Do asset-backed funding structures need an update?

The changing circumstances of defined benefit pension schemes and their sponsors, along with innovations in design, have led to a recent trend for ‘second-generation’ ABFs replacing existing arrangements. 

While there is still some appetite from employers to put new ABFs in place, there also may be reasons to replace some of the structures that already exist – for example, to expand the scope of the existing ABF, reflect changing commercial circumstances or improve tax efficiency.

An ABF put in place several years ago using particular assets and structured in a particular way might no longer work as well for the employer and trustees as it once did

With at least 90 structures currently in place, the core attraction of an ABF structure for employers is a reduction in the the rate of cash contributions paid, with returns on existing company assets used to pay pension trustees. Under an ABF arrangement, an employer will provide assets to sit in the ABF structure throughout its life.

Trustees accept lower cash contributions in the short term but benefit from recourse to the valuable ABF assets if the employer becomes insolvent. ABFs can be structured so that an employer obtains tax relief and a reduction in Pension Protection Fund levy contributions.

What is driving the creation of second-generation ABFs?

The rationale for updating these funding structures is quite varied, but a typical reason is to expand the ABF’s scope, to cover all of, or a substantial proportion of, cash deficit recovery contributions.

However, in other cases original agreements have become unsuitable for the needs of either the sponsor or trustees.

An ABF put in place several years ago using particular assets and structured in a particular way might no longer work as well for the employer and trustees as it once did. A replacement structure may be able to address these changing circumstances.

One key feature that may need updating is the structure of cash flows.

Some old ABFs were set up with a ‘bullet’ payment at the end of the life of the arrangement. Such payments can be unpredictable, and so the employer and trustees may be keen to move to a structure where more substantial income is paid throughout the life of the ABF instead. 

Developments in the way in which ABFs are structured mean that a replacement ABF may also be more tax-efficient than an old structure.

Costs come down

Implementing a replacement ABF arrangement can be a win-win for both employers and trustees, but does require careful, and sometimes costly, due diligence for trustees.

Boards will need to carefully consider any proposals in light of the Pensions Regulator’s guidance and their fiduciary duties to members, and will invariably require legal, actuarial and covenant advice.

ABFs are typically perceived to be expensive to implement. However, the cost can vary depending on the complexity of the structure and our experience is that the cost of implementing straightforward structures has come down over the years as advisers have learned lessons from previous work.

ABFs in the face of Covid-19

The trend for both first and second-generation ABF structures being created is likely to be disrupted by Covid-19, as businesses focus on navigating immediate challenges.

But in the medium and long term, many schemes still have significant technical provisions deficits, leading to substantial cash being otherwise demanded of employers.

Although many schemes are increasingly cash flow-negative, the financial risks for pension schemes are usually far in the future, and so long-term security is typically more important than receiving cash today. 

Alex Nicklin is an associate and Rizwan Rahman is a senior associate at CMS