Taylor Wimpey sets up escrow as scheme funding improves
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The £2.4bn Taylor Wimpey Pension Scheme and its sponsor have set up an escrow account as the scheme is fully funded on a technical provisions basis. Are escrows becoming more common as schemes look to bridge the time to their long-term objective?
UK defined benefit schemes had an aggregate surplus of £99bn at the end of June 2021, up from a surplus of £94.6bn at the end of May, pushing the PPF funding level up to 105.8%. More schemes – nearly 3,000 – were in surplus than in deficit (about 2,400). The total surplus of schemes in surplus had increased to £216.7bn in June, compared with £129.3bn a year earlier.
The Taylor Wimpey scheme is one of the schemes that has recently reached full funding on a technical provisions basis and has agreed with its sponsor that contributions continue for six months into an escrow account. They will be suspended if the funding level increases beyond 100% and restarted if it falls below 98%.
Money will be tipped from the escrow into the fund if the funding level falls to 95% for two quarters, if the company becomes insolvent or if there is a deficit on the scheme’s long-term funding basis in June 2028. “Any remaining funds in the escrow account not paid to the Scheme will be returned to the Company in 2028,” the scheme notes.
Escrows 'being talked about’ more
Anecdotal evidence confirms that employers and trustees are starting to think about how to deal with an actuarial surplus. Escrows come into the picture in this discussion because any money they hold is considered to be outside the scheme and still with the employer – though ringfenced for pensions use – meaning there is no tax charge if leftover cash is reimbursed to the employer. Were the scheme to return the money from its accounts, a 40% tax charge would arise.
Zahir Fazal, chair of trustee firm Bestrustees, says a number of schemes are now fully funded on a TP basis, including two that he is a trustee of.
Generally, he says, employers are “continue paying contributions depending on what the long-term strategy might be; essentially where they are strategically looking for buyout, there can be cases where they say they are willing to continue paying contributions but want to avoid trapped surplus”.
Although there is not a rush towards them, escrow accounts – and in some cases reservoir trusts – are now “being talked about”, he says, revealing that he will be discussing this issue with a scheme sponsor as well.
As schemes approach or hit full funding, the trustees would discuss the issue together with the employer, he says: “If you’re heading for a surplus, it’s a convention most trustees would have with the employer.”
When schemes’ funding improves, they often reduce investment risk – in fact, many now have triggers in place to do so as they meet certain funding milestones. This would reduce the expected returns, and therefore the likelihood of an actual surplus arising after wind-up.
Bestrustees director Huw Evans says derisking is typical in those circumstances: “Most schemes will derisk and strengthen the basis so that there is no material surplus,” he says, explaining that many are hoping to qualify for the ‘fast-track’ to compliance under the Pensions Regulator’s proposed new DB Funding Code, which would require high resilience to investment risk by significant maturity.
In the case of Taylor Wimpey, he says the most likely reason for setting up an escrow is “that the two sides have struggled to agree a funding valuation with the trustees wanting stronger technical provisions whereas the company is arguing that this creates an unacceptable risk of trapped surplus”.
Escrows can protect scheme funding in the case of poor investment performance or covenant events that are adverse to the scheme, such as credit downgrades or dividend payments from the sponsoring entity, he explains, adding: “It is theoretically possible that it’s a device for funding to buyout while minimising the risk of trapped surplus, but I haven’t seen an escrow used for that purpose: it’s not a tax efficient way of achieving that objective.”
Could members benefit from surplus?
Where an actual surplus does arise, depending on the trust deed and rules, trustees might be able to increase member benefits, but this happens “hardly ever”, says Evans; discretionary increases disappeared when their cost had to be recognised immediately against profits by the sponsor under accounting rules, he says.
And “if sponsor consent is required, it is unlikely to be forthcoming”. But where trustees have a unilateral power to award increases, a surplus and a derisked portfolio, they “would make a discretionary award sooner rather than later because the number potential beneficiaries of such an award is falling over time”, he says.
Even where such a power exists, there is however a risk that the employer might not approve, particularly if the scheme is still in deficit; British Airways and the trustees of the Airways Pension Scheme went to court in 2013 over pension increases and only settled in April 2019. The scheme is now awarding increases and one-off lump sums to pensioners and deferred members in exchange for the employer no longer making contributions unless the funding level fell below 100%; in March 2020, the scheme was 105.4% funded.
Guarantees less secure for schemes
Escrows are one way of dealing with a surplus; another would be a company guarantee, but although they are simpler and less expensive to implement, they are potentially harder to enforce, says Evans, because “it’s easy for a big company to move resources in and out of an entity at short notice”, potentially to a jurisdiction where insolvency protection legislation is different.
Companies would sooner give a guarantee, but an escrow is “far more secure from a trustee perspective” agrees Marcus Hurd, managing director of trustee network ndapt. He says ndapt is “seeing a lot more companies entertain the idea of escrows because schemes are getting to full funding” as a route to receiving back any unused cash.
Can an escrow give investment flexibility?
TPR’s income requirement to have a long-term objective has brought this into focus, he says, as there is a realisation that “once you get there that’s it”.
Despite what TPR proposed in its DB Code, Hurd says having an escrow account gives trustees more flexibility with the investment strategy. “If you know a pool of money is available, it gives you greater investment freedom, you can get to full funding quicker,” he argues, describing the typical derisking approach after a funding improvement as “half a step forward, half a step back” as it requires further contributions. Employers “typically prefer the assets to do the hard work rather than cash contributions”, he says, but adds that “clearly it’s a balance”.
Employers are also increasingly putting pressure on trustees to cease contributions once they reach TP funding, he says, which he attributes to a poor understanding of TP funding.
"You are not actually fully funded, you still have a big journey to go to buyout, it’s just a staging post,” he says, and turstees therefore often have to explain this and negotiate how to reach buyout funding if that is the long-term objective.
But “a good trustee with a good relationship with the employer would cross this hurdle before” the scheme gets there, he says. “It’s not necessarily that cash will continue but that both need to work together on how to bridge that journey. That's where escrows, guarantees and any security can play a big part.”
A surplus on TP is not a surplus on a buyout basis, Sackers partner Vicky Carr stressed as well. “Once you get to TP what do you do after that? Currently under pensions legislation, once you get to TP you’ve sort of done what you need to do, although obviously the LTO is coming in,” she says.
In the case of Taylor Wimpey, “they may be putting some money into an escrow but seeing if the investments get them to their LTO by 2028, and if the investments haven’t got them there, money can tip in from the escrow”, she speculates.
A true surplus only really arises once a scheme has been bought out, she points out, “because then you know definitely that you have money left over”. Escrow is a common way to manage this risk, she says; the idea being that a surplus is avoided. Typically, the company and trustee will manage it by agreeing to meet expenses out of the scheme among others, she says. “If there is a surplus, it tends to be very, very small because it has been managed.”
What options would you consider to manage a potential scheme surplus?