Pension funds have increased their use of asset- backed funding (ABF) deals recently as economic stress and subsequent quantitative easing (QE) have pushed scheme liabilities and deficits sky high. According to advisory firm KPMG, the volume of deals on its own books reached £700m in the six months from September 2012 alone, easily outstripping the £600m seen in the entire year beforehand.
“You can plug the deficit with shuffling the deckchairs and I have concerns some trustees have not been as diligent as they should be around these arrangements.”
Russell Lee
While this figure is specific to KPMG’s own activity in the space, it is no doubt a useful indicator of the rise of ABF. Pension schemes and sponsoring employers are realising the benefit of these structures which use business assets to generate regular cash payments into the pension scheme and tackle ballooning deficits.
A continuing reduction in transaction costs is likely to drive deals at a similar pace for the rest of the year. The average value of KPMG’s ABF deals in the six months from last September was £42m, with more than half the transactions for £50m or less and the smallest just £12m. This compares to a market average of £138m in 2010.
Under an ABF deal a special purpose vehicle (SPV) is set up between the sponsor and the pension scheme into which the employer transfers business assets to generate cash which is paid to the pension scheme.
High profile examples include drinks manufacturer Diageo’s decision to place 2.5 million barrels of maturing whisky with a book value of £500m into an SPV as part of a 10-year funding plan to plug an £862m deficit in 2010. And in 2011 travel firm TUI placed two of its brands, First Choice and Thomson, valued at £275m, into an SPV on a 15-year term to address its £400m deficit.
As part of the latter deal, TUI retains complete operational control over the Thomson and First Choice brands and the assets remain entirely within the group which manages the partnership. TUI pays a royalty into the partnership structure of 1.65% of turnover, which will generate approximately £50m a year. Only on insolvency do the TUI pension schemes have a right to take control of the partnership and the brands at which point they could use the brands either in a continuing royalty-type arrangement or dispose of them in order to get the £275m.
Two years on, TUI Travel group pensions manager Nick Dunk says, the funding partnership is regarded very much as “business as usual” and “underpins discussions between the company and pension trustees with regard to funding and investment strategies”.
A similar deal which made headlines recently was Dairy Crest granting its pension scheme trustees a floating charge over £60m of maturing cheese in the event of insolvency and paying £40m into the scheme after selling its spreads business, St Hubert. But contrary to what many people think, this deal was actually a contingent asset and not an ABF structure (see box-out below).
Drivers
According to KPMG partner David Fripp, the recent increase in ABF deals has been driven by QE and “scared global money” chasing safe-haven UK gilts. The price of gilts has subsequently risen and yields have fallen, reducing the discount rate used to value long-term liabilities meaning liabilities are discounted to a bigger net present value.
“Companies have been going through valuations and there have been some shocking and unwelcome numbers,” says Fripp. “The net effect of the growth in liabilities, even when offset by some positive experience on the asset size, is that you still have large and very persistent deficits that need addressing.”
Mercer principal in the financial strategy group Russell Lee agrees the economic backdrop has contributed, but believes the main driver was actually HMRC’s clarification in February 2012 of the tax rules surrounding these structures. Once this was clear, he says, advisers pushed ABF structures to clients and deals came together during the period KPMG’s research was undertaken.
He adds: “By May last year the position with regard to tax was nailed down and the incentive for tax advisers to pitch became more compelling. People who had been on hold were effectively coming in and getting it done – and the timing to get a deal done is probably three to six months.”
Indeed, the tax benefits of ABF deals are a major reason why employers have undertaken them. The government’s new legislation aims to only allow upfront tax relief for employer assetbacked pension contributions where the arrangement meets certain conditions.
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