The alarming rate at which defined benefit pension scheme deficits have increased over the last decade is not ‘new’ news: increasing life expectancy and volatile investment performance have seen sponsoring employers and trustees faced with the difficult job of plugging the gap through remedial action, in order to reduce (and hopefully eventually eliminate) such funding shortfalls.
Schemes are now considering more innovative methods for managing deficits, including the use of ‘non-cash funding structures’, known to the industry as Special Purpose Vehicles (‘SPVs’), to produce an income stream for the pension scheme. These can be particularly helpful for sponsoring employers who have cash flow difficulties. The net present value of the income stream can be taken into account when valuing a scheme’s assets, which could result in a material deduction being taken off the deficit, with similar advantages for the employer’s balance sheet. There may be various tax advantages too.
Marks and Spencer, Sainsbury’s, ITV and Whitbread have each set up SPVs as part of wider funding plans to meet scheme deficits. For example, the Marks and Spencer SPV holds a substantial property portfolio which, through a leaseback agreement with the company, is currently reported to provide income to its pension scheme of around £72m per year over a 15 year period.
KPMG recently published a survey entitled Asset-backed Funding for Pensions (2010): we are very grateful to them for their research and background data in preparing this article
Around £4 billion of asset-backed contributions have been made available to pension schemes using SPVs. Security of nearly £9 billion of assets has been granted to scheme trustees. Sponsoring employers are using SPVs to spread their funding obligations over periods well beyond most typical recovery plans, with an average period of 17 years. In most cases, payments are also back end loaded.
Given the gloomy national and global economic forecasts and resulting pressures on company cash flow, it is anticipated that the use of these structures will continue to grow.
The principle behind the use of SPVs as a method of funding pension schemes is fairly straightforward. A company transfers cash-generative business assets to a separate legal personality and then leases them back. Importantly, the vehicle is usually bankruptcy remote from the employer which means that the trustees are given increased security on sponsor insolvency.
Scottish Limited Partnerships (‘SLPs’) are commonly used because of the advantages they have over partnerships incorporated in other jurisdictions. They have a separate legal personality, unlike other (English) partnerships which are tax transparent and do not have a legal status which is distinct from their partners. An SLP can own its assets, enter into contracts, borrow money and grant certain types of security. The fact that SLPs do not themselves pay any tax means that they are tax neutral; instead partners pay tax on their share of the partnership income and any gains they have received. The pension scheme trustee (which will usually need to be a sole corporate trustee limited by shares owned by the sponsoring employer’s group) and the sponsoring employer would become limited partners, neither of which have a role in managing the SPV. A separate group company would be appointed as a general partner and would have day to day responsibility for managing the SPV.
The governing documentation of whichever vehicle is chosen will specify that the income produced by the asset will be paid to the pension scheme. The assets could include real property and intellectual property – for example, a company which rents shops or office space to tenants can use the income produced by those rentals to make payments to the pension scheme via an SPV. This allows the company to utilise its property income in a more effective way than might otherwise be the case.
It should be remembered that the value produced by the chosen assets can (like any other investment) fluctuate. For example, whilst placing intellectual property into an SPV can unlock the value of this asset in a way which is not always otherwise easily the case, the reputational value of such intellectual property brands can increase or diminish over time. This is likely to result in a discount being applied when determining the net present value of the income stream.
There are synergies for both sponsoring employers and trustees in the potential for cash conservation, a stronger balance sheet, and greater security for the pension scheme.
Sponsoring employer advantages. The company retains control over the assets held by the SPV which revert to the company at the end of the term, subject to certain carve outs. It can also be agreed and documented that the cash supply to the scheme stops in the event that a surplus builds up in the scheme, which reduces the risk of “trapped” surplus. The SPV can have tax advantages which are of significant value for the company because they can facilitate an acceleration of corporation tax deductions.
Trustee advantages. Sponsoring employers may be willing to provide greater value to the pension scheme through these structures than through alternative funding methods, such as cash contributions. The income produced for the scheme will aid the funding position and enhance the security of members’ benefits. This may avoid the need for the sponsoring employer to close the scheme (either to new entrants or to future accrual) or to implement changes which would reduce members’ future benefits. The income stream provides an additional bond-like asset for the scheme, which in many cases can be sold on the open market for cash if necessary. Despite these advantages, trustees must ensure that the proposed SPV is in members’ best interests and is robust enough to stand the test of time.
