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Pandemic profit hit and Brexit push covenants up priorities list

19 Nov 2020

A sharp deterioration in profit outlooks at many final salary scheme sponsors has pushed the issue of sponsor covenants further up trustees’ agenda, and there could be investment implications.

The economic impact of the Covid-19 pandemic has been painful for many defined benefit (DB) pension scheme sponsors. In the first nine months of 2020, around two thirds of companies with a DB scheme issued a profit warning, of which 90% were Covid-related, according to Ernst & Young.

The Pensions Regulator (TPR) has responded to the deteriorating outlook by issuing new guidance for trustees aimed at protecting schemes from potential sponsor distress. The guidance stresses the need for preventative steps trustees can take to ensure that their scheme is not left out of pocket if the sponsor defaults.

The regulator urged all trustees to update their integrated risk management approach factoring in a potential sponsor default and suitable triggers. It also warned trustees to be mindful of the fact that if they delayed putting scheme protections in place, other stakeholders, lenders to the sponsor in particular, would be in a better position to extract value from the sponsor. TPR stressed that trustees should engage early on, not just with the sponsor but also with other creditors to manage potential risks.

The role of other creditors could become increasingly pressing because the pandemic has led to a surge in corporate borrowing. Between January and August, bank loans to non-financial companies in the UK increased to £43.2bn, more than five times the amount they lent in 2019, according to Ernst & Young. “Trustees are the first line of defense for savers and their pension schemes,” said Mike Birch, TPR’s director of supervision. “It is vital they actively monitor their employer’s health to look for warning signs and are ready to act as the economic impact of global events develop.”

TPR listed cash-flow constraints, credit downgrades, removal of trade credit insurance, the disposal of profitable business units and the loss of key customer contracts as early warning signs that the sponsor might be facing financial distress. Some of these factors will look familiar to DB scheme trustees.

Many large final salary scheme sponsors, including Tesco, National Grid, Rolls Royce, Rentokil, BT and Centrica, had a significant proportion of their bonds mature this year and had to refinance, in some cases against the backdrop of a reduced credit rating.

Suspensions of deficit contributions were also increasingly common, according to Daniel Gerring, head of pensions at Travers Smith, and Matthew Harrison, managing director of Lincoln Pensions, when discussing the risks to sponsor covenants at the PLSA Conference in October.

Despite the rise in warning signals, a survey of trustees at the event suggests that they not all shared the same level of concern. The majority (57%) of attendees at the PLSA seminar on covenants predicted tough times ahead but that their sponsor had been able to adapt, while close to a third said the impact of the pandemic on covenants had been negligent to date. Some 12% said that they had felt a material impact requiring, for example, deficit contributions. Only 1% said that their sponsor was showing signs of extreme stress due to the pandemic.

The same survey also revealed that information sharing was the most common approach for trustees to engage on these challenges (57%), while suspending dividends was on the agenda for 21% of respondents and nearly a quarter sought mechanisms to restart or increase contributions. At the same time, 37% have not sought any mitigation mechanisms. The deteriorating economic outlook is also reflected on the asset side of the DB scheme seesaw, although the investment implications are far from clear.

By the end of October, asset values for FTSE350 DB schemes had fallen by £5bn in a month. For schemes across the Pension Protection Fund universe, aggregate assets had dropped by £18bn during the same period, according to the PFF7800 Index.

Trustees looking to adapt their investment strategy to these challenges might find themselves being pulled in opposite directions. On the one hand, they face higher return expectations to offset the economic hit on their portfolios. Indeed, research from one consultancy found that, on average, they would have to increase investment returns by 1.4% to stay on track for their endgame plans.

This pressure could increase in the event of a further Bank of England rate cut, which might add to the pressure on liabilities. Bank of England governor Andrew Bailey acknowledged in the Financial Times that the UK and Europe failing to agree a trade deal might force the central bank into action again.

On the other hand, trustees are being urged by TPR to consider de-risking their investment strategy if their sponsor is showing signs of financial distress. Among others, the regulator urges trustees to put in place a value-at-risk assessment and reconsider what level of investment risk might be deemed appropriate as well as put in place additional inflation and interest rate hedges.

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