Contingent assets

Guidance on how to approach ascribing an appropriate value to a contingent asset, and, therefore, evidence that it is sufficient to provide the specified level of support when required.

Published: December 2024

Introduction

Incorporating contingent asset support into your covenant assessment

Contingent assets can provide valuable support to a scheme that is not otherwise available from the employer, or can enhance a scheme’s existing claim against its employer.

To factor contingent asset support into your covenant assessment, you must reasonably expect these to be:

• legally enforceable
• sufficient to provide the specified level of support when required

This is referred to as the 'relevant criteria' for a contingent asset throughout the DB funding code.

Paragraph 34 of the Employer covenant section of the DB funding code states:

"A contingent asset’s legal enforceability is determined by the terms and conditions of the relevant agreement and the applicable law. Trustees should be satisfied that they have sufficient legal advice in relation to the enforceability of proposed contingent assets for both the UK jurisdiction and any relevant overseas jurisdictions. They should then consider whether, on balance, taking into account any qualifications in the legal advice, if this supports taking additional risk."

Paragraph 37 states:

"To understand whether a contingent asset will provide a particular level of support when required, trustees should identify the following.

1. The scenario in which the contingent asset is likely (or able) to be called upon (for example in the event of insolvency of the employer).
2. An appropriate method to assess the expected realisable value of the contingent asset. This will primarily be driven by the type of contingent asset, such as whether it’s a security arrangement (for example security over an asset, cash in escrow, letter of credit) or a group or parental guarantee)."

Using contingent assets to support scheme investment and funding risks

Where you can evidence that a contingent asset meets the relevant criteria, they can be used to support the following.

• Additional risk-taking within the scheme’s journey plan, to the extent you can factor in a value for the contingent asset into your assessment of supportable risk.
• A longer recovery plan (subject to further requirements as set out in the code), particularly where this exceeds the employer’s reliability period. This requires that:
  • the contingent asset is sufficient in value to cover at least the expected remaining deficit at the end of the reliability period (unless otherwise stated in the code)
  • you have reasonable certainty that you can access this value during the recovery plan period if the employer cannot meet its obligations under the recovery plan

Where a contingent asset is of sufficient value, it may be reasonable to support both categories above. Where this is the case, it is important that you are careful not to double count the value attributed to this asset.

We recognise that contingent assets may also be beneficial in mitigating detriment caused by an employer transaction or event – read the transaction guidance in Clearance for more details – or to support an otherwise weakening covenant. However, this does not automatically mean they will be suitable to support the scheme risks set out above for funding purposes.

Types of contingent assets

While we cover the most common types of contingent assets in this section (security, guarantees and contingent funding mechanisms), we recognise that there continues to be significant market innovation around alternative forms of contingent support.

Where alternative forms of contingent support are provided, we expect you to understand the advantages and disadvantages of these arrangements, and to be able to evidence that they meet the relevant criteria of a contingent asset. When placing reliance on these arrangements, you must be able to attribute a value to this support using the same principles set out in this section.

Although asset backed contributions (ABCs) are often considered contingent assets, typically these are used to increase the scheme’s asset position and therefore reduce or eliminate the scheme’s TPs deficit. They should not be used to support additional funding and investment risk.

We recognise that some schemes may benefit from a capital-backed journey plan arrangement. These arrangements have similar characteristics to contingent-funding mechanisms and escrow security, and you should apply the same principles when determining if they support additional or prolonged risk-taking.

You should note that contingent asset support is different from the following.

• Informal covenant support, which is non-legally binding and could be withdrawn without trustee consent. This could be a letter of comfort provided by a group entity, or an informal arrangement where a parent or group company provides cash to the employer to pay deficit repair contributions (DRCs) on a voluntary basis. Informal support is not sufficient to justify taking additional risk.
• Reliance on employer balance sheet assets, which the scheme does not have direct security over. This could be a large cash balance that could quickly be eroded through covenant leakage or supporting trading losses. You should consider the employer’s balance sheet in more detail when you are assessing the employer’s capital structure and determining resilience as part of your assessment of prospects
  
  Read the Prospects section of our covenant guidance.

Proportionality considerations

It is important that you take a proportionate approach to assessing the value of any contingent asset support provided to the scheme.

Where you are placing material reliance on a contingent asset, a more thorough assessment will be required to ensure that the value of the contingent asset can support the level of funding and investment risk being taken.

Conversely, where the level of reliance is small relative to the size of the contingent asset, less analysis may be proportionate to evidence that the contingent asset can comfortably support this risk.

Valuing security arrangements

Common types of security

Security arrangements provide schemes with direct security, or a legally binding promise over a tangible or intangible asset, where a monetary value can be assigned. These arrangements can typically be called on if the scheme’s employer is placed in insolvency proceedings (therefore improving the scheme’s return on insolvency), or if there is a failure to pay contractual DRCs. These arrangements could also provide a diversification in the covenant support available to the scheme to the extent they are provided by third parties (for example, letters of credit or surety bonds).

Common types of security include the following.

• Security over employer, group or third-party assets. These could be in the form of a legal fixed charge or floating charge alongside, or in priority to, other stakeholders.
• Letters of credit, bank guarantees and surety bonds. Employers may obtain these in return for a regular premium from a third party (normally a recognised bank or insurer) to guarantee up to a predetermined amount. This could equate, for example, to coverage of up to the full section 75 deficit.
• Escrow accounts. An escrow account is an arrangement where the employer (or a third party) pays funds (either as a lump sum or as cash contributions) and/or an asset into an account that will pass to the scheme under certain conditions, but will otherwise be returned in whole or in part to the employer.

