Financial distress arising from the end of government support for businesses affected by COVID-19 is likely to hit DB pension schemes. Nigel Morrison looks at how scheme sponsors can fulfil their obligations.
As the global economy recovers, a rise in the number of corporate insolvencies will potentially have a significant impact on defined benefit (DB) pension schemes. Much has been written about the possible impact of coronavirus support expiring later in the year, but very little commentary has looked at the effect of this financial distress on DB pension schemes.
Unfortunately, the withdrawal of direct financial support, and the end of indirect measures will be a problem for DB pension trustees who need to fund schemes without threatening the solvency of the sponsoring employer.
How much support did business get for coronavirus?
The four main government-backed schemes came to an end in March 2021, but before then, some £75 billion of new loans had been provided. In addition to these loan schemes, significant additional support was available through other financial programmes, including the postponement of business rates for certain sectors (£10.8 billion), direct grants to businesses (£11 billion), VAT deferrals, and, of course, the furlough scheme.
Alongside all of this financial support, the UK government also offered businesses a further lifeline by temporarily restricting the ability of creditors to issue winding-up petitions against their debtors unless underlying causes of non-payment were not coronavirus-related. This temporary stay has recently been extended to 30 September 2021, but it may need to be extended further to ensure there is no conflict with the timeline for the lifting of the restrictions on rent payments.
During this period, many businesses that sponsor DB pension schemes also obtained an agreement to postpone the deficit recovery payments arising under the agreed schedules of contributions. However, there are no reliable statistics to evaluate the scale of this postponement.
What will happen after coronavirus support is withdrawn?
There is no doubt that there is an extraordinary amount of additional debt now in existence that needs to be supported and serviced, whether in the form of new loans or the backlog of existing liabilities for VAT and other measures. It's probably at record levels now, so it's easy to think that this could be an insurmountable problem for many businesses. We should, therefore, expect to see an inevitable surge in financial distress and insolvencies later in 2021 and into 2022.
But, this outcome may not actually be quite so clear cut.
Firstly, many businesses have continued to trade very successfully for a variety of reasons: because they are providing goods or services that were in demand during the lockdowns, or they have seen significant reductions in their overhead costs because of remote working and other changes in normal practices.
We also know that liquidity levels are currently very high in many businesses. Some of this might be ‘false’ liquidity created by loans drawn down in case they were needed, and we also need to consider the postponement of VAT and other rates, which will unwind in due course as they are repaid.
Furthermore, we have continually seen extensions and revisions to the various support packages, and while, of course, it must end eventually, the UK government does have a careful line to tread. It must judge when it's realistically possible to wean business off this support. If it moves too soon, the government risks adding to corporate distress.
Nevertheless, on the face of it, and assuming that there are no further significant extensions to this support, we should prudently expect a rise in financial distress and consequent insolvencies. However, it may be the end of the year or possibly early 2022 before the full impact becomes evident.
How will this rise in financial distress impact DB pension schemes?
The normal manifestation of financial distress in businesses is for liquidity restrictions to arise, with a consequent focus on preserving cash: by collecting outstanding debts as quickly as possible and stretching payment terms for suppliers and creditors.
For a DB pension scheme, the key liquidity question will be whether the sponsoring employers are able to meet their collective obligations under the terms of the currently agreed schedule of contributions. This schedule includes both ongoing contributions for future accrual and deficit repair payments. As the ability of a sponsoring employer to flex the future accrual contributions is somewhat restricted, this would potentially impact directly on employees’ wages and salaries. So, attention is likely to focus on the level and timing of the payment of any required deficit repair contributions.
Although the payments due to pension schemes under any agreed schedule of contributions are legally enforceable against the sponsoring employers, discussions around the temporary deferral or rescheduling of the deficit repair contributions could give distressed businesses much-needed funding and liquidity headroom.
This was certainly the case in 2020. Many sponsoring employers sought the pension trustees’ agreement to requests for the deferral of deficit repair payments as the magnitude of the financial impact of coronavirus became clear.
The Pensions Regulator (TPR) quickly issued guidance regarding these deferral requests, and it was soon apparent that a key consideration for trustees faced with these requests was understanding the underlying longevity of the employer’s business. This was necessary for pension trustees to know whether the deferral of contributions in the short term would increase the probability of members obtaining full benefits in the long term: by securing the future of the employer.
Unfortunately, this is not a straightforward assessment, particularly given that the materiality of many of the long-term issues arising due to coronavirus only became clearer as coronavirus progressed. For example, the significant and potentially irreversible shift to online shopping in many markets.
Sponsor longevity is not an easy matter for trustees to assess when markets are stable, and the threats to both the ongoing solvency and liquidity of employers have made this even more difficult. However, it's taking on ever greater relevance for pension trustees because of the increased focus on the need to agree on long term funding targets with employers. This is the target date at which a pension scheme is expected to be fully funded with a low-risk investment strategy and a low level of reliance on future funding from the sponsoring employer.
What does the new TPR code of practice mean for DB pension schemes?
This increased focus on long term funding targets is being driven by the requirements outlined in the recent Pensions Schemes Act 2021 and the new TPR code of practice expected later this year. This new single code of practice will replace 15 different codes of practice currently in force. It's expected to introduce two ways for defined benefit pension schemes to comply with the scheme funding regulations – ‘Fast Track’ and ‘Bespoke’.
Currently, ‘Fast Track’ schemes will be expected to move towards a low-risk investment and funding strategy with little reliance on the ability of a sponsoring employer to provide funding in the future because of the underlying maturity of the scheme. Consequently, the periodic valuations that are required by these types of pension schemes are expected to receive lower regulatory scrutiny from TPR.
The alternative basis – ‘Bespoke’ – is expected to be used by less mature schemes seeking greater flexibility to use funding and investment strategies outside of the characteristics outlined by TPR. Accordingly, pension trustees and the sponsoring employers should expect far greater interaction with TPR, who will be looking to ensure that employers are funding schemes as efficiently as possible.
This growing focus on setting low-risk long term funding targets may, in the short term, increase the funding needs of pension schemes. This might also be exacerbated by the move towards predetermined investment and funding strategies under TPR’s expected ‘Fast Track’ approach or greater regulatory interaction in the valuation process under the ‘Bespoke’ approach.
What does the future look like for DB pension schemes?
Unfortunately, these changes could put even more pressure on employers already facing increasing liquidity challenges as trading returns to normal, not least to repay the additional lending accrued to remain solvent over the last 18 months. This is also, of course, happening at a time when successfully addressing current liquidity issues is likely to be a make or break issue for employers.
There will, therefore, be a difficult tightrope for trustees and employers to walk between addressing the additional funding requirements of pension schemes and changes to TPR's code of practice without jeopardising the long term solvency of the employer.
If you're an employer or trustee for a DB pension scheme looking for support to handle challenges in covenant assessment, pension audit, or actuarial advice, contact Nigel Morrison or Phil Green.