Real Estate Executive Report: January 2011 - Part 2

Using real estate to address the deficit

The economic downturn has resulted in reduced profits and cashflows for many companies. This weakening of employer covenants in the eyes of pension scheme trustees' has in turn led to higher funding targets and requests by trustees for larger cash contributions. Understandably, companies have been keen to consider alternative funding structures to help meet their obligations. There has been an increasing focus, as a result, on the use of guarantees, pledges over assets and other forms of contingent assets to help satisfy trustees.

More recently, structures that provide schemes with an investment, backed by valuable and income producing group assets, have proved very attractive to corporates and trustees alike.

To date asset backed funding structures have been implemented by a range of companies, including Whitbread, Marks & Spencer and Sainsbury's (all using property assets), amongst others.

The various structures implemented to date have funded more than £2 billion of aggregate deficit with predictions that this trend will continue to gain momentum.

A key factor when considering alternatives to cash funding is the balance of complexity with the effectiveness of the option in addressing scheme funding (both for recovery plan and Pension Protection Fund (PPF) levy purposes).

The key alternatives fall into three broad categories:

1. Contingent arrangements such as parent guarantees or legal charges, may help trustees to accept longer but entirely cash funded recovery plans. These structures however, do not enable the scheme to recognise a plan asset and there is no immediate improvement to scheme funding.

2. Direct asset funding structures, on the other hand, do transfer real value to schemes. Property can be sold or transferred directly to a scheme and recognised as a plan asset and the corporate can benefit from tax relief on the value of the contribution, just as it would do with a cash contribution. However, in doing so, the company loses control of the asset – along with any potential profit and loss benefit on future uplift in value – which may prejudice future operational flexibility.

3. Asset backed funding structures such as those mentioned above, albeit more complex, can immediately repair a significant proportion of scheme deficits. At the same time they can reduce PPF levies, build in protection against future overfunding of the scheme, and help to reach agreement on a wider recovery plan by utilising 'lazy' unencumbered balance sheet assets in a manner which may previously have required bank involvement e.g. through debt financing or sale and leasebacks – and with the additional costs and fees that those options would entail. The corporate retains operational flexibility and achieves an affordable cashflow profile.

Putting real estate to work

Asset backed funding structures involve the sponsoring employer group establishing some form of special purpose vehicle, commonly in a form of limited partnership, into which group assets such as real estate, would be transferred. The limited partnership leases the assets back to an operating company within the group for a market rate rent. The partnership owns the valuable assets in its own name, ring-fencing the assets from the wider corporate group and its creditors.

The corporate group would then make a monetary contribution to the pension scheme and the scheme would make an investment into the limited partnership.

Cash efficient profile

The pension scheme would be entitled to an annual share of the partnership income profits over a period – say 15 to 20 years, effectively equating to a valuable bond-like investment, backed by assets, that pays an attractive coupon over the term of the structure.

The scheme would also be entitled to a capital sum at the end of the term of the structure; the corporate group would retain the rights to future capital profits, in addition to operational control and flexibility, and the right to substitute assets. However, the value of the assets held by the partnership would need to be sufficient to ensure enough profits are made by the partnership to pay the annual income share to the trustee and to provide adequate collateral to support the upfront value of the investment that the trustees have made in the partnership, should the sponsoring employer find themselves in a distressed situation.

Enhanced protection for trustees

The partnership investment held by the scheme is backed by group assets that have independent, third party resale value, providing the trustee enhanced protection, should the sponsor covenant weaken or, in the worst case, the sponsoring employer become insolvent.

The limited partnership takes legal title to the assets, ring-fencing them from other creditors of the group. Trustees recognise that as a result their security position is significantly improved compared to a conventional cash based funding plan. This can help them to be more receptive to other requests of the corporate for example, in agreeing to wider changes to member benefits.

It is of course, important to consider how this structure interacts with group banking arrangements, however, the structures are typically viewed in a positive light given the company is proactively addressing the deficit whilst improving cashflows within the business. The trustees also need to ensure that they are happy that the structure does not breach restrictions on employer related investments and investment diversity. Guidance has recently been published by the Pensions Regulator to help trustees in this area.

Choice of assets

In principle, the range of assets can include almost anything, provided they have independent value and can generate an income stream.

Real estate is the most obvious choice and its tangible nature makes it easier for trustees to understand. That being said, more esoteric assets such as intellectual property, receivables or stock such as whisky in one structure are increasingly being considered.

No change to accounting and tax profile

Whilst the accounting treatment of the structures may vary depending on the particular commercial arrangements made with the pension scheme, they often have no impact...