Three out of four DB schemes are planning to use contingent funding to manage schemes risk according to the latest report from LCP.
More schemes are expected to go down this route over the next two years rather than putting additional cash funds into their pension, which can divert capital from sponsoring businesses. This issue has become particularly acute in the wake of the Covid crisis, which has hit the revenue streams of many companies. Many of these firms will be looking at alternative options to provide security for scheme members without locking away capital says LCP.
LCP says the impact of new regulation will also drive this trend. It says contingent funding arrangements can take a variety of forms but generally involve a company agreeing to contribute more to its pension scheme if certain triggers are reached.
It’s report ‘Contingent funding: Emerging trends and market practice’ it says arrangements have been used for a while, but it believes that there are several key factors that will account for a big rise in their popularity. These include:
- The Pensions Regulator taking a tougher stance on scheme funding: potentially leading to shorter recovery period and more ‘prudent’ funding targets and investment strategies. LCP points out sponsors need to provide mitigation for a much wider range of events under the new Pensions Schemes Act 2021.
- The Covid-pandemic: This led to between 10 and 15 per cent of sponsors seeking to negotiate deficit reduction contributions in 2020. As part of these and similar negotiations, trustees may seek guarantees of future funding, which can be triggered on a contingent basis. PPF levies may also rise in the wake of Covid and these approaches can lead to levy savings.
- Changes to insolvency legislation: This puts pensions schemes further down the queue of creditors if a company goes bust. Trustees may be looking for alternative guarantees to call on if the worst happened.
- Increased TPR focus on dividends and other forms of “covenant leakage”: contingent approaches can help a company maintain a progressive dividend policy without threatening scheme security, and can also be structured so that the scheme shares in certain upside scenarios.
Contingent funding typically involves putting money in an escrow account, which holds funds that can be drawn on by a scheme, parent company guarantees, asset-backed funding or guarantees provided by banks or insurers.
LCP says recent trends in this space include combinations of different approaches, more complex structuring of this arrangement — or example, a parent company guarantee that only comes into existence if certain covenant or funding metrics fall below a pre-agreed level at some point in the future —, Covid-specific agreements, and a more strategic use of these approaches within a dynamic framework that considers upsides as well as downsides.
LCP partner Phil Cuddeford says: “We are seeing a surge in interest in contingent funding arrangements, ranging from cost-efficient vanilla approaches to highly bespoke ones.
“This is being brought on by big changes in the economic and regulatory environment. Contingent funding can be a win-win, giving members the security they need while not depriving businesses of the money they need to rebuild post-Covid and to invest for the long term.”
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