Update | Pensions: asset-backed funding arrangements

As you may have no doubt read countless times, the onset of the global financial crisis, the nose diving markets, the stunned economic growth in the UK, the uncertainty surrounding quantitative easing and the drop in corporate bond yields have seen pension deficits spiral out of control at staggering rates.

Pension trustees and employers have had many a sleepless night considering how to plug this hole. Their advisers and consultants have formulated several clever and cunning ways to try to stem the flow but there is one method which is gaining traction and it's a rather bold way to utilise assets. The pensions world is awash with talk of asset-backed pension funding - the securitisation of a non-cash asset to create regular income stream payments to the pension scheme.

The first asset-backed funding arrangement (ABFA) was implemented by Marks & Spencer in 2007. Since then popularity for this sort of arrangement has rocketed. KPMG estimate that in 2012 alone there were seven arrangements entered into by FTSE quoted companies valued at over £500m and more recently smaller enterprises including charities and co-operatives have entered the fray seeking to take advantage of cheaper set-up costs in smaller arrangements of this nature.

2013 shows no sign of the popularity of such schemes fading and mid-year figures suggest no lack of appetite for these types of arrangement as several such arrangements have been entered into with increasing complexity in many cases.

Is this a creative and innovative way '¨of plugging pension deficits in a repressed economic climate? Or is this a short sighted vehicle on the verge of falling foul of '¨the complex regulatory and legislative pension matrix?

Jury is out

A simplified asset-backed funding arrangement involves the employer making a contribution to a pension scheme. The pension scheme immediately uses the contribution to acquire, from the employer, typically a property with a regular rental stream. The asset is temporarily held as an asset of the pension scheme. The terms of the disposal contain an option by which the property reverts to the employer after a set number of years.

Employer related investment pension legislation generally prohibits the direct holding by a pension scheme of assets used by the employer in its business. Subject to certain exceptions, not more than 5 per cent of the current market value of scheme assets may at any time be invested in an employer related investment. Certain employer related investments are strictly prohibited, including the trustees granting an employer related loan or guarantee. These restrictions not only apply to investments in the employer, but also to investments in parties associated or connected with the employer, and in property used by the employer or '¨its associates.

Breaches of the employer related investments restrictions are taken very seriously and can result in penalties and in more extreme cases will be a criminal offence. It can also impact on the calculation of the scheme's assets as the invested resources of a scheme in breach of employer related investment restrictions are to be excluded from the calculation of the scheme's assets for the purpose of an actuarial valuation.

To avoid being caught be the employer related investment regulation and to allow the employer to make continuing use of a non-cash asset a more complicated form of ABFA is typically used. These involve the income producing non-cash assets being transferred into a Special Purpose Vehicle, typically a Scottish Limited Partnership of which the employer or connected persons become members of the partnership. The trustees too have a limited interest in the partnership and are entitled to a share of '¨the partnership profits.

The employer makes a contribution (being the asset) to the partnership. Assuming for the moment that the asset is a property, it is then leased back to the employer for its own use but will agree to pay a fee for renting the asset from the partnership. These fees are the profits of '¨the partnership which is then distributed '¨to the trustees and any surplus is returned to the employer.

Unlike in the UK where a partnership is essentially made up of the individual partners, a Scottish Limited Partnership has a separate legal personality and is therefore able to hold assets. However it is does not fall within the definition of a company under the relevant legislation and so is not caught by the 'associated company' restrictions of ERI. That at least is the theory although some experts believe the jury may still be out on that one. Nevertheless, and certainly in relation to some of the 'big ticket' arrangements that have been established so far, both the Pensions Regulator and more importantly Her Majesty's Revenue and Customs, '¨have 'blessed' the deals and deemed '¨them acceptable.

Attractive prospect

Asset-backed contribution arrangements can be attractive to the employer as they are able to address pension scheme funding issues immediately without having to commit cash.

It also allows the employer to '¨effectively retain the benefit of the capital growth of the asset. The pension scheme will have a guaranteed income return on their investment.

If the employer defaults on payment, the scheme is usually able to take full ownership of the asset. This can make these arrangements more attractive to the pension scheme than a straightforward funding schedule with the employer which, while the law requires one to be agreed, and which typically will agree the contributions to be paid over an several years it will not have an underlying guarantee if the employer falls into financial difficulty.

Spectre at the feast

One of the clear disadvantages on the horizon is the spectre of Scottish Independence. In all likelihood, was this to occur, Scotland would effectively become a foreign jurisdiction and all these clever Scottish Limited Partnerships would cease to have effect. No doubt all the necessary unwinding will have the consultants rubbing their hands in glee at the thought of even more fees, but for the schemes involved, it is likely to be a nightmare. Most properly drafted arrangements will include provisions for cessation however and as long as these are clearly and well-drawn up, problems - although irritating - may '¨be manageable.

The other obvious disadvantage is the cost and complexity of establishing these arrangements. Initially due to their bespoke nature, the cost would have been prohibitive to all but the most established and significant schemes. However, as time has gone on, most of the hard work will already have been done in terms of the 'standard' drafting and consultancy advice required and some advisers are now able to provide almost a 'commoditised' product, However, every case will turn on its merits and considerable tailoring will still be needed in most situations.

Underpin

While the advantages of using asset-backed pensions appear to be too good to resist, trustees will need to consider very carefully the use of alternative funding mechanisms, and employers and trustees should take legal advice on whether the mechanism might involve employer-related investment and breach the ERI restrictions. This was affirmed by the Pensions Regulator in its recent corporate plan, where it warned that the use of asset-backed funding arrangements could increase risk where scheme advisers failed to anticipate "all the implications of using [the] structure".

In a previous statement made by the Pensions Regulator, if there is a risk '¨that the mechanism could breach the '¨employer-related investment restrictions and affect the scheme, the agreement '¨should include an "underpin" providing '¨an alternative funding structure (for example, straightforward cash contributions or another arrangement of equal '¨financial value).

The regulator expects to be informed of the use of alternative funding mechanisms through the valuation submission or in a revised recovery plan. The details of the funding mechanism should also be communicated to members in a "clear and transparent" manner.

Trustees should ensure that assets supporting the funding mechanisms are independently valued and a proper risk/reward analysis provided by the Scheme Actuary. Generally the Pension Regulator would look on these schemes as something as a last resort but this approach will almost certainly need to be modified as more and more are entered into. The only other dark cloud on the horizon may be some European regulatory meddling but until that time comes, the plug will remain firmly in the plughole!