The death of contingent assets has been much exaggerated, says Bob Campion, who finds the use of alternative scheme funding methods alive and kicking

Contingent assets were the talk of the pension community two years ago, most memorably with drinks maker Diageo pension scheme’s use of barrels of whiskey. In that instance, the Diageo trustees were given rights to income from maturing whisky from its parent company to help tackle a £862 million deficit. Using the assets of the parent company to help manage scheme funding is a tactic that many trustees have adopted, but the practice has rarely found the headlines since - is it still an option for trustees or is it fading away?

There are two main uses of contingent assets. The first is to help minimise the risk-based part of the levy imposed by the Pension Protection Fund (PPF) on all eligible defined benefit schemes. This is typically achieved by putting in place a ‘parent company guarantee’ for schemes where there are many operating companies. The company with the best rating from Dun & Bradstreet (D&B) makes a written guarantee to sit behind the liabilities of all other participating companies should they become insolvent. With companies within the same group often receiving very different scores from D&B, the parent company guarantee can make a significant difference to the overall rating, reducing the levy by thousands or even millions of pounds. But the parental guarantee makes little real difference to the security of the scheme from the trustee’s perspective and has been likened to ‘gaming’ the PPF levy system.

Wiser now, the PPF is toughening up on parental guarantees, recognising that some were not as robust as had been first thought. But given that almost every pension scheme who stood to benefit from a guarantee has now put one in place, few new arrangements are expected. The PPF collects a fixed amount every year - the estimate for 2013/14 is £630 million. If every scheme were to put a guarantee in place their levies would all end up the same - the guarantee was about first mover advantage, and then ensuring your scheme was competing in a level playing field. But that game has now run its course.

Another strategy that has been previously popular is setting up a Scottish Limited Partnership. Retailer Marks and Spencer is the best known example, forming a partnership in 2007. In the arrangement the company gave properties to the partnership and leased them back, with the rental income going to the pension scheme to support its funding. New partnerships are still being looked at but, like parental guarantees, they are no longer as popular. “The amount of the tax benefit has reduced slightly and there are not quite so many of those being put in place,” says Stephenson Harwood partner Fraser Sparks. “The quietening down of contingent assets is to a large degree because people have looked at those options and if they thought they were viable they have done them.”

But that is not true of all arrangements and there are examples where contingent assets are set to have a much longer lasting appeal for trustees by providing genuine funding support. Outside of parental guarantees, the primary motivation for contingent assets is to reduce the amount of cash funding needed in recovery plans for pension schemes in deficit. Trustees who are provided with additional security by their sponsor are able to be less demanding when it comes to the details within their actuarial valuation and their schedule of contributions, allowing them to accept less cash support in the short term. Anything sponsors can do to improve their covenant will reduce the pressure for immediate cash contributions. But the parent company guarantee will have little impact on this. What the trustees need is real assets.

Most sponsors have fixed assets they can call on in this circumstance - buildings, machinery, contracts and even patents - that a market value can be attached to, as in the M&S example. A legal document can be drawn up that apportions the yield on an asset (such as property - or barrels of whisky) to the trustees, or that transfers the asset to the trustees in the wake of insolvency of the sponsor or other agreed circumstance. The process in itself is not cheap or quick, requiring many expensive legal and corporate man hours. And it can be difficult for companies to identify assets which do not already have a call over them. Often loan agreements and banking covenants will place a hold over key assets which prevents them being promised elsewhere. But while parental guarantees are now commonplace, this more direct form of contingent assets is much less so. And given market conditions as they are, many more sponsors and trustees are likely to be considering their application in the coming months.

Class of 2010
Timing is everything when it comes to actuarial valuations. And for pension schemes who last conducted a valuation in 2010, the trustees could be in for an unpleasant surprise when the triennial cycle comes around again in 2013. By March 2010, most asset values had rebounded strongly from the crash of 2008/2009. But since then many assets have failed to grow, as the eurozone debt crisis picked up a head of steam. Gilt yields, however, have plummeted as the UK’s treasury benefited from the crisis across the Channel. That will mean many schemes in the class of 2010 will find their funding position is likely to have deteriorated from their last valuation come March 2013 if the present conditions persist. Unless the employer’s covenant has substantially improved - which is unlikely to be the case for most businesses in the midst of a recession - trustees will be expected to ask for additional security in the form of contribution hikes.

In that environment, contingent assets are likely to be among the first alternative suggestions put forward by advisers. Research by Aon Hewitt shows that the average technical provisions funding level was 86 per cent in March 2010, whereas today it would be more like 76 per cent. “A 10 per cent point shift down may not sound large but when you convert it to deficit size the deficit will have increased from 14 per cent to 24 per cent - so if nothing else changes an increase in cash contributions of 70 per cent may be required,” says Aon Consulting partner Lynda Whitney. “Alternative financing techniques will have a role to play in bridging the gap between trustees asking for this 70 per cent increase in cash contributions and companies who would rather see no increase and the recovery plan extended by many years.”

Sponsors are often fearful of overfunding their pension schemes, and believe the valuation of liabilities to be artificially high due to historically low gilt yields. In that instance, Escrow accounts can be used, providing access to an asset without promising it outright. “There are a lot of schemes in deficit and companies are keen on using contingent assets in their recovery plans to give comfort to the trustees without making direct cash payments into the scheme,” says Sackers associate director Vicky Carr. “We have seen a number of Escrow arrangements being put in place where there are concerns about trapped surplus. There is an asset there but the employer knows that it can get the assets back if it hits a certain level.”

The topic of contingent assets is not as likely to crop up on trustees’ agendas as has been the case in previous years. And with all financial strategies, if they prove too effective they are likely to attract unwanted attention from regulators and the tax authorities. But trustees who are offered a real asset that would be of value to them in a worst case scenario should be comfortable relaxing their demands for cash – demands which are increasingly difficult to satisfy in the challenging trading conditions. Rumours of the demise of contingent assets have been greatly exaggerated. And if capital markets persist with low gilt yields and mediocre asset returns, next year could see contingent assets back in
the limelight.

Written by Bob Campion, a freelance journalist

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