How to make scheme funding work - tips 10 and 11

Over the past few weeks, we’ve been looking at the issue of unlocking flexibility in your pensions funding, following on from points raised in the Pensions Regulator’s (tPR) annual funding statement.

We’ve been sharing our tips and techniques with a view to helping you unlock the flexibility that’s potentially available in your scheme funding. In the last two of these top tips we look at new developments in asset-backed contributions and how to use internal hedges between sponsors and trustees.

10. New developments in asset-backed contributions

The use of asset-backed contributions (ABCs) has increased lately, as employers face larger cash contribution demands and instead turn to alternative means of financing their schemes.

In particular, we’ve seen:

  • increased use of inter-group loans/receivables from overseas parents
  • increased use of ABCs by smaller schemes
  • greater understanding of structures by companies, trustees, banks and tPR
  • reduced implementation costs
  • better clarity on tax treatment, and
  • ever more innovation, for example, use of reservoir trusts for holding short-term cash (enabling quicker tactical investment strategy changes and ability to reclaim surplus).

It’s likely that ABCs will remain a focus for 2013 valuations. While ABCs can be developed to suit scheme-specific circumstances, common advantages typically include:

  • immediate security for trustees – enabling financing over a much longer period
  • reduced danger of trapped surplus, and
  • covenant enhancing so supports, for example, return-seeking investment strategy.

11. Internal hedges – spotlight on inflation

When scheme actuaries set funding assumptions, it’s typically market forecast interest and inflation rates that are used. When setting an inflation assumption for example, the starting point is often the difference between fixed-interest government bond yields and the yields on index-linked government bonds less, perhaps a small adjustment to allow for anomalies in gilt markets.

Our analysis of historical rates of such market-implied inflation vs actual inflation, with the benefit of hindsight, shows that market forecast inflation has overstated actual inflation by over 1%p.a. on average. This is significantly larger than the typical correction applied for scheme funding purposes – so pension scheme inflation-linked liability values could be overstated by as much as 20%.

There are various ways to recognise this:

  • Reduce unnecessary prudence in the inflation assumption.
  • Contingent inflation financing - where the employer agrees to fund inflation on a pay-as-you-go basis. This means that required contributions are based on a lower baseline inflation assumption with additional funding paid only to the extent that actual inflation is higher than expected. This removes the over-reserve for inflation in the baseline cash contribution levels but gives trustees comfort that higher inflation will not result in an increase in the deficit.
  • Formalise the contingent financing in the shape of an internal hedge between sponsor and trustee which, if structured correctly, can be recognised as an asset for its future capital value under the more prudent scheme funding assumptions.

Previous tips

If you want to see the previous scheme funding tips then click on the links below:

How to make scheme funding work - tips 1,2 and 3

How to make scheme funding work - tips 4,5 and 6

How to make scheme funding work - tips 7, 8 and 9

Your experience

We’d like to hear about your experiences of scheme funding negotiations and hear what advice you’d give others to make sure they’re well prepared. Use the comments box below to share your thoughts.

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