U.K. surety bond deal gives new pension funding option

A FTSE 100 company has become the first to make surety bonds part of the funding strategy for its defined benefit plan, a new option for corporate executives looking to make good on pension promises.

The 5½-year, £400 million ($679 million) deal, for an undisclosed pension fund, was put together by Aon Risk Solutions, the risk management unit of Aon PLC.

The deal brings together eight insurance companies and is “the largest syndication the U.K. surety market has ever seen,” Mark Holt, Aon team leader, said in a news release from the firm.

It is a transaction that can potentially be transported overseas, to other companies grappling with the strain that DB pensions can place on balance sheets.

The innovative deal “is very much a crossover piece between pensions and insurance, which has many people excited,” said Lynda Whitney, London-based partner at Aon Hewitt.

The concept of a company offering a guarantee on its pension promise is not new. “When a pension trustee is negotiating with a sponsor about contributions to bring it to fully funded status, there is a range of things that can be done,” said Chris Redmond, senior investment consultant at Towers Watson & Co. in London. “A trustee can agree (to) a plan for contributions and accept that at goodwill. Sometimes they may want slightly greater assurance around that, and in particular to protect ... against the sponsor defaulting.”

In that instance, the corporate sponsor can go to a bank for a letter of credit, which underwrites future contributions to the pension fund.

But using a surety bond, an undertaking from an insurance company to pay a certain sum to a pension fund under specific conditions, is a new option. Triggers for payout vary from company insolvency to non-compliance with a pension fund's deficit recovery plan.

Now the door has been pushed open on alternative sources of capital.

“There may be preconceived ideas that corporates have to use a letter of credit,” said Leroy Hobson, London-based head of surety for Zurich Insurance PLC's U.K. global corporate business, one of the insurance companies involved in this first pension fund deal.

“This is not the case. Zurich surety is increasingly finding that some of our larger global corporate clients, typically FTSE 100 or FTSE 250 large multinational global corporate groups, are looking at ways to diversify the provision of financing and in most cases (including the guarantee to pension fund trustees) surety bonds are good alternatives to letters of credit and bank guarantees.”

A corporation might choose to use a surety bond to fulfill its benefit promise because that would keep lines of credit with a bank open and available for other needs.

“Most financially sound, large multinational global corporates do not struggle to raise finance, but some will have large bank facility requirements,” said Mr. Hobson. “There is some benefit to freeing up some of those banking lines through the use of surety capacity and surety facilities.”

A more recognizable use of surety bonds would be in the construction industry, to guarantee a bridge or road, he said.

Ms. Whitney agreed: “A surety bond is a totally different capital pool, which leaves the financial director with more flexibility of what he can do with his own capital. This is putting pensions to one side, and it is not interfering with the general corporate structures around investment capital.”

Surety bonds are also a tool for the corporation in ensuring that capital is not tied up in the pension fund. “Sponsors are also worried that if they make contributions to a pension fund, which then experiences better-than-expected investment performance such that it didn't need those contributions to deliver its promises, it may have a capital surplus in the pension fund,” said Mr. Redmond. “They cannot get to that. Surety bonds reduce the risk of that happening.”

Ms. Whitney said the opportunity is attracting pension fund attention. “We have a number of clients ... looking at surety bonds as an alternative — we don't see this as the silver bullet, but we are seeing a general move of looking for solutions that sit outside cash,” said Ms. Whitney. She said half of Aon Hewitt's pension fund clients have a non-cash element to support the pension fund, from cheese to brands to brandy. And the pricing is similar to a letter of credit.

But there's another advantage over letters of credit. “Surety bond providers tend to have slightly better credit ratings than the banks these days,” Ms. Whitney said.

And there is interest internationally, she added, with colleagues overseas looking to learn from this first deal, although regional taxes and regulations might affect its viability. Letters of credit are used elsewhere, including Canada, she noted.

Mr. Hobson said the concept of using surety bonds for a pension fund is now firmly on Zurich's radar. “We are aware that at least a couple of brokers are exploring their client base to see whether similar structures can be pursued. Surety bond guaranteeing payment into pension funds would be an area that (we) would like to focus on, develop and grow in the future,” he said.

But there might be one small fly in the ointment: the treatment of surety bonds when calculating the premium a corporate sponsor is charged by the Pension Protection Fund, the U.K. agency that serves as a lifeboat for participants in the event of insolvency.

“Surety bonds are not on the standard forms for PPF acceptability (when calculating the levy),” said Ms. Whitney. While letters of credit are accepted in some cases, the PPF is strict on what can be used.

Coincidentally, the PPF is seeking comment from the U.K. pension industry on the future calculation of levy payments. “We will be submitting information about surety bonds to them, as we believe that there is such similarity that the two markets should be treated equally,” she said. n