposures are de-risked, trustees become less reliant on covenant strength to underwrite their pension risks. Agreements that were negotiated many years ago may now need to be scaled down to match the current level of risk, although, as specifically set out in the Regulator’s 2023 Annual Funding Statement, trustees will need to ‘evaluate any such proposal critically, and understand the value being given up’.
In more extreme cases, legacy contingent funding mechanisms may need to be scrapped entirely, and potentially replaced with something new. Complex arrangements such as ABFs (Asset Backed Funding arrangements) can be costly and time consuming to maintain, so trustees and sponsors may in some cases agree that it is in the best interests of all parties to do away with the existing setup and establish something that better fits with current objectives, risk appetites and budgets.
How can I find out more?
If you are interested in finding out more, please watch our recent The future of contingent funding: Developing solutions for the new DB pensions landscape 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.