Readers will be aware that occupational pension schemes providing benefits on a salary-related or defined benefit (DB) basis - including 'final salary' pension schemes - have been in the news for several years.
This is because companies sponsoring such schemes have experienced increasing difficulty funding them. Funding a DB scheme is rooted in the fact that employer contributions to it are open-ended: in other words, the employer underwrites the benefits provided under its DB pension scheme.
There are a number of consequences to this, and companies and their advisers have had to find more creative ways of funding DB pension schemes. Possibly the best example of such creativity in the last three to four years is employers' use of so-called asset-backed funding (ABF) vehicles, with the best-known being Diageo's use, in summer 2010, of an asset-backed funding vehicle in which the asset was whisky - approximately 2.5m barrels of it!
Structure of an ABF partnership
Put simply, an ABF works as follows:
- The employer transfers an asset, for instance commercial property, another tangible asset (e.g. Diageo's whisky or Dairy Crest's cheese) or intellectual property, into a separate entity. The separate entity is usually a Scottish limited liability partnership (SLP).
- The trustees of the DB scheme invest in the SLP. This investment is held as an asset of the DB scheme. The trustees are entitled to a share in the profits of the SLP.
- The employer, having assigned the asset to the SLP, pays rent or a licence fee for the use of the asset and has day-to-day control over the SLP. The rent/fee paid to the SLP forms its profits, and the trustees, as a partner in the SLP, are paid a share of that profit, with any excess going back to the employer.
- Where the value of the rent/fee from the SLP falls below a given level, the trustees have step-in rights, enabling them to take control of the SLP. Ultimately, they may sell the asset for the benefit of the scheme.
Potential issues in ABF structures
An ABF makes use of what is regarded by many, at time of writing, as a loophole in the law applying to employer-related investments (ERI).
Applicable legislation provides that a DB pension scheme may not invest more than 5% of the value of its assets in its sponsoring employer(s).
Currently, use of a SLP within an ABF structure falls outside ERI legislation, meaning trustees are able to make use of the ABF structure described above without infringing ERI legislation. Although the structure described above is lawful, it has not been tested by the courts.
Although it is not completely clear that such a consequence would be automatic, in the event that Scotland were to vote in favour of independence from the UK later this year, there is a risk that Scottish independence would, ultimately, cause an ABF structure which used a SLP to fall outside the loophole in the law relating to ERI and, therefore, bring it back within that legislation.
The Pensions Regulator (TPR) issued guidance on ABF structures in November 2013 (The Pensions Regulator: Asset-backed contributions Guidance for trustees and their advisers, 19 November 2013). Although the guidance acknowledged that ABF has, in certain cases, provided a reliable income stream for pension schemes, it stressed the following points (amongst others):
- ABF structures are, as yet, untested in the UK courts
- TPR is not of the view (promoted by many commentators) that ABF structures provide 'bond-like' security in the context of pension scheme funding
- TPR expects pension scheme trustees to accept ABF only after having explored all other alternatives. In making this point, TPR indicated that it may require trustees to demonstrate (to TPR) how they have satisfied themselves that ABF represents the best option for their pension scheme
The use of ABF structures has become more common of late, partly because there are several examples of ABF having worked successfully, and partly because the cost of setting up such structures has fallen since ABF started to be used in around 2010.
It is our view that ABF structures will continue to be used throughout 2014, but it is also clear that trustees of pension schemes will need (arguably more so than before) to go through a clear and careful process in deciding whether they are of genuine benefit to their particular pension scheme.
TPR has made clear its reservations about ABF and it has been equally clear in warning trustees that it is likely to require them to explain how and why they see ABF as offering the best deal for their schemes in future.
Shoosmiths advises corporate entities and trustees of DB pension schemes in relation to ABF vehicles.