It is very important that employers and trustees consider all of the implications involved in setting up SPVs. Implementation can be complex and lengthy and a range of professional advice and technical expertise will be needed throughout the process, including pensions and other legal disciplines, accounting and tax advice.
Hammonds LLP has experience in transactions of this kind which enables us to provide clients with strong support as part of an advisory team.
Structure and assets
Firstly, the company needs to ensure that it has sufficient legal capacity to enter into the arrangement. The structure which is chosen must clearly define the rights of the company and the trustees (particularly on insolvency). The assets which are to be placed in this structure will then have to be identified and transferred.
Commercial considerations will include ensuring that flexibility for the future is maintained and investor relations are managed appropriately. In addition, the proposed arrangements will need to fit with any planned future corporate activity and with the company’s banking covenants.
The chosen asset needs to be valued for the pension scheme accounts, the company accounts (if the asset is to count as a scheme asset for accounting purposes) and for PPF levy determination purposes. The value of the asset to the scheme represents the market value of the future income stream. It is also important that an appropriate valuation basis for the asset is adopted by the company, bearing in mind not only the proposed deal with the trustees, but also its tax and accounting position. The method of valuation will need to be agreed between the company and the trustees and should be validated by a third party.
Pension law issues
A number of pension law issues will arise. For example, trustees will need a power under their scheme’s Definitive Deed and Rules to invest in a partnership. A rule amendment will be needed if there is no such power. In addition, the trustees must be satisfied that the investment is appropriate for their scheme, having regard to the need for diversification.
The parties must also ensure that the structure adopted avoids breaching the statutory selfinvestment restrictions. The use of the SLP helps to circumvent employer-related investment issues, due to the partnership being a separate legal entity (and having separate ownership of the assets) from its partners. The SPV is also exempted as a collective investment scheme (as defined under the Collective Investment Schemes Order made under the Financial Services and Markets Act 2000) if all investors are in the same corporate group – this is why the trustee must be a corporate subsidiary, limited by shares owned by the group.
The proposed structure will need to inter-link with the sponsor’s statutory funding obligations. In particular, it will be important to ensure that income from the funding structure can be turned on and off on an “as required” basis. In addition, any triggers designed to protect the scheme in the event of corporate default – a central feature of these structures – should be carefully defined.
Tax issues should be considered as early as possible. Potential tax issues include: corporation tax on the transfer of assets into the SPV by the company; transfer taxes payable by the SPV and the company on the sale and lease back/licence back of the assets into the SPV (including VAT); and the stamp duty land tax consequences of the sale and lease back of real property assets.
It may be advisable to consult HM Revenue and Customs before setting up the SPV to avoid any nasty surprises further down the line.
Real estate issues
If real estate assets are to be placed within the structure, appropriate legal advice will be needed, for example, titles to properties proposed to be transferred may contain relevant restrictions. In addition, the terms of any transfers and leases – eg market value, rents, term, rent reviews, assignment, repair and other covenants – will need to be agreed.
The use of intellectual property rights (such as brand names and trademarks) in an SPV can effectively unlock value which may otherwise be invisible in the company accounts. The asset must be valued – to ensure that it has robust value and can act as a form of security. It is likely that the value of the brand will fall on corporate insolvency and it may be possible to put insurance in place to address this risk.
Care must be taken to ensure that using intellectual property rights in the SPV do not endanger in any way the value or validity of any underlying trademark registrations. The company must retain the freedom to use its trademarks and the powers to enforce them against third parties where necessary. Finally the structure should contain provisions allowing for the rights to be bought back for a capital sum (determined under an agreed mechanism), when the SPV comes to an end and in identified distress scenarios.
Whilst SPVs have great potential for reducing pension scheme deficits and ameliorating cash flow difficulties relating to scheme funding, they should be established with a great deal of care. Individual pension schemes and employer circumstances can be vastly different and what is appropriate for one scheme may not work for another. It is vital that employers and trustees who are interested in establishing an SPV for their pension scheme should seek advice at the earliest stage in this process.