How to value security arrangements

Read paragraphs 38 to 41 of the Employer covenant section for expectation on how to value security arrangement. These are discussed in more detail below.

There are two key factors to consider when assessing the value of a security arrangement: legal access to the value, and certainty over that value.

Where a security arrangement has a clear, demonstrable, and readily recoverable market value, we would expect the value of these arrangements to be recognised at face value, subject to any limitations to the scheme’s legal access.

A scheme’s legal access is determined by the terms and conditions of the arrangement, and any associated legal agreements. Limitations to a scheme’s legal access often relate to the following.

• How long the scheme has legal access to the security for (ie the duration or maturity date of the legal contract) relative to the scheme’s expected journey plan.
• Any caps that restrict the amount of value that can be returned to the scheme when called upon.
• The triggers attached to accessing the value in the asset (the contingent event).
• Any protections put in place with the employer if the security loses value.
• Any onerous conditions attached to the contingent asset (eg a weakening in trustee powers, changes to the arrangement if we exercise our powers, or enhanced participation by the employer when determining the scheme’s investment strategy).
• The jurisdiction in which the security sits and its enforceability (including the ranking of the security relative to security granted to other creditors and any wider intercreditor agreements with other stakeholders).

Where an arrangement requires annual renewal (for example, letters of credit or surety bonds), you need to assess the risk associated with non-renewal and renewal processes (eg the administrative burden where there is a short timeframe under any extend or pay provisions), and any associated arrangements that would then take effect.

You should also consider if there are any further limitations that could restrict you from accessing the value in the contingent asset, whether permanently or temporarily. For example, when a charge is registered, a hardening period needs to have passed before the scheme has full access to the security granted in an insolvency of the security provider.

Where an asset’s value is less certain, you must determine the most appropriate valuation methodology based on the most likely scenario in which the contingent asset will be called upon (eg insolvency), and the timing in which any asset value is likely to be realised. For example, where security can only be realised in the event of an insolvency, it may be more appropriate to use a forced sale valuation approach rather than looking at the existing value in use.

Where the asset is provided by the employer, you should also consider the potential impact of enforcement on the employer’s future performance and financial ability to support the scheme. Where the impact is likely to be materially negative, you should factor this cost into the valuation and consider whether it would prevent you from calling on it in any situation other than an employer insolvency.

To assist with valuing assets, it may be appropriate to seek professional valuation advice. Any reasonable costs associated with this advice should be paid for by the employer or wider group. The advice should specifically express that it may be relied upon by the trustees and their advisers without limitation.

Reassessing and monitoring the value of security arrangements

At a minimum, we expect you to reassess the value of security arrangements at each valuation, or more frequently if appropriate for the scheme’s circumstances – for example if the contingent asset represents a material element of scheme support. Where you feel a full independent valuation is not appropriate every three years (based on the asset type and /or volatility of the asset’s valuation), you should record your reasons for not doing so and the steps taken in place of this.

You should also have processes in place to monitor for any potential deteriorations in the asset value between valuations. Where the asset’s value is reliant on trading performance of a business or other external factors, at a minimum, you should be requesting written confirmation from the employer on an annual basis to confirm that there has not been, or there is not expected to be, any material deterioration in the contingent asset's value over the past and next 12 months.

Example 1: Cash in escrow

A relatively immature closed scheme is heavily invested in equities.

As part of the scheme’s triennial valuation, the trustees engage independent covenant advisers to assess the level of the covenant support provided to the scheme by the sole participating employer. The trustees conclude that the covenant support has weakened since the last triennial valuation. Due to a decline in free cash flow, the level of investment risk being run is no longer supportable and the trustees are therefore considering de-risking.

However, given the immaturity of the scheme, the employer has requested that the trustees consider maintaining their existing investment strategy over the long term. The employer proposes that the existing investment strategy is maintained in exchange for the employer's parent paying additional contributions into an escrow account. The contributions would be equal to the difference in an appropriate value at risk (VaR) between the existing investment strategy and the de-risked one favoured by the trustees, and would be made when the investment strategy is agreed. The experienced funding level would be compared to the expected funding level had the trustees pursued their original de-risking plans. This measurement would be carried out annually and upon insolvency of the employer, but would only trigger a true-up payment where the experienced funding level is below the expected projection at the triannual valuation (or at insolvency).

Application of the guidance

The trustees seek legal advice on the matter above, and this confirms that they will be able to access the cash in the escrow at the earlier of the following dates:

• at the next triennial valuation date, or any valuation dates following that, when the experienced investment performance will be measured against the expected projection had the trustees pursed their de-risking plans
• on insolvency of the participating employer, assuming the experienced funding level is below the expected projection

Based on the above and the certainty over the value of the asset (given the additional contributions will be paid into the escrow account at the time of agreeing the investment strategy), the trustees agree that the cash in escrow can be used to take additional investment risk, beyond what would be supported by the employer's cash flow in isolation. They therefore agree to maintain their existing investment strategy.

Example 2: Property used as security

As part of the scheme’s triennial valuation, the trustees are asked to take additional funding risk, beyond what is supportable from employer cash flows, of £25 million, in exchange for security over one of the employer’s factories.

