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Asset-Backed Funding and contingent assets — key pieces in the funding jigsaw? January 2021 isio.com Document classification: Public
Asset-Backed Funding and contingent assets —key pieces in the funding jigsaw?
January 2021 isio.com
Documentclassification:Public
ThePensionsRegulator’sconsultationissuedinMarch2020intothedefinedbenefitfundingcodeofpracticecontained50referencestocontingentassets.ThissuggestssucharrangementsfeaturestronglyinTPR’sexpectationofhowemployersandtrusteesmayapproachfuturefundingnegotiations.
Inthefirsteditionofourseries,weexploredhowABFshavedevelopedoverthelastdecade.InthisarticlewelookathowABFsandcontingentassetarrangementsarekeytoolstoreachthedesiredlong-termobjective(LTO)requiredbythenewPensionsSchemeBill.
Ratherthanattemptingtodescribehowsucharrangementscanassistwiththefundingjourney,let’sfast-forwardtotheendandconsiderwhatthefundingandinvestmentstrategymaylooklikeoncethatLTOisreached.
Assumingbuy-outisnotthecurrentobjective,atypicalLTOmaybewheretheschemeisfundedonalow-dependencybasiswithlimitedrelianceonsponsorcovenant,withalow-riskinvestmentstrategydeliveringlong-termcontractualincomewellmatchedtothescheme’scashflows.
InsuchcircumstancesitiseasytoseehowABFinparticularisagoodfit.Awell-designedABFarrangementcanprovidethatlow-risk,long-termcontractualincome.ThecashflowsfromanABFcanbelinkedtoRPI,CPIorafixedratetomatchtheincreasesbuiltintoascheme.Inmanyways,anABFcanbeaconsideredanidealassetforaschemetohold—assumingtheunderlyingcollateralissufficienttomitigateemployercovenantrisk(moreonthatlater).
Ifthisisaccepted,thenthatLTOisperhapsnotasfaroffasinitiallythought.Fundingadeficitwitha20-yearABFdoesnotmeanLTOisatleast20yearsaway.InsteadtheABFcanacceleratethejourneyplan.Granted,notallthecashflowsfromtheABFwillhavebeenreceivedbutthatislittledifferentfromreceivingthecashandinvestingitininvestmentsthatdelivercontractualincome.
Fit for purpose?
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Inthisillustration,theliabilitiesmaybemeasuredusingalow-dependencydiscountrate.TheinitialdeficitnotcoveredbytheABFwouldperhapsnotexistwhenmeasuredonatechnicalprovisionsbasiswhichtracksovertimetoalowdependencybasisorcanbecoveredbyadegreeofinvestmentoutperformance.
ValueofABF CashfromABF Existingassets Liabilties
ExamplefundingprogressiontoLTOusingABF
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Atparagraphs199and200intheconsultation,TPRstates:
WedoknowthatfromdiscussionwithTPRtheydohaveconcernsoverABFsandcontingentsecurityarrangementswheretheunderlyingasset’svalueistoocloselycorrelatedwiththeemployercovenant.Thisisreflectedincommentsatparagraph34wheretheyhighlightareasofbadpracticeasincluding:
IsthiswhatTPRhasinmindforajourneyplantoLTO?There’snoreasonwhythisshouldnotbeanappropriateplan.TPRcertainlyacknowledgestherolethatcontingentassetscanplay.(Notethat,strictly,ABFsarenotcontingentassets,astheyexistasanassetfromdayone,butweassumeTPRisusing‘contingentassets’asanumbrellatermstocoverallsimilararrangements.)
“Although we consider cash funding of the scheme to be the primary form of support, additional backing (such as contingent assets or group guarantees) can be an important tool for trustees and employers to navigate funding challenges, and we recognise the value these can provide to underpin risks being borne by schemes.
We are keen that these remain a central part of funding solutions, for instance to support long RPs (particularly where shorter ones are unaffordable) or risk-taking in the investments or TPs—particularly if the employer covenant is not otherwise able to support these risks.”
“Reliance on additional support that doesn’t provide the comfort it claims to offer (e.g. a guarantee from a strong company being assumed to provide a strong covenant indefinitely, or reliance on a contingent asset that does not have real value when needed.)”
UltimatelythisisthekeytoconstructinganappropriateABF—theassetmustmaintainsufficientvaluetocollateralisetheoutstandingpaymentobligation.However,therearefeaturesofABFsthatareoftenoverlookedthatmitigatethisrisk.
Firstly,mostABFs(andcertainlythetax-qualifyingones)areamortising,meaningthatthevalueoftheABFreducesasthepaymentsaremade(i.e.thereisnobulletpayment).ThisisdemonstratedintheillustrationabovewheretheABFvaluediminishesovertime.Thismeansiftheassetmaintainsitsvaluethelevelofcollateralisationincreasesovertime.Thismitigatesalotoftheriskofplacingrelianceonanassetoveranextendedperiod.
Secondly,acommonfeatureofABFarrangementsisthattheassetvalueistestedperiodicallytoensureitcontinuestoprovidesufficientcollateral.Ifthecollateralbecomesinsufficient(perhapsdueafallinthevalueoftheasset)thentherecouldbearequireto‘top-up’thecollateraloracceleratecashpaymentstoscheme.Again,thisprovideseffectivemitigationandshouldensureTPR’sconcernsonover-reliancearenotborneout.
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