Gilt market volatility - short-term borrowing by pension schemes

In the light of the recent volatility in the gilt market, we know of several pension schemes putting in place borrowing facilities with their sponsoring employers or financial institutions. The purpose of these facilities is, for example, to reduce leverage or to provide additional assets to allow the scheme to meet collateral calls in relation to their LDI investments. The facility may help avoid having to sell scheme assets – particularly illiquid assets – at an undesirable time.

Pension schemes are able to put in place these arrangements, but as ever there are some pitfalls to look out for.

Powers: Trustees need to check that their trust deed and rules gives them the power to borrow. If it doesn’t, it may be possible to amend the rules to insert this power.

Process: Trustees will need to go through a process to satisfy themselves that putting in place a borrowing facility is appropriate, and in members' best financial interests, compared with the possible alternatives. They will need investment advice from their investment advisers.

Legal restrictions: There are various restrictions in the pensions and pensions tax legislation on borrowing by pension schemes.

• Trustees cannot borrow more than 50% of the value of their scheme’s net assets.
• Trustees can also only borrow for the purposes of providing liquidity on a temporary basis. This means, typically, that trustees must have other assets of sufficient value to meet their expected liabilities (for example liabilities to post collateral), but that it is not possible to realise those assets at a sensible commercial price in the required timescale. The loan also needs to be repaid within a set timescale (or it will not meet the criterion of being “on a temporary basis”).

Terms: The loan must be on arms-length commercial terms, paying a commercial interest rate. If it is not, it runs the risk of HMRC categorising it as an unauthorised payment. In drawing up an arms-length loan agreement, there are the usual issues to consider – pricing, currency, drawing mechanics, repayment mechanics and early repayment triggers, representations, covenants etc.

For further information, please speak to your usual Mayer Brown pensions contact, or to Andrew Block, Edward Jewitt or Simon Fisher.