The employer proposes to cover the cost of an independent valuation of the property every three years (in line with the triennial valuation process). Management will also provide annual confirmation, following the audit of the employer’s financial accounts, that, to the best of their knowledge, the value of the property has not materially changed and is not expected to in the next 12 months.

Application of the guidance

After taking legal and covenant advice, the trustees note to management that they have concerns in relation to the certainty of the value of the asset and ability to access it, should that be needed. This is because the factory proposed as security has a unique layout, and its value is reliant on the continued use by the employer. The trustees also recognise that the most likely scenario in which they will call on this security is if the employer was placed into insolvency proceedings. Therefore, any valuations of the asset needs to be on an insolvency basis.

After thoroughly discussing the matter, management and trustees agree that the security should be provided by an unencumbered, liquid investment property of the employer generating rental income from third parties and not used by the core-operations of the business. This security is, therefore, unlikely to negatively impact the employer’s ongoing covenant if it was called upon, and its value is unlikely to be materially negatively impacted by an insolvency of the employer.

In the context above, legal advice confirms that the trustees can access the value and sell the property in case of any missing DRC payments, downside investment event that the employer would not be able to fund, or insolvency of the employer. In addition, the value of the property has been independently confirmed to be £29 million under a forced sale, so sufficient to cover the risk it supports with a level of headroom.

The trustees agree to the revised security proposal to cover the additional risk, subject to the following.

• The independent valuation of the property every three years, sourced and paid by the employer, been undertaken by a reputable real estate agency, and including a duty of care from the valuer to the trustees.
• The above valuation as well as management annual confirmation that the value of the property has not, or is not expected to, materially change in the next 12 months, to be coupled with more frequent reviews of indicators that could suggest the asset’s value has declined (for example a decline in property prices in the area or a deterioration in the property’s state of repair).
• Any deterioration in the valuation below £26 million (ie £1 million above the £25 million minimum value required to cover the higher additional funding risk) to require the employer to put cash into the scheme for an equal amount, unless an alternative arrangement is agreed between both parties.

Valuing guarantees

Guarantees from related and third parties, such as parent or group companies, provide a scheme with legal recourse to a party other than its employer in a pre-defined situation (eg non-payment of obligations to the scheme by the employer).

Often, guarantees are provided to schemes to mitigate for a deterioration in covenant following a transaction or event (such as a group reorganisation or other corporate activity). However, they can also be used to support additional risk taking, provided the guarantee meets the relevant criteria set out in our DB funding code.

Depending on the terms and conditions of the guarantee, other benefits could include the following.

• Improving the scheme’s access to cash, provided a formal look through to the guarantor’s affordability is given.
• Improving the scheme’s return on insolvency, where an underpin (for example, up to the section 75 deficit) is provided.
• Strengthening the employer’s prospect assessment, given it can incentivise the group not to allow the employer to fail, or can deter any detrimental corporate actions, if such events were to trigger payment under the guarantee.
• Diversifying covenant risk away from just the employer(s).
• Providing trustees with early insight into group-wide events that could directly or indirectly impact the strength of the covenant.
• Giving trustees a seat at the table during negotiations along with other creditors of the employer or guarantor.
• Reducing the scheme’s annual PPF levy contributions (where the guarantee is PPF compliant and where the scheme is in PPF deficit).

Although this guidance focuses on how to assess if a guarantee is sufficient to take additional funding and investment risk, this should not detract from the other benefits set out above.

Look through guarantees

Paragraphs 42 and 43 of the Employer covenant section of the code states:

"Some guarantees are structured in such a way that they largely replicate the obligations placed on a statutory employer. This includes providing a formal look through to the guarantor for affordability purposes. These guarantees provide an ability for trustees to claim against the guarantor in respect of all monies owed by the employer to the scheme without restrictions or qualifications once a trigger event has taken place. They cannot be revoked without trustee agreement. These are referred to as 'look through' guarantees.

Where trustees benefit from a look through guarantee, when assessing the employer covenant, they should assess the guarantor’s financial ability to support the scheme as if it was a statutory employer."

While our code purely refers to a guarantee, in practice it may be easier to document the requirements of a ‘look through’ guarantee across more than one legal agreement. To meet the requirements of a ‘look through’ guarantee, you must be comfortable that the framework of agreements allows for the following.

• An underpin for the full section 75 deficit.
• Missed DRCs under the terms of the schedule of contributions.
• A legal mechanism enabling you to look through to the guarantor’s cashflows when setting contributions. If this is absent, yours and our powers are restricted to looking at the affordability of the statutory employer(s) on a standalone basis.
• No time limitations (referred to as evergreen).
• No onerous conditions attached that could compromise yours or our powers.
• Legally enforceability both in the UK and any relevant overseas jurisdictions. This should be supported by appropriate legal advice.
• An information sharing protocol, which ensures you can monitor the strength of the guarantor.

Enhancements can be made to a guarantee, and its supporting agreements, so that it meets the look through criteria set out above by entering into a legally binding separate agreement or side letter arrangement.

If you are uncertain that an existing guarantee meets the look through criteria, or that it has been documented appropriately, you should seek professional legal advice.

Where you are taking significant additional risk based on the guarantor, and/or there are concerns about the prospects of the guarantor and its ability to meet any future requirements of the scheme, you should consider including appropriate trigger-based provisions. These would need to be undertaken by the guarantor (for example, providing cash or security) if pre-agreed thresholds are breached. For example, trigger-based provisions could be linked to a decline in the assessed value or credit rating of the guarantor.

