Pensions World

Employers struggling to finance their pension scheme could use asset backed funding structures, suggests David Fairs, KPMG

Property, whisky and trademarks have all been used in asset backed funding structures (ABF structures) and the number put in place has significantly increased in the past 12 months. With volatile stock markets, depressed bond and gilt yields and increased deficits, ABF structures will be used even more extensively in forthcoming funding valuations.

This article looks at some of the reasons both companies and trustees implement such arrangements, some of the more recent developments around ABF structures and some of the issues that are likely to be encountered.

First, let us look at the reasons often cited for putting an ABF structure in place:

Enhancing the employer covenant: Recovery plan lengths have tended to become longer over the period that scheme specific funding has operated. In such circumstances, trustees are exposed to the employer covenant for a longer period and have sought additional security or a charge over assets. ABF structures have sought to provide that security but also provide additional benefits to both the company and trustees.

This prioritising of assets in favour of the trustees often enables trustees to agree to a less conservative set of assumptions for a valuation than when such security is absent or agree to a longer recovery period. In effect, the pledged security enhances the employer covenant.

Preserving cash in the business: ABF structures tend to give rise to longer deficit recovery plans largely because the additional security provides comfort in the event that there is a default on contribution payments. A new KPMG survey (2011 Survey on Asset Backed Funding Structures) suggests that the average recovery period increases from approximately 9.5 years to 17 years where such structures are put in place, with the majority of such structures supporting a recovery period in excess of 20 years.

In addition, an ABF structure often supports an acceleration of tax relief over a similar pattern of cash contributions. For significant contributions, the tax relief may need to be spread over four years but this may be sufficient to meet the cash contributions for the early years of the recovery period.

Reducing deficit and PPF levy: There is a variety of legal and accounting structures deployed, but ABF structures typically result in an overnight reduction in the deficit for funding and accounting purposes which in turn may result in a reduction in the PPF levy payable.

Avoiding trapped surplus: Where companies have concerns that the cash contributions required by trustees might result in trapped surplus, mechanisms are introduced to switch off the flow of funds from the ABF structure to the pension scheme when the pension scheme reaches an agreed funding position.

Efficient financing of pension scheme: The current economic environment is producing significant deficits for some employers, resulting in significant cash demands from trustees. If the sponsoring employer is operating at reduced profitability or is facing challenges on refinancing, increased cash demands from trustees just add to pressures on working capital. If the employer can use unencumbered assets to support an ABF structure, it can significantly ease pressures to pay cash to the trustees in the short term. The majority of structures still use property, but over the past 12 months we have seen the use of brands, receivables and loan notes.

Most of the items listed above address the benefits from the employer’s perspective, but there are equally advantages from the trustees’ perspective, particularly where the employer is unable to meet deficit payments over a short time frame. A commitment to cash payments over a longer period of time but with suitable assets pledged in the event of default may give the trustees a high degree of comfort that cash will be paid either through cash contributions or through taking control of assets in the event of a default.

Challenges to overcome

On the face of it, the use of ABF structures seems overwhelmingly positive, but there are challenges to overcome.

Firstly, placing assets in a special purpose vehicle with partial ownership by the trustees may constitute an employer related investment. Although legal opinion seems pretty robust that the use of a Scottish Limited Partnership means this is not the case, the Pensions Regulator encourages trustees to consider a plan B if at some point either the law or legal opinion changes.

Raft of tax issues

Secondly, there is a raft of tax issues to consider. Moving the assets into the ABF structure potentially gives rise to considerations around capital gains tax, VAT, and stamp duty land tax. Similarly, consideration of these taxes at the time that the ABF structure unwinds need to be thought through. While assets sit in the ABF structure, consideration also needs to be given to income and capital gains tax and also potentially stamp duty land tax, if assets are swapped in and out.

Equally, there has to be a careful construct on how the trustee acquires its interest in the ABF structure if the company is looking to gain a corporate tax deduction on the initial investment.

HM Revenue & Customs accepts that these structures reflect a genuine commercial need, but there are structures which produce tax deductions where monies are not ultimately paid into the pension scheme or where double tax relief occurs. The announcement in the Autumn Statement is aimed at exactly these types of arrangements, but leaves the way open for genuine commercial structures.

Accounting should simply be a reflection of the construct of the ABF structure, but companies often have tolerances around the impact on profit and loss, balance sheet or key statistics such as return on capital employed. This can often lead to tweaks to the underlying structure to produce a certain economic fact pattern and hence accounting treatment that is within the required tolerances. Understanding the accounting policies of the business and involving those responsible for accounting policies is therefore critical in shaping the ABF structure.

From a legal point of view, the high level structure can be relatively straightforward, but complications arise depending on the nature of the asset, the complexity of the triggers that cause assets in the ABF structure to fall into the pension scheme or be returned to the employer and any related issues such as other legal charges or covenants.

As well as these technical areas, a big area of negotiation on the establishment of the ABF structure is around the value of the trustee interest.

For the more straightforward structures where there is an income stream and reversion to property the value can be derived by looking at a discounted value of the income stream based on the company being able to make cash payments and a reversionary value of the asset backing the income stream. In most cases, a distressed value of the asset is considered on the basis that the underlying asset might be stressed at the same time as the employer is unable to make cash contributions. Quite often the trustees look for an independent valuation of what the asset might be worth in such circumstances. Some structures put in place over the past 12 months have mechanisms in place to switch off contributions to the pension scheme where the pension scheme moves into excessive surplus. In most cases, this requires stochastic modelling of possible future outcomes to derive a value for the various interests under the ABF structure.

It might be thought that the majority of actuarial firms would be keen to provide services in this area, but some are reluctant to do so and so most valuations have typically been done by accountancy firms or boutique finance houses which can provide the necessary actuarial, finance and modelling capabilities. Clearly, where the assets are more esoteric, more specialist assistance may be required.
In some cases, the values placed on the asset by the trustee and company advisers can be noticeably different with the result that detailed discussions on different modelling techniques and assumptions can arise.

Gaining popularity

ABF structures have a number of benefits for those struggling to finance their pension scheme, where there is a desire to strengthen the covenant of the employer or simply the employer wants to optimise the financing of pensions. Getting the detail of the ABF structure in place however requires a raft of legal, tax, actuarial, accounting and finance expertise.

However, as more of these arrangements are put in place and the issues become clearer, we are likely to see them become more accessible to schemes with modest deficits.