Historically, it could be said that corporate pension scheme funding represented a topic which had long occupied a lowly position on the agendas of many employers. However, with regulation tightening and market conditions negatively impacting on un-hedged schemes – coupled with increased media attention – employers’ obligations are coming under intensified scrutiny, and shortcomings in funding positions have never been more apparent.

In the immediate wake of the Brexit result of June 2016 and the accompanying falling gilt yields, the Financial Times reported that the UK’s defined benefit (DB) pension deficit had widened by £80bn (US$100bn) to £900bn – against an estimated £250bn back in 2000. To put the latest figure into context, one FTSE 100 employer confided that their deficit gap had widened by approximately £100m overnight, following the outcome of the June 23 referendum. In this period of political uncertainty – and with sterling falling to its lowest level in more than 30 years – it has never been more important for employers and trustee boards to address their respective deficit funding arrangements to ensure schemes are adequately protected in the long term.

The main challenge for sponsors in addressing funding shortfalls is arguably the conducting of an effective balancing act between the scheme trustees and company shareholders. The trustees must be satisfied with the level of funding committed by the sponsor. At the same time the employer must make sure that the contributions required are affordable, as shareholders may have concerns when considering the potential knock-on effects that large contributions could have on dividends.

The trustees do, of course, have a strong vested interest in the performance of the sponsor, as it is ultimately the company’s financial standing which governs the degree of protection the employees enjoy. While it will often be the aim of the trustees to achieve the maximum injection of capital into the scheme, without unduly weakening the covenant of the employer, allowing the sponsor to preserve and improve its own covenant is still therefore firmly in the interests of the trustees. Potential methods for achieving this include:
1. Holding sufficient capital on the balance sheet, and thus not sparking concern in the minds of creditors.
2. Allowing the company to explore investment strategies that may require a capital injection in the short term, but potentially yielding significant dividends longer-term.
3. Exploring alternative forms of security that can be pledged to the trustees, thus replacing the need for some capital requirements.

Since the financial crash of 2008, the long-term credit ratings of traditional high street banks have, in several cases, been seen to deteriorate, with many insurers’ ratings surpassing those of their banking counterparts. This has contributed to insurance companies’ product offerings widening and allowing them to compete more effectively with the banks in areas such as security provision.

Preceding the financial crisis, trustees were generally happy to accept various forms of collateral, the reliability of which never coming into question, such as government bonds (gilts). Sponsors also benefited from this, having been able to satisfy trustees with forms of security at no capital cost for the employer, for example parent company guarantees (PCGs).

While in an ideal world this securitisation arrangement would exist indefinitely, it is also unrealistic to suppose that the waters will not at some point be tested around further requirements and alternative forms of collateral. This is now being realised by many employers in the UK and also globally in respect of their UK pension liabilities.

Amid the recent volatility seen in markets across various business sectors, Mercer, part of the Marsh & McLennan group, found in in its Pension Risk Survey 2016 that the accounting deficit of defined benefit pension schemes for the UK’s 350 largest listed companies increased – from £127bn at the end of November 2016 to £137bn as of 30 December 2016 – even though the FTSE 100 index ended the year at an all-time high that day, and trebled from £39bin in November 2015.

Strengths of surety bonds

Looking ahead, it can be expected that due to Brexit, a change of leadership in the US, and other major events such as the French elections, trustees and sponsors are facing significant uncertainty over the remaining months of 2017. According to Mercer’s research, schemes will have to be responsive on a variety of issues, with the best outcomes being achieved by tackling all of covenant, funding and risk management issues together.

One form of alternative security that is becoming increasingly popular among sponsors is that of surety bonds. These bonds are constituted as a contract of guarantee, not insurance, issued in favour of the scheme trustees by a third-party insurance company on behalf of the sponsor’s insolvency and inability to pay contribution payments when required.

Surety bonds are not a new instrument to the market and may best be known to some for their use in construction contracts and general transactions, which require securitised payment obligations. Although using surety bonds in conjunction with pension scheme funding is a relatively new solution, we are now seeing consistently more deals being completed in the marketplace – it is therefore a product now proving effective for both employers and trustee boards alike.

The insurers issuing these guarantees are highly rated (A to AA Standard & Poor’s) and are showing a growing appetite for writing this type of obligation. As they indicate on the basis of having a right of recourse to the employer, however, should they be required to pay out to the trustees, it is usually the stronger sponsors for which the sureties will reserve significant capacity.

A key benefit for the sponsor here is the ability to pledge a third-party guarantee in lieu of capital into the scheme, therefore providing significant easing of pressure on the cash position. For some schemes, actual or potential trapped surplus may be a problem; surety bonds can help with this issue by delaying cash contributions so the situation is not unduly exacerbated. These bonds, by accounting standards, are also classed as contingent liabilities. They therefore sit off-balance sheet and do not tie up an employer’s banking facilities; unlike similar products offered from the banks such as letters of credit (LOCs).

Surety bonds offer a versatile solution and can be used to protect the trustees in several ways, such as: full deficit coverage, individual or grouped contribution payments and simple payment deferrals. Surety can also be instrumental in facilitating wider strategies, such as: scheme merger, scheme sectionalisation, corporate restructuring, merger and acquisition (M&A) carve-outs and the underpinning of agreed-upon investment strategies and de-risking plans.

Trustees and sponsors alike can view this form of security as a useful negotiating tool which protects both the scheme members, with a strong covenant from third-party providers, and the sponsor itself, through the improvement the solution can bring to a sponsor’s liquidity position. The bonds are on-demand instruments and, therefore, if the sponsor is deemed by the trustees to be in default, the insurers will pay out directly to the beneficiary within five to 10 days. Surety bonds can also be used in the UK in conjunction with the Pension Protection Fund (PPF) and the annual levy imposed on each employer. When written on the PPF bond wording (found on the PPF website), sponsors can potentially achieve additional savings on bond premiums, due to the guarantee being classed as an admissible PPF asset.

As the marketplace’s biggest player, Marsh provides surety broking and consulting servicing to businesses across a wide range of sectors and has arranged this pension solution for a number of clients, with aggregate bond values well in excess of £1bn.

As the UK’s financial and political future continues to be shrouded in uncertainty, we see the surety solution for pension scheme funding being an invaluable tool in employers’ armouries, especially when looking at ways of easing capital pressures and reassuring trustees with a strong covenanted promise to pay in the event of sponsor failure.

Copyright © 2023, Bond-Pro, Inc. All Rights Reserved.