While unusual contingent asset deals may grab headlines, more ‘mundane’ arrangements may increasingly be used to fund pension deficits, finds David Adams.
If it wasn’t such a serious business there would be something slightly comic about some of the innovative arrangements some pension schemes have used to bolster their long-term financial security. The original trend towards the use of asset-backed funding arrangements, using what are generally referred to as contingent assets, was driven in part by trustees and/or employers seeking to reduce PPF levies. More recently the economic and financial climate has brought on a new wave of these arrangements, as trustees and employers try to reduce scheme deficits. For example, about a third of the schemes within Aon Hewitt’s client base now have some kind of contingent asset in place.
One recent example got a little more press coverage than might otherwise have been the case because of the nature of the assets used: in April, Dairycrest used the maturing cheese it holds in stock as the basis for a £60 million asset-backed funding arrangement to help close an £83 million deficit in its pension scheme. The value of the maturing cheese was said to be £150 million. There have been similarly eye-catching deals before: in 2010, you may recall, Diageo offered its scheme £430 million of maturing whisky as a contingent asset.
Not every employer can offer its scheme such headline-worthy assets. Contingent assets could be the products an employer makes, or plant machinery, intellectual property or even a brand. But more often the assets are financial guarantees or property owned by the employer. And it’s actually the structures behind some of these arrangements, particularly those based on the creation of Scottish Limited Partnerships (SLPs), which may be of the greatest significance to most trustees and employers struggling to fund scheme liabilities.
Broadly speaking there are two basic forms of arrangement: the conventional approach and the SLP approach. The latter allows the use of more intangible assets such as brands. In either case, the scheme is given some sort of rights over an asset held by the company.
For this to be an option the employer needs to have the right sort of asset to offer. The arrangement may simply be too expensive to put in place for smaller schemes, particularly when it comes to using SLPs. “It’s worthwhile seeing if there is something more simple you can do, like creating an escrow account,” says Aon Hewitt partner Lynda Whitney. “It might not have the same tax breaks, but it might work better for smaller schemes.”
Many of the most innovative arrangements involve the creation of SLPs. “Both the trustees and the company have rights as part of [the SLP] agreement,” says Barnett Waddingham partner Paul Hamilton. “Usually the trustees would get the right to some income generated by the asset over a particular period. That is crystallised as an asset, which is then counted as part of the scheme. That immediately reduces the deficit.”
In those cases, says KPMG partner David Fripp, it may be wrong to refer to these as contingent assets. “These are real assets as soon as the structure is put in place,” he points out. “I call them asset-backed funding structures.”
The employer retains ownership and control over all capital rights by the terms of the SLP. The scheme’s rights are restricted to the income, but it would (usually) have rights to the capital if the employer becomes insolvent. “So, for example, a company might use a property it owns that is worth £100 million,” Fripp explains. “It could then pay £7 million of rent to the partnership per year, for say, 25 years. The scheme asks what is the value today of all the £7 million it will get. It then books that value in its accounts today. Over the 25 years it will be paid more than £100 million: £175 million in this example. You book only £100 million, the net present value, adjusting approximately for the time.” There would also usually be some provision in the agreement for the payments to stop if the scheme became fully funded.
Fripp stresses the need for trustees and employers to take advice, which might involve consulting a property surveyor and specialist brand and trademark valuer, accountant and lawyer. One important factor to bear in mind is how the asset might be affected if the employer finds itself in serious financial difficulty. Would a brand still be a valuable asset in those circumstances? Perhaps – but perhaps not.
Fripp is convinced more smaller schemes will be able to consider putting such arrangements in place, even though they are expensive to implement. Spence & Partners director and head of the trustee advisory practice Marian Elliott agrees, noting that legal and advisory services are becoming cheaper now there are more precedents in operation – but that the most esoteric structures and assets will mean more expense.
Reducing the PPF levy may still be an important motive for using contingent assets. But for trustees and employers seeking to do this there are reasons to proceed with caution: there are additional administrative costs to meet – and an obligation to actually meet those rules.
“Once you’ve put in place a contingent asset in the form required by the PPF it is very difficult to get out of it,” says Stephenson Harwood partner Fraser Sparks. “Employers need to think about the wider commercial consequences.”
“One of the fundamental things that the PPF requires is that the guarantee is evergreen: it’s not time-limited,” says JLT Pension Capital Strategies managing director Charles Cowling.
Might that mean that some SLP arrangements fail to qualify for PPF levy relief? Apparently not, for now, at least. “The way the legislation works the contingent asset is an asset of the scheme straight away,” says Hamilton. “That’s one thing I might be nervous about, [as a trustee or employer], because that might change in future – not just in terms of the PPF, but the regulator too.”
But there are other reasons to consider using contingent assets. It may appeal to an employer keen to encourage a well-funded scheme to alter its investment strategy and so avoid over-funding. Or it may be a good answer to other challenges. “We’re working [with] an overseas business that is pulling out of the UK but keeping its UK pension scheme running as a closed arrangement,” says Sparks. “The overseas parent company is providing a guarantee, backed by a guarantee from a bank.”
Some employers may not be able to enter into this kind of arrangement for regulatory reasons. Others may be hamstrung by practical issues. Whitney cites the hypothetical example of a property that has been an industrial site so would need to be cleared and sanitised at significant expense before it could be used for any other purpose: “So at the point when the trustees need the asset it might have no value, or even be a liability.”
Finally, schemes creating an SLP should note that if Scotland votes to become independent in 2014 (unlikely, judging by current polls, but possible), this will create a legal anomaly around the entity’s status, which might then need to be treated as a company under English law. Whatever the final outcome of any legal debate that might then ensue, it would probably leave lawyers and advisers feeling happier than trustees or employers.
But, those potential pitfalls aside, it does seem very likely that we will continue to see more use of contingent assets over the next few years.
“I think you’ll see quite a lot more schemes implementing these deals, particularly as the adviser costs have come down over the past 12 to 24 months,” says Elliott. “We’re starting to see arrangements like this for schemes where the deficit was only around the £40 million level. That’s good, because often that’s the sort of size where innovative solutions are needed.”
“Take-up is accelerating, because the financial pain is persisting,” says Fripp. “We’ve completed more in the last six months than in the previous 12 months and they’re being done for smaller schemes.” Difficult times may push more employers and trustees to consider joining them.
David Adams is a freelance journalist
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