Using contingent funding to avoid a trapped surplus upon full scheme buy-in
Pensions & benefits Endgame strategy and journey planning Strategic journey planning
How we helped convert a letter of credit to an escrow account to manage the risk of trapped surplus on full scheme buy-in.
The background
Initially, this client had a letter of credit in place - this was established as part of a wider package to mitigate loss of covenant following the sale of the UK employer from a relatively strong US parent to a smaller UK buyer.
The letter of credit covered contributions due to the scheme over a three year period, to provide comfort to the trustees regarding the weaker post acquisition covenant.
A letter of credit is a guarantee provided directly to a scheme by a bank covering a set amount. In the event that the employer doesn’t fulfil its specified obligations to the scheme then the scheme can call on the bank to step in.
Lenders will sometimes require collateral for letters of credit. This depends on the position of the counterparty (the employer and/or its group).
Our solution
The buyer agreed to aim to buy out the scheme within a set period, the first step towards this being a full buy-in. The letter of credit (LC) could not be used to support this process and the buyer needed to access some of the cash collateral backing the LC to transact the buy-in. However, the buyer did not want to contribute the entire amount directly to the scheme because of the risk of creating a surplus that would take time to be returned and bear a higher tax charge than the tax relief the employer had initially benefited from in relation to contributions.
To provide sufficient support for the scheme and avoid the risk of over-funding, we suggested an escrow account be used. An escrow account is a bank account held independently of two parties, the funds in which can be released to either party based on certain pre-agreed conditions, for example the funding level of the scheme.
The result
The cash collateral backing the LC was transferred to an escrow, and the LC was cancelled. This managed the risk of trapped surplus along with a deferred premium mechanism agreed as part of the full scheme buy-in transaction.
The contribution made to the escrow, is expected to be enough to support the scheme's journey plan to buyout and wind-up.
