Despite a recent caution from The Pensions Regulator (TPR) and a clampdown from the Financial Reporting Council (FRC), asset-backed contributions (ABCs) are increasingly winning a place at the defined benefit table. The numbers of transactions are not only rising, but they are also appealing to a wider audience and attracting a broader range of assets. The trend is set to continue in 2014.
Although they may vary depending on the scheme, an ABC typically involves the pension plan forming a Scottish Limited Partnership into which non-cash assets are transferred. They are either licensed or leased back to generate a regular income stream to the scheme to generate annual cash distributions. They are not a new concept, having made their debut in 2006 when M&S committed £1.1 billion of property in a sale and leaseback deal. While there was a flurry of activity at the time, the market did not take off until the financial crisis when deficits widened off the back of quantitative easing and low corporate earnings.
“We have just been through a period where gilt yields were at record lows and when actuarial valuations occurred, liabilities appeared to be at historical highs,” says Deloitte partner Tony Clare. “However, as bond yields have risen ABCs are seen as a good compromise between employers and trustees. It gives the companies breathing space and also provides protection for over-funding.”
The new tax rules brought in by the Finance Act 2012 also had an impact. This is because, where certain key requirements are met, an upfront tax deduction can be taken for the value of the contribution made by the employer to the scheme under the ABC. This is broadly equivalent to the present value of future payments that will be made by the partnership to the trustees over their term of investment in the partnership. For some groups this means that an upfront tax deduction may be available for the contribution, but for other employers there can be flexibility to defer the timing of the tax relief over the life of the structure, according to Deloitte tax director Chris Coulston.
A recent study by the accounting firm demonstrates how fashionable ABCs have become. About 40 asset-backed funding structures have been completed since 2010 with an aggregate value over £5 billion. Four years ago, they were mainly the preserve of the larger funds, with only half of the implementations slated to fund deficits of less than £100 million. Today that figure stands at 80 per cent.
A separate report published by KPMG in January echoes these trends. It revealed that ABCs grew by nearly £2 billion in 2013 alone with 23 deals completed. By contrast, there were only 29 structures over the preceding five years. It also found that the average size of deficit addressed dropped from around £100 million in 2012 to £80 million in 2013.
“They are growing in popularity among smaller schemes, with our study showing that seven new ABCs were implemented during 2012/13 with a value of £25 million or less, compared with just three transactions prior to that,” says KPMG pension partner David Fripp. “The reason is that they are less challenging to trustees and advisers as they have become more widespread and better understood. However, although they are less expensive today, the cost and complexity will still deter the very small schemes.”
Moreover, there is a growing trend to use less mainstream assets. For example, drinks giant Diageo blazed the trail four years ago by transferring maturing whisky with a book value of £500 million into a pension funding partnership. The spirit generates an annual income for the pension scheme of around £25 million. Meanwhile, more recently, Dairy Crest used 20 kilograms of maturing cheese worth £60 million to help whittle down its £84 million pension deficit.
“There is a hunt for the softer assets such as brands,” says BDO partner Richard Farr. “However, unlike property, it doesn’t have a hard value and therefore will also need a good ransom value. This will be important in distress scenarios when leverage is key to maximising value.”
Law firm Wragge & Co associate Christopher Stiles adds: “We are definitely seeing more creative ideas but it depends on the circumstances. Brands are intangible. For example, a company with a brand that is a household name would be in a better position. There are also sophisticated companies who are able to properly value brands. However, property continues to be the most straightforward.”
This is why commercial real estate continues to be the most popular, accounting for 66 per cent of all deals during the period between 1 September to 31 October 2013, slightly up from the 61 per cent in previous KPMG surveys. Next on the list were intra-group loans, which stayed the same at 14 per cent. This involves a group company promising to pay the vehicle a certain amount each year.
Although overall many of these structures look good on paper, there are of course risks. “Whilst innovative funding mechanisms such as ABCs may help employers meet their obligations to schemes, the benefit of such arrangements can be overstated,” says The Pensions Regulator DB policy manager Fiona Frobisher. “While an ABC might appear to instantly remove a scheme’s deficit, in reality the scheme relies on many years of payments from the ABC (which are often funded by the sponsor anyway) before the value is realised. If an employer provides a recovery plan and a contingent asset instead, the scheme is likely to be in the same, if not a better, position. Sometimes a recovery plan alone may be better than an ABC.”
Other problems can occur “if the trustees take the net present value of the payment stream under the ABC at face value,” she adds. “When making decisions in relation to the scheme, they need to recognise that much of this asset value depends on the ABC making payments into the future and that these payments generally rely on funds from the employer.”
Late last year, TPR issued recommendations to help raise trustees’ awareness of these dangers. The checklist according to Frobisher includes conducting a critical evaluation of the proposal, such as obtaining independent advice and considering the cost of set up as well as maintenance against any long term benefits. Trustees were also advised to compare the proposed ABC against alternatives – i.e. recovery plan with a contingent asset – and evaluate the length of time over which the deficit will actually be met.
In addition, trustees should evaluate any impact on the employer covenant – for example whether any assets are transferred from the employer to the ABC vehicle. Last but certainly not least they should agree an ‘underpin’ with the employer to protect the scheme’s position, such as in the event that the courts find that ABCs are void for illegality or where there is a change in the law.
Clare believes that: “The regulator is less concerned with the structures put in place today but future arrangements because of the higher number of smaller schemes adopting ABCs. Quite rightly, they do not want to see any shortcuts taken.”
TPR is not the only body looking into ABCs. The FRC also recently launched a crackdown on companies that have used these structures to reclassify pension obligations as equity instruments in their accounts. “Whilst the equity accounting treatment had only been adopted by a small number of companies, and was not reflective of the wider market, the announcement is still helpful in establishing the parameters for companies considering these types of structures.” says Coulston. “The FRC’s preferred reporting aligns with the accounting treatment that we have always recommended our clients adopt.”
Mercer financial strategy group partner John O’Brien adds: “The FRC has an issue but it only applied to a small number of arrangements – probably less than five out of 50-plus classified the obligations as an equity instrument. I think ABCs will continue to increase because they ease the strain on corporate cash flows but trustees need to have a strong governance structure and due diligence process in place.”
Lynn Strongin Dodds is a freelance journalist