Guarantee with a formal look through, but with no insolvency underpin

A guarantee may include a formal look through to the affordability of the guarantor, but not provide an insolvency underpin to cover the full section 75 deficit of the scheme.

Where such a guarantee is in place, it is likely to only be reasonable for the guarantor’s cash flows to be assessed and considered for the purpose of determining reasonable affordability and to set the recovery plan. But it is unlikely to be reasonable for the guarantor’s cash flows to be assessed and considered for the purpose of supportable risk when setting a scheme’s journey plan.

As the guarantee does not include the underpin in an insolvency scenario or the wider clauses set out under the look through guarantee, there are several key risks that the scheme would remain exposed to when compared to a full look through guarantee which meets all the criteria above. These risks include the following.

• There would be no legal ramifications to the guarantor if the employer becomes insolvent. The guarantor would have no obligation to pay the section 75 debt that would crystallise on the insolvency of the employer.
• The guarantor, depending upon the legal arrangements of the guarantee, could exit the guarantee, leaving the scheme with a level of funding and investment risk that is unsupportable by the scheme employer. If a scheme stress event has occurred between the guarantee being put in place (and therefore a higher risk investment strategy being implemented) and the guarantor exiting the guarantee, the scheme could be in a worse position than if the guarantee had never been in place.
• There is insufficient legally binding funding support in place from the guarantor for the scheme to support its journey to a low dependency funding basis.

Guarantees that do not meet the look through criteria

Paragraphs 44 and 45 of the Employer covenant section of the code states:

“However, if a guarantee doesn’t meet the criteria of a look through guarantee, trustees should determine the level of support a guarantee can provide by considering the following factors.

1. The guaranteed amount (including whether the amount is capped and, where the amount is calculated by reference to the scheme’s funding position on a particular basis, how that funding position may develop over time).
2. The duration of the guarantee and any termination clauses.
3. The circumstances in which a claim can be made under the guarantee (or, where the guarantee provides for a variety of triggers, the most likely scenario in which the guarantee would be called upon).
4. The guarantor’s financial ability to provide that support at the time it may be required.

Generally, we expect the level of reliance trustees place on a guarantee that can only be triggered by an unexpected future event, such as employer insolvency, to reduce the more unlikely the event is, unless trustees can demonstrate with reasonable certainty what value would flow to the scheme.”

If a guarantee does not meet the criteria of a look through guarantee, you cannot treat the guarantor as if it were a statutory employer when assessing the employer covenant. However – provided you can evidence that it is legally enforceable, and you can ascribe a value with reasonable certainty to the level of support it can provide when required – this value can be factored into your assessment of supportable risk.

You should consider the following factors when ascribing a value to a non-look through guarantee.

The scheme’s legal access to the guarantor as determined by the terms and conditions of the guarantee and any associated legal agreements, including the following.

• The amount covered under the guarantee in the event of insolvency (eg amount, floating or capped, reducing value by contributions made).
• The duration of the guarantee (eg time-limited or evergreen) and any termination clauses (eg where a guarantee may fall away if the guarantor were to stop being the ultimate shareholder of the employer(s)).
• Whether the guarantee covers missed DRCs under the schedule of contributions.
• Any legal mechanism that enables trustees to consider the guarantor’s cashflows when setting contributions (referred to as a 'look through to affordability').
• Any restrictive conditions attached (eg by accepting the guarantee, your powers or TPR’s powers are weakened).
• Any triggers attached to accessing value from the guarantor pre-insolvency (eg contingent contributions from the guarantor linked to the scheme funding level before an insolvency event) including the regularity of testing the triggers (at least annually and on termination of the guarantee).
• Any triggers attached to accessing value from the guarantor after insolvency (eg, at what point and under what conditions can a claim be made after insolvency? For example, do recoveries need to be realised against the participating employers before any payment from the guarantor?).
• Any 'keep well' provisions to protect against a weakening of the guarantor’s position, which could lead to a lower recovery from the underpin when called upon in the future. These are normally linked to a deterioration in key financial metrics (such as EBITDA or debt levels) or external credit ratings, and can trigger the provision of cash, additional security or further group guarantees.
• Any legal enforceability and jurisdictional issues (eg any difficulties in accessing value abroad when required or hardening off periods). This may require further legal documents or underpin for additional benefits.

The guarantor’s financial ability to provide the specified level of support when required. As part of this you should consider the following.

• The guarantor’s cash flow position and affordability relative to its obligations under the guarantee. Typically, the guarantor’s affordability should only be considered if the scheme has access to the guarantor’s cashflows and/or liquidity via a formal look through agreement.
• The expected realisable value on any insolvency underpin.
• The prospects of the guarantor, to the extent this may impact the trustee’s assessment of a. and b. above. Read Prospects to understand how this can be assessed.

Further guidance is set out below to assist you in ascribing a value to guarantees providing an insolvency underpin.

Because guarantees can vary significantly based on their terms and conditions, and as ascribing a value to a guarantee is often complex, it is important to seek professional advice where you feel you do not have the relevant skills and expertise to assess this yourself.

You or your professional advisers should reassess the value ascribed to a guarantee at least every triennial valuation where it is supporting additional risk, with regular monitoring of the guarantor's performance and position in between valuations.

Assessing the reasonable certainty of the insolvency value

There are a number of approaches to estimate the value that would flow to the scheme in an insolvency situation, including but not limited to entity priority models, estimated outcome statement models, credit rating agency analysis and other loss given default models.

