The trustees of the closed £6.6bn Nationwide Pension Fund have negotiated an arrangement of up to £1.7bn consisting of mortgage-backed securities should the employer become insolvent. Are contingent assets moving up the trustee agenda? 

 

When the Pensions Regulator’s executive director of regulatory policy, analysis and advice David Fairs introduced the proposed defined benefit funding regime to the industry back in September 2019, he also said the regulator wants to encourage greater use of contingent securities to give scheme sponsors flexibility with their cash flows, seemingly to ease fears that the new regime could drain scheme sponsors of cash. 

  

Contingent assets, which are held outside the scheme, have been used by employers to provide security to DB funds for a number of years; Diageo, Dairy Crest and Barclays are just some of the employers that have entered these agreements. 

 

The Nationwide Building Society has become the latest to agree to a similar arrangement. The trustees negotiated rights over up to £1.7bn of contingent assets as part of the 2019 valuation that was signed off in late 2020, said trustee of the Nationwide pension fund, Mark Hedges. 

 

“It represented a win-win for both sides," he said, as the deal “significantly protects the members but is a process that probably, assuming returns are in line with prudent assumptions, means that the sponsor wouldn’t have to put additional money in”. 

 

The deal worked for both parties. “We got through the hurdles of legality and structuring. Everybody is now pleased we have a position that benefits both sides,” he said. 

 

The assets involved are AAA-rated mortgage-backed securities issued by Nationwide’s funding vehicle, Silverstone. As the assets mature, the building society will replace them with the most senior tranche of securities available. “We can’t be subordinated to any other issues, which is important for the trustees, it maintains the quality of the asset,” Hedges explained. 

 

 

The sponsor covenant is very strong according to Hedges, who said an insolvency is therefore not a concern at present, but the deal provides peace of mind that the scheme could pay benefits if that were ever the case. “This would take us well above PPF-level were the sponsor to ever go insolvent,” he said, meaning the fund could be self-sufficient at that point, with relatively low risk in the investment strategy. 

 

To achieve this long-term objective, from the next valuation the scheme - which is now 102% funded on a technical provisions basis - will look to reduce the discount rate to 0.5% over gilts by 2027, which also reflects the scheme’s closure to future accrual from 1 April this year. It currently applies a discount rate of gilts + 1.25% for deferred members and gilts + 1% for pensioners.  

 

Investments will derisk over time, with a substantial increase in matching and a reduction in return-seeking assets depending on performance, said Hedges. “If they outperform you can derisk quicker than your LTO. It’s fair to say that our strategy still targets a date ahead of that agreed with the sponsor,” he noted. 

 

 

Pure contingent assets can take different forms; they could be a security, escrow account or contingent funding plan which stipulates that cash changes hands depending on what happens with the sponsoring company, as in the plan of Nationwide. At the other end of the spectrum are asset-backed contributions which are not contingent on any scenario and thus boost a scheme’s funding level on day one, with the scheme owning the asset.  

  

Their use has been encouraged by TPR, and “interest is definitely growing”, said Wendy Hunter, a partner at law firm Squire Patton Boggs. “We have seen more clients, employers and trustees, willing to think about the use of contingent assets,” she noted. 

 

The reasons for this vary somewhat. Hunter explained that in the past, contingent asset arrangements have been seen as a way of providing additional funding certainty, often to enable an investment approach with lower prudence than might otherwise be acceptable. 

 

In recent years, however, they have also been used to provide mitigation for any covenant changes like corporate transactions, as well as where a flexible apportionment arrangement is put in place.  

 

But the driver that is seeing the fastest growth in her view is employers wanting to avoid the build-up of surplus.  

 

"When a scheme is nearing buyout funding, an employer which is wary of overfunding but still wants to complete the journey may propose the use of an escrow arrangement so that the trustees have the comfort of knowing the funds are going to be available if needed for the buyout at an agreed time,” not just if the employer fails, she said, while the sponsor knows that the assets are not in the scheme itself and can be returned if left unused. 

 

Others however have not seen an uptick in the use of contingent assets but are not ruling out that this will still come. Anne-Marie Winton, partner at law firm Arc Pensions Law, said it was still business as usual in terms of use and type of contingent assets. 

 

“I think we’ll see an increase in contingent assets being offered and accepted when employers can predict with more certainty the affordability of deficit repair contributions in a post-lockdown world,” said Winton. “I don’t think we are quite there yet on timing to see major changes in their use,” she added.  

 

 

Consulting firm LCP also predicts an increase in the use of contingent assets, spurred by numerous regulatory changes. TPR’s tougher line on funding with shorter recovery plans and more prudent funding targets and investment strategies mean employers offering contingent assets can avoid increasing contributions, and can lower their Pension Protection Fund levy, particularly if this would have increased because of weaker covenant, for example. 

 

Covid-19 has also seen about 10-15% of employers negotiate a reduction in deficit repair contributions. As part of this, companies might have pledged assets instead. 

 

In addition, there have been changes to insolvency law recently which mean that the pension scheme could rank lower in the creditor hierarchy should the sponsor fall over, and trustees might be looking to get alternative security. 

 

LCP partner Phil Cuddeford said contingent assets have pros and cons for the sponsor and the trustees. While they improve the covenant strength for members and can allow the employer to use cash for business investment and allow it to avoid trapped surplus, there could be less flexibility for the business in the future. The setup and running costs of such an arrangement can be very high, and there is a risk that it is no longer fit for purpose before it expires, he said. 

 

 

To implement contingent arrangements, schemes and sponsors sometimes use Scottish limited partnerships, a type of vehicle that exists under Scots law. With rumblings of the SNP planning to demand another referendum on Scottish independence, the question arises if schemes with SLP’s could face problems in the event that Scotland does become independent. 

 

“Several lawyers argue that Scottish independence would not invalidate the employer related investment or other aspects of SLPs, for technical reasons linked to the definitions of shares, securities and partnership interests,” said Cuddeford, noting that SLP contracts usually contain 'change of law’ provisions that would allow a restructuring if needed.  

 

But the question should definitely be asked when considering an SLP. “This is one of the must-have issues for companies and trustees to have on their list for legal advice,” he said. 

 

Hunter said that it is unclear what Scottish independence would mean for employers and schemes that use SLPs and are located south of the border.  

 

“I would expect that any transition to independence would take time and that, as with Brexit, a large amount of care will be put into enabling many sorts of cross-border arrangements to continue without a cliff-edge upset,” she suggested, but cautioned that nobody knows whether that “would be enough”.  

 

“A wise precaution for those setting up such arrangements now would be to include provision for review or exit from the arrangements in the event of Scottish independence, amongst other things,” she advised. 

 

Have you been discussing a contingent asset arrangement with your sponsor recently?