Funding improvements mean sponsors and trustees may now be looking at how best to avoid trapped surpluses
Law Debenture pension trustee director James Rickards and Dentons partner Carolyn Saunders look at the use of escrow to solve problems such as trapped surplus, facilitate buy-in/buyout, and how it can be utilised as an effective tool for insurance transactions.
Over the past few years many schemes (particularly those who used leveraged liability-driven investment portfolios) have seen significant improvements in their funding levels caused by rising gilt yields and, by extension, higher discount rates.
This has meant sponsors and trustees may now be exploring an insurance transaction or looking at avoiding a trapped surplus, which attracts tax consequences if returned to the sponsor. This raises questions of where sponsors and trustees can ‘park' money so it does not sit in the scheme, and therefore become trapped, but is available to trustees if certain conditions are met - perhaps to use as an indemnity of last resort or for expenses - and returned to the sponsor if not. An escrow can frequently solve this dilemma.
At its most simple an escrow is a tri-partite arrangement between two parties and the escrow agent requiring the escrow agent to hold cash (typically) pending the outcome of a future event, upon the occurrence of which the parties will jointly instruct the escrow agent where the cash is to be transferred.
The classic example is in an M&A transaction, where a portion of the purchase price might be held in escrow for a period of time, whilst certain commercial contingencies play out to determine whether amounts withheld at closing should be paid to the seller or given back to the buyer. In addition to M&A there are a wide range of other uses for such arrangements. As noted above one particularly topical use of escrows is assisting sponsors avoiding a trapped surplus in their scheme.
Rather than fund the scheme directly the funds are paid to the escrow agent and, will often sit in an interest bearing account in cash, placed on deposit or be invested in money market funds. As the gatekeeper to the account the escrow agent will only pay out to the scheme on the instructions of the relevant parties if certain triggers are met and vice versa with respect to the sponsor e.g. if the scheme funding levels fall beneath an agreed amount (money flows to the scheme) or funding levels increase beyond a certain amount (money flows to the sponsor). Escrows can also be used in an insurance transaction.
For instance rather than purchase expensive (and often non-responsive) residual risk insurance a sum can be placed in escrow to indemnify the trustees should they face claims in future years. The funds will return to the sponsor at the end of the term of the indemnity. An escrow could also be used in the context of run-on scenarios where trustees are looking for ‘downside protection', as a way of mitigating a potential future deficit in the scheme.
Escrows are a valuable tool for trustee boards who are looking for a practical way to have access to an amount of money in lieu (for example) of contributions. In the current environment they can represent a useful way of avoiding a trapped surplus thereby providing the trustee with peace of mind and benefiting the sponsor because of any tax savings on a prospective return of surplus. In addition they are comparatively easy to setup and negotiate and this can be a big advantage if things are moving in quickly in the context of (say) a transaction.
Increased use across pensions market
Escrow arrangements are not new, but the use of escrow has increased recently across the pensions market, as has awareness of the potential applications of escrow arrangements. And that has consequences for trustees of defined benefit arrangements, particularly when set alongside other developments such as the growth of alternative solutions to buyout and the thinking around employer access to surplus.
It is well known that trustee decisions must be based on relevant factors and this requires trustees to sense check the continuing validity of any course of action initiated some time ago - if only to demonstrate a robust decision-making process. Recent positive changes in the funding of defined benefit schemes may cause some sponsors to re-think their in-principle commitments to de-risking and escrow could allow trustees to facilitate a stepping away from de-risking by providing comfort around the employer covenant.
Helpfully, escrow is an endlessly flexible solution, in the sense that the funds set aside and the terms and conditions attaching to the release and/or increase of the escrow funds can be tailored to the precise circumstances and needs of the parties.
Conversely, escrow may also be used to facilitate buy-in/buyout. The possibility of using escrow to provide a cost-efficient alternative to residual risk insurance has already been mentioned. In addition, escrow might enable a buy-in to proceed despite potential blockers. As an example, we have been involved in a number of buy-ins recently where historic errors have come to light that cannot be resolved within the buy-in timetable - perhaps because further investigation is needed or a court decision on the error is required.
If the worst-case scenario can be costed and the sponsor is prepared to put the appropriate funds in escrow, then the buy-in can proceed. Taking that further, escrow may also enable progress to be made in situations that could otherwise stall because of concerns about the implications of the Virgin Media case.
James Rickards is a pension trustee director at Law Debenture and Carolyn Saunders is a partner at Dentons