This guidance intentionally does not define which model, nor what level of detail, is appropriate when assessing the reasonable certainty of such values, as these will vary in accordance with the specific circumstances of the scheme and employer. This is a complex area and will require professional judgement and expertise.

Valuing an insolvency underpin

To place reliance on an insolvency underpin, you will need to have reasonable certainty of the value that would flow to the scheme in an insolvency situation. Factors to consider as part of this assessment include the following.

1. Whether there is a ‘keep well’ agreement: An employer or guarantor’s capital structure and balance sheet position can quickly change during times of stress and distress. This is particularly common in the run up to insolvency, where liquidity is likely to be constrained, and the asset base may be depleted by borrowing against assets or liquidating them to raise cash. This introduces a significant level of uncertainty over the potential recovery of any underpin. Such uncertainty can be significantly reduced if the guarantee contains a suitable 'keep well' clause or separate keep well agreement.
   
   If no keep well clause or agreement exists, you should limit additional risk to the support you can be reasonably certain will be available when required. This is likely to be hard to evidence if an insolvency is unlikely to occur in the short term, due to the uncertainty of how the guarantor’s financial position might look at the potential insolvency event.
   
   
2. What the most likely insolvency scenario is, and when it is most likely to happen: Typically, there are two scenarios where an insolvency underpin will be called upon: an employer-only insolvency, or group-wide insolvency.
   
   • An employer-only insolvency: If the guarantor is deemed highly likely to remain a going concern even if the employer fails, it is reasonable for you to place value on this underpin as long as you can evidence with reasonable confidence what value would flow to the scheme when required. When assessing this, you should also consider the likely timing of an insolvency event, and if it would trigger other obligations on the guarantor including (but not limited to) cross guarantees on bank debt and / or guarantees provided to other DB schemes.
   • Group wide insolvency: If it is reasonably likely that a failure of the employer would lead to the failure of the guarantor, or where both are reasonably likely to fail due to similar factors (eg a market disruption, or reliance on intergroup funding), it is often very difficult to determine with reasonable certainty what value would be recovered from the guarantor. While a ‘keep well’ agreement will aid your assessment, there will be scenarios where you still conclude you cannot be reasonably confident of the recoverable value of the underpin.
     
     
3. What existing secured and unsecured commitments the guarantor has and how this will impact the estimated return to the scheme under the most likely insolvency scenario.
   
   • When considering the value to attribute to a guarantor’s underpin, you must also be mindful of structural subordination.
   • Structural subordination describes a creditor’s position and priority (including that of the scheme) to access value compared to other creditors in a group, based on the secured or unsecured nature of its claim, and where it is in the organisational structure. Please refer to the Prospects section for more detail on structural subordination.

Even if you are not able to place reliance on an insolvency underpin guarantee as outlined above, this type of guarantee is likely to provide other benefits for the scheme, as set out earlier in this section.

Example 3: impact of different types of guarantees on limited covenant support

As part of the scheme’s triennial valuation, the trustees obtain independent covenant advice that assesses the employer covenant support as limited. This is based on the following:

• Cash: the employer generates limited cash flow and has limited liquid assets, which means that affordability is significantly constrained.
• Contingent asset support: the employer has limited net assets, and the scheme has no legal security over any of the employer or wider group’s assets. No other contingent asset arrangements are in place.
• Prospects: The employer operates in a niche market segment with challenging prospects. As a result, the reliable period of available cash is limited to a period of three years. Despite the expectation that the covenant will continue to deteriorate over the medium to long term, insolvency is currently deemed unlikely over the medium term.

Given the covenant support limitations, the trustees conclude that supportable risk is limited. In this context, and given the employer’s constrained affordability, the trustees may have no option but to accept a 15-year recovery plan, which is beyond the period of reliability. However, they would agree this recovery plan only on the understanding that the scheme will be treated equitably in relation to other stakeholders and there will be no covenant leakage.

During scheme funding negotiations, the employer’s group agrees to provide a legally binding guarantee from a trading group entity. This entity has significant cash flows and a balance sheet with significant net assets relative to the size of the scheme.

The proposed guarantor operates in the same market sector as the statutory employer. However, it has a much larger diversification of activity and operates across multiple geographical regions. In addition, the guarantor operates the group’s research and development and holds the intellectual property and trademarks.

The trustees have taken independent covenant advice, which concludes the guarantor would be able to support materially greater risk than the statutory employer given its access to larger cash flows and its stronger prospects. However, the extent of additional risk that the scheme can take based on the provision of the guarantee is highly dependent on the legal terms of the guarantee.

The trustees do not have the unilateral power to set contributions or wind up the scheme.

The following scenarios explore some different proposals and outcomes.

Scenario 1: Providing a full ‘look through’ guarantee

The group proposes a guarantee that meets all the look through criteria (as set out in this section) and includes an underpin for the full section 75 deficit.

Outcome:

By providing a full look through guarantee, the trustees can factor in the guarantor’s covenant when setting the scheme’s journey plan and recovery plan.

As the guarantor has higher cash flows and better prospects, the trustees can rely on higher maximum affordable contributions and a longer reliability period when assessing the level of supportable risk to factor into the scheme’s journey plan. Given more risk is supportable, the scheme’s actuary concludes that the scheme’s TPs deficit is lower than originally calculated.

