For an organization that I have no hope of ever joining, I get a lot out of the Institute and Faculty of Actuaries and yesterday they came up with another document that went straight into my reading tray. It will stay there and get a second read as I look to digest the thoughts of a number of bright people on Capital Backed Funding Arrangements

Occupational Pension Schemes which want to continue to provide pensions independently of the PPF or an insurer, can do so by applying for capital backing from the secondary banking system. If this sounds suspiciously like LDI, it isn’t. Whereas with LDI , the money to supercharge a gilt portfolio is delivered through derivatives, in a capital backed funding arrangement, the money is put up as a contingent asset which the scheme relies on – to meet its financial objectives.

Capital Backed Funding Arrangements are agreements which offer a particular investment
return or financial outcome for a defined period, backed by third-party capital which
underwrites this commitment. The existing employer continues to sponsor  the scheme.

The IFOA paper explains in what circumstances this external capital can be helpful.

Each benefit offers trustees an option to decline the “fast-track funding”, promoted by the Pensions Regulator. Capital Backed Journey plans are designed to offer trustees “self-determination” – the right to make choices – rather than have choices made for them.

Let’s look at each  in turn

CBFAs can allow trustees to park certain problems that could otherwise require the scheme to go “cap in hand” to a sponsoring employer for more money. “Downside Protection” basically means – “self-sufficiency” albeit at the price of sharing the upside (surplus) with the partner.

Similarly, the external capital can be used to ensure that pensions and other scheme benefits are paid without the scheme having to sell off assets at the wrong time “pay benefits cashflows”. Previously this would have been achieved by swapping scheme assets for a bulk annuity from an insurer which would sit as a trustee asset (buy-in), the CBFA keeps options open.

And a CBFA can be used to keep a pension scheme afloat and out of the PPF by offering the scheme not just capital but an additional sponsor. The CBFA can be used as the last person standing is the sponsor goes bust and the capital within the CBFA an ensure that members don’t get the PPF haircut. Once again, the agreement ensures that the upside of this capital and sponsorship is available to the provider of the capital as profit.

And the CBFA structure brings with it investment expertise that might not previously have been available at an affordable price.

Unsurprisingly, the concept behind CBFAs, to keep schemes invested to pay pensions, is going to please consolidators such as superfunds and displease those seeking to buy-out benefits into insurance polices – insurers.

While CBFAs (also known as Capital Backed Journey Plans) are unlikely to compete with insurers for the affections of most trustees and sponsors, they form a valuable additional option for trustees for whom buy-out/in is either undesirable or unavailable.

That the source of capital is likely to be through private equity, will undoubtedly attract the same knee-jerk response as opposes much of the Mansion House Reforms.  But the IFOA’s paper sees past the initial prejudice to the essential trade off , trustees will have to make if getting into bed with a CBFA

The key consideration for trustees and sponsors is to understand what they are gaining as a result of entering into a CBFA arrangement (e.g., external capital support, future return or funding guarantees) and what they are giving up (e.g. cost, control or flexibility)

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An excellent paper that every trustee should read!

The paper is structured in such a way as allows readers to dive deeper into the subject as they progress. It is therefore a good read , whoever you may be. I read to the end and to the excellent appendices which detail the ways in which the capital can be deployed and the vehicles that have been created to help trustees.

As the Pension Regulator trudges its depressing path towards another incarnation of its DB funding code, it is finding itself being passed by these vehicles that can carry trustees, schemes and members to longer term objectives, without recourse to “fast-track” approval and the lockdown of ambition that involves.

Typo alert; bottom of page 10

The additional employer enables the term of such arrangements to be longer than those with a pure return focus e.g., 15 years+ for schemes with ding-to-strong covenant employer covenant (Sic).