This is an excellent article from my friend Simon Kew who trades as the Pensions Jackal on twitter. The subject may seem obscure but it isn’t – if you are in a Defined Benefit Pension Scheme you should know about this stuff. Here’s Simon…

A recent survey of leading chief executives has highlighted their concern that spiralling defined benefit costs, the impact of market movements on funding and potential EU solvency issues are all constraining UK business performance. I am sure that a further concern for these business leaders will be the Pensions Regulator’s recent statement that he will help trustees ‘bolster recovery plans’ in 2012 – quite how, nobody yet knows.

At any time, it is reasonable to expect an employer to try and maintain an amount of free cash for unexpected outlay or capital expenditure, but even more so in the current economic climate. Therefore, making available a contingent asset or some other form of security may help trustees to gain comfort and protect members’ benefits, where reduced contributions are being mooted by an employer. Additionally, that security may bring about a reduction in the PPF levy – although as I write this, we are still waiting for the PPF’s final guidance on how this security should be assessed moving forward, to ensure it qualifies.

Firstly, let’s define the term ‘contingent asset’. In plain terms, it is an asset that is transferred from an employer to a scheme, when one or more prescribed events takes place and only then. Because of this, it isn’t included in the scheme assets. Despite this, there is likely to be a positive effect on covenant, due to the sponsor’s demonstration of willingness to fund the scheme. There is also a benefit to the employer, as by providing a contingent asset it may be able to negotiate reduced cash contributions as part of a longer recovery plan or, if covenant is affected to the good, a lower Technical Provisions funding target.

A contingent asset is not just bricks and mortar. It could be a guarantee from the group or a third party, cash in an escrow account or security over assets. Any of these would be payable when the agreed event takes place e.g. the insolvency of the employer or maybe a drop below a certain level in scheme funding.

As I have already mentioned, in some cases, contingent assets can be used to reduce the PPF levy – a further benefit to all concerned.

Transferring an asset to the scheme is another option employers and trustees can consider. This is where the asset actually moves from the employer to the scheme or a Special Purpose Vehicle (SPV).

Last year in an innovative and interesting solution, Diageo helped to fill its pension deficit by transferring maturing whisky to the scheme, providing an annual income of £25m over 15 years, when the barrels will be sold back to the company. This sale, it is believed, will eliminate the remaining deficit. If it has value and it can be realised by the trustees when required, pretty much anything apart from Employer Related Investment (ERI) goes here although these transfers can be expensive to administer, mainly due to the legal costs involved and determining the true value of the asset on offer. What the ‘true value’ is will depend on many factors, not least the time it will need to be sold, which may well be after an insolvency event.

Thus far we have assumed that there is an asset to offer which, in the current economic climate, is unlikely for most sponsors. If this is the case, trustees and employers can investigate one or a number of this range of options: Negative pledges – Employer makes a commitment not to do something, such as granting new security, without the agreement of the trustees;

Positive pledges – Employer makes a positive assurance where they may, for instance, pay a percentage of any dividend to the scheme or an amount based on increased profitability; Insolvency ranking – This can involve the scheme being granted a ranking, perhaps pari-passu with the bank, or the subordination of other creditors to improve the scheme’s position on insolvency; and Parental / Group support – The ultimate parent, or other companies in the group structure could be called on to provide funding or assets, or to guarantee all or part of the funding deficit.

Ideally, any of these options from contingent assets to pledges should be of benefit to both employer and scheme, albeit for different reasons. Once schemes are sure that the offering can be realised when necessary, they can take comfort from increased security, or the promise that more cash will be made available as the employer’s profits increase. Employers may be able to negotiate reduced deficit repair contributions when cash constrained, by granting contingent security on an asset that, often, will be of no financial detriment and could return once funding levels reached the agreed target. All of these methods, when undertaken after careful consideration and informed advice, can impact positively on covenant as ability, willingness and even legal obligation can become clearer to the trustees, the Pensions Regulator and Pension Protection Fund.

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