The scheme also benefits from greater access to available cash when setting the recovery plan, which leads to a material reduction in the overall recovery plan length.

Scenario 2: Provision of a section 75 PPF-compliant guarantee with no look through to affordability

In this example, the group proposes to provide the trustees with an evergreen guarantee that covers the section 75 deficit at the point of insolvency, as well as any missed DRCs. Although this is PPF-compliant, it does not offer a formal look through to the guarantor for affordability purposes. There are no pre-insolvency triggers proposed, or a keep well agreement in place.

Outcome:

The trustees commission advice to determine the most likely scenario where the guarantee would be called upon and, based on this scenario, the value that would flow to the scheme from having the section 75 underpin.

The outcome of this assessment concluded that the most likely scenario would be a group-wide insolvency. While the value of the guarantor's balance sheet can currently support the section 75 deficit, it is likely to deteriorate significantly before an insolvency event. The covenant adviser also notes it is unlikely the scheme will obtain access to this underpin in the short to medium term, as the employer is unlikely to go insolvent during this period.

Based on the above analysis, the covenant adviser concludes that it is difficult to estimate with reasonable certainty the value that would flow to the scheme in this scenario. Therefore, although such a guarantee would provide strategic benefits – such as a seat at the negotiating table in case of corporate activity, an additional claim for the section 75 debt in an insolvency scenario improving recoveries, early access to news related to corporate events and stronger employer’s prospects – the trustees decide not to rely on the guarantee to support taking additional risk within the scheme’s journey plan.

In these circumstances and without any formal look through to the guarantor’s affordability, the trustees must rely solely on the employer’s available cash when considering the scheme’s funding and investment risks, and when setting an appropriate recovery plan. Therefore, the recovery plan remains at 15 years.

Note: Although this form of guarantee (and that set out in scenario 4) should not support additional risk-taking, it can be very valuable to a scheme. This is particularly true where the employer has a higher chance of defaulting on DRCs or entering insolvency proceedings. In addition, such guarantees may also be useful in providing the trustees with certain strategic benefits, as noted in the example above (please see the valuing an insolvency underpin section above for more detail).

Scenario 3: Providing a section 75 PPF-compliant guarantee but with a keep well agreement

The group proposes a similar guarantee to that set out in scenario 2. However, they also include a keep well agreement linked to key financial metrics of the guarantor. If the metrics deteriorate below set thresholds, guarantees will be provided by further, material group entities to restore the overall financial support available to the scheme through the new guarantees. Alternatively, in case such entities did not exist at the time required, a cash injection equal to the section 75 debt will be made into an escrow account in favour of the scheme.

Outcome:

Providing a keep well agreement means a deterioration in the guarantor’s identified key financial metrics beyond the set thresholds will be offset by gaining access to other group entities (via further guarantees) or an escrow account with adequate liquidity, restoring the required financial support.

The scheme’s covenant adviser reviews the balance sheet of the guarantor and other proposed entities, and assesses how this access to value may change following a group-wide insolvency – all based on the information available at the time. They conclude with reasonable certainty that the scheme will be able to recover at least 75% of the value of the section 75 guarantee in a group insolvency scenario.

The trustees are therefore comfortable attributing some additional value to the guarantee when assessing the level of supportable risk within the scheme’s journey plan, while being aware that the cash provided by the guarantee cannot be accessed during the reliability period without an insolvency event triggering it. This means the scheme can take a modest amount of additional risk over the reliability period, which reduces the TPs deficit.

As the scheme has no formal look through to the guarantor’s affordability, the trustees must continue to rely solely on the employer’s available cash when setting the scheme’s recovery plan. However, given the TPs deficit is smaller, the recovery plan length can be reduced.

Scenario 4: Providing a TPs guarantee with no look through to affordability

The group proposes to provide the trustees with a guarantee that covers the current TPs deficit, as well as any missed DRCs. There is no look through to the guarantor for affordability purposes or pre-insolvency triggers. However, there is a keep well clause.

Outcome:

Even though the guarantor can currently support the scheme’s TPs deficit in full, as this represents only a small proportion of the full section 75 deficit, the trustees conclude that it would be disproportionate to carry out any insolvency analysis at this stage. Given this, they conclude that the underpin is insufficient to support any additional risk-taking in the scheme’s journey plan. They also remain reliant on the employer’s available cash when setting a recovery plan and, therefore, this remains at 15 years.

Scenario 5: Providing a section 75 guarantee which is time limited and has a look through to affordability

The group proposes to provide the trustees with a six-year guarantee that covers up to the full section 75 deficit, any missed DRCs, and provides a look through to the guarantor’s affordability when setting contributions.

Outcome:

Given it is unlikely that the employer will go insolvent over the next six years (ie the lifespan of the guarantee), the trustees felt it disproportionate to carry out any insolvency analysis at this stage, and, therefore, concluded that no value should be attributed to the guarantor’s underpin when assessing supportable risk.

However, as the guarantee provides a time-limited look through to the guarantor’s affordability, the trustees also needed to decide whether they wanted to include the guarantor’s additional cash flows in their assessment of maximum supportable contributions for the six-year period they have access to them.

Following a discussion with their covenant advisers, the trustees concluded that, under the current terms of the guarantee, they would not be comfortable using these additional cash flows to take more risk in the journey plan, as this could put the scheme in a potentially worse and more risky position at the point the guarantee expires compared to if the guarantee had not been factored into the supportable risk assessment.

Having presented their conclusions to the employer, the employer offered to enhance the terms of the guarantee by providing a keep well provision and a legally binding pre-insolvency trigger. These additional elements would ensure the scheme would receive an additional cash payment (above those agreed under the recovery plan) from the guarantor if there was a shortfall in expected versus experienced scheme asset investment performance when the guarantee expires, or, if earlier, the keep well provision or pre-insolvency trigger is met, or the employer enters insolvency. This would protect the scheme from being in a worse position following the expiry of the guarantee, or if the other three relevant events outlined above crystallised, than if it had not entered into it.

Given the cash rich nature of the guarantor, the trustees and their advisers concluded that the guarantor would be good for the money if any payment was triggered. They therefore agreed to factor the guarantor’s cash flows into their assessment of supportable risk for the guarantee period. This enabled the scheme to justify taking more risk in the scheme’s journey plan until the expiry date of the guarantee, and therefore reduced the scheme’s overall TPs deficit.

As the trustees were also able to factor in the guarantor’s available cash into their affordability assessment when setting a recovery plan, annual DRCs could be higher and the length of the recovery plan shorter.

Example 4: Impact of a guarantee and other legally binding commitment on reliability

The scheme is sponsored by a single employer, which is part of a much wider group. The scheme does not have any contingent assets in place.

The employer represents 5% of the group’s trading and cash flows, and operates only in the UK market where it offers two products. Its recent performance has been volatile, but the overall profit and cash generation were positive over the last three years. The employer has no external debt, but its balance sheet is modest in size, and mainly represented by investment in subsidiaries and account receivables. Management’s five-year forecasts show an improving trading and cash flow over the next two years, then stabilising from year three, given certain challenges expected at that time.

The group is a large corporate, with global operations and a variety of products in different sectors. It has been increasingly profitable and cash generative over the last five years, and management and market analysts expect this trend to continue over the next seven years, with no foreseeable material risks beyond that.

The scheme is undertaking a triennial valuation, and the trustees seek independent covenant advice to inform their considerations. This concludes that the period of reliability is between four and seven years, but uncertainty over cash flow increases after year four. The covenant adviser also notes that the wider group would be able to provide material, additional covenant support to the scheme, given its size compared to the scheme and its prospects. However, this cannot be factored into supportable risk considerations due to the absence of formal support to the scheme.

Based on their assessment, the trustees propose a four-year recovery plan to the employer, which, based on the covenant advice, is in line with reasonable affordability.

The group would like to spread DRC payments over the next seven years, due to additional reasonable alternative uses of cash they have identified, and, during negotiation with the trustees, offers an evergreen section 75 guarantee from topco.

Application of the guidance

The covenant adviser notes to the trustees that the proposed section 75 guarantee would provide the scheme with a legally binding access to a material group with significant cash flows and balance sheet, potentially improving the covenant support. However, the scheme is unlikely to obtain access to this underpin in the short to medium term, given the employer is unlikely to go insolvent during this period.

Despite this limitation to the access, with the addition of this section 75 guarantee support provided by topco, the trustees consider it more reasonable for them to conclude on a reliability period of seven years, at the top end of the range assessed by their covenant adviser. The trustees, therefore, are comfortable to agree to a seven-year recovery plan. This, and considering the additional reasonable alternative uses identified by management, means this recovery plan length is deemed to be in line with reasonable affordability.

Third-party guarantees

Where a scheme has a guarantee with a third party or entity that is no longer part of the employer’s group, we would expect you to consider the same factors as if the guarantee was provided by a parent or group entity when assessing the level of reliance that can be placed on the guarantee for scheme funding and investment purposes. This includes considering the scheme’s legal access to the guarantor and the guarantor's financial ability to support the scheme when that support may be needed.

Alignment with the PPF certification process

Annual PPF levy costs can be reduced by putting in place a compliant contingent asset. In the case of Type A contingent assets where a reduction in levy of £100,000 or more is expected, the PPF requires a professional report on the strength of the guarantor. The frequency of levy calculations and contingent asset certification results in the risk to the PPF being very short-term.

Conversely, the funding and notional investment risk factored into the scheme’s journey plan can persist for many years until the scheme reaches significant maturity.

Because of the different risk profiles, trustees should be mindful of the differences in how the PPF proposes trustees consider contingent assets for PPF certification purposes compared to our approach for valuing contingent assets for scheme funding purposes. For example, where a scheme has an insolvency guarantee from a group entity, we would expect trustees to place limited weighting on the underpin in a group-wide insolvency scenario, unless the trustees can demonstrate with reasonable certainty what value would flow to the scheme. Although this approach may appear similar to the PPF’s methodology, under our methodology trustees must consider when such an event is likely to arise over the long term.

Where insolvency is imminent, the insolvency dividend can be demonstrated with greater reliability. This approach is broadly aligned to the PPF’s methodology given this is reassessed every 12 months. However, where an insolvency is more remote, under our methodology, trustees are less likely to be able to demonstrate with reasonable certainty what the insolvency dividend would be. This reflects the increasing inherent uncertainty trustees and their advisers may have over what the guarantor’s balance sheet position may look like at the point of insolvency, and the likely recoverability of any assets at that point in time.

Valuing related or third-party contingent funding mechanisms

Contingent funding mechanisms allow for additional cash to be paid into the scheme based upon pre-agreed triggers. Where these arrangements are legally binding and provided by a related or third party (rather than from the employer), it may be reasonable for some or all these potential payments to be used to support additional risk-taking when setting the scheme’s journey plan, depending on the legal terms of the specific mechanism.

These arrangements can form part of a separate agreement with a third party, or be included as part of a wider guarantee agreement.

Importantly, any triggers should provide the scheme with access to value in advance of an insolvency of the employer. They can sometimes be referred to as 'pre-insolvency triggers'.

Although there can be many types of pre-insolvency triggers, particularly valuable trigger events would be where a deterioration in funding level or certain covenant dynamics trigger a set level of payments to be made into the scheme to improve it to a pre-defined position.

The factors you should consider when determining what value should be attributed to a related or third-party contingent funding mechanism within your assessment of supportable risk are set out in the code extract below.

Paragraph 47 of the Employer covenant section of the code states:

"When determining the level of support a related or third-party contingent funding mechanism can provide, trustees should consider the following factors:

1. the quantum of the agreed payments
2. the circumstances in which the scheme will have access to these payments (we would expect a trigger event to provide access to value in advance of an employer insolvency)
3. the likelihood of the additional payments being triggered
4. the third-party’s financial ability to make the payments when required"

Although there may be benefits from having a contingent funding mechanism directly with your employer, it is important that these arrangements are not factored into your supportable risk assessment in the same way as a third-party contingent funding arrangement. This helps to avoid double counting, given an employer’s cash flow is already factored into your calculation of maximum supportable contributions, which also forms part of your supportable risk assessment.

Likewise, you should be mindful of double counting where such arrangements are provided by another party (such as a look through guarantor) whose cash position is already factored into your assessment of maximum affordable contributions or supports the value ascribed to another contingent asset within your supportable risk assessment.

Example 5: Pre-insolvency trigger linked to credit ratings

A group would like the trustees to take higher investment risk and proposes putting in place an evergreen contingent funding mechanism linked to the employer’s investment grade credit rating.

The group proposes that if the employer’s credit rating deteriorates to one rating before default, the parent entity (who is not an employer of the scheme) will make a payment into the scheme that will bring it up to being fully funded on its long-term objective.

Application of the guidance

The trustees note that the trigger for any pre-insolvency payment would require several credit rating downgrades to occur, and at the point it hits the trigger, the parent entity as well as the employer is likely to be in a very distressed position. Therefore, the trustee is unable to take a view with any reasonable certainty that the parent entity would be able to make the payment at that time.

After taking covenant advice on the matter, the trustee put forward a counter proposal which sets the trigger at a higher credit rating. If the credit rating deteriorates to the last investment grade rating, which is considered to be early enough to maintain reasonable certainty, the parent entity would have sufficient funds to make any payments required at that time. This may allow the trustees to consider the potential pre-insolvency payment as part of their wider investment and funding considerations.

Other arrangements used to improve scheme security

There are many types of arrangements that can help improve scheme security and reduce scheme risk, in addition to the types of contingent assets discussed previously within this section.

We recognise that such arrangements can be highly valuable to a scheme. However, depending upon the specifics of how these arrangements are structured, some may be difficult to value and others may not always be covenant-enhancing like more common contingent assets. Instead, they may go towards maintaining the existing level of covenant strength and prospects.

You will need to assess the benefits of other arrangements to improve scheme security, including the likelihood that these will trigger a payment into the scheme when needed, and whether a quantified value can be placed upon the arrangements with reasonable certainty. Where this is not possible, we do not expect you to use these arrangements to support additional risk.

Other types of arrangement that may improve scheme security include the following.

• Negative pledges: This is where an employer commits not to perform certain acts without the prior agreement of trustees, such as granting security over assets or extracting value from the employer (eg through dividends). Where there is a legally binding consequence attached, trustees might take some comfort that negative pledges protect the employer covenant. However, they do not directly enhance it, and we would not expect any additional risk to be taken because of a negative pledge being in place.
• Employer performance-linked contingent contributions: This includes performance-linked contribution mechanisms such as 'profit sharing' agreements and dividend matching policies. These can be of material value to schemes, and we encourage trustees to seek such arrangements, particularly where recovery plans are long. Such arrangements can also be an effective way of maintaining equitable treatment with other creditors. However, they do not provide downside support for a scheme in the way that security or a group guarantee can provide. We would not expect trustees to take additional risk based upon them in isolation.
• Improving the scheme’s insolvency priority: As an alternative to obtaining direct security, trustees can seek to improve their insolvency position by entering into a creditor subordination agreement or intercreditor agreement that subordinates competing creditors. This option is normally used to subordinate intercompany creditors. It will therefore only be available to schemes whose employer(s) are part of a wider group and will only provide value where the employer(s) has material intercompany creditor balances. Such arrangements do not protect against asset erosion in the run up to insolvency, which will diminish any return to the scheme. We do not expect such arrangements to support additional risk in the scheme.
• Amending the scheme’s trust deed and rules: Such amendments include making each employer to a multi-employer scheme jointly and severally liable, or increasing the trustee powers by providing them with the unilateral power to set contributions or wind up the scheme. These powers can be valuable and provide leverage when setting DRCs. However, it is very rare for such amendments to be made, and often it is an option of last resort to use these powers (with very few situations arising where trustees have done so historically).

We may revise the covenant guidance when needed and include industry feedback. Send comments or queries about the new guidance to covenantguidance@tpr.gov.uk.

Back to top

Is this page useful?