The past year has left a legacy of financial challenges for many businesses. Paul Brice and Phil Green look at key considerations for trustees and sponsors of DB pension schemes as they seek to understand the issues facing the underlying businesses and the difficult decisions being faced.
While some sectors should recover quickly from the financial impact of last year as lockdown measures ease, other sectors may face fundamental structural change.
The uncertain business environment currently being faced is compounded by the high levels of debt that many companies have taken on to survive the past year. The need to repay these additional facilities may be complicated by the unwinding of government support schemes, such as furlough and VAT deferrals, which will also need to be financed.
This poses significant risk as companies face financial pressures while their underlying business remains heavily impacted.
What does this mean for sponsors and trustees of defined benefit (DB) pension schemes? When navigating the corporate challenges that undoubtedly lie ahead, trustees need to assess the long-term viability of the sponsor to find an appropriate balance between looking after the needs of their members and the scheme, while at the same time seeking to preserve the long-term financial health of the employer.
Short-term versus long-term issues
Trustees and sponsors shouldn't assume that the liquidity issues faced over the past year will cease once restrictions have been lifted. For many businesses, the easing of lockdown may make matters worse in the short term, particularly where the need to meet costs and purchase stock in advance of revenue levels returning to previous levels exacerbates working capital requirements. This is all at a time when many businesses are already over-burdened by debt.
An understanding of the underlying markets in which the sponsor operates in is required, as some of these will have fundamentally changed due to the impact of COVID-19. An obvious example is retail, where a greater focus on internet sales means many independent retailers are likely to face considerable challenges even after restrictions are relaxed.
Does the business have longevity?
Ultimately, trustees need to understand the likely longevity of the sponsor in considering what is in their members' best interests. It may not always be appropriate to support the sponsor through contributions or other concessions so that it can meet its current financial challenges if, in the long term, the sponsor may not be able to support the scheme and in the meantime, the scheme’s funding position deteriorates such that members’ accrued benefits risk being diluted. This is clearly a complex judgement call requiring legal, actuarial, and covenant advice.
Trustees, therefore, need to review and consider with their advisers the alternative outcomes available - and the likelihood of those outcomes - before agreeing to any restructuring or refinancing proposal. Sponsors need to consider how trustees might be looking at the situation when considering their options.
The issue of sponsor longevity may be more difficult to assess if the sponsor is part of a wider group that has no legal obligation to support DB schemes but where the group has historically provided support - whether through access to finance or intra-group trading. In these circumstances, it will be key to understand the importance of the sponsor to the wider group, the likelihood of such arrangements continuing, and the legally binding nature of any support for both the sponsor and the scheme.
Finally, the impact of Brexit may also have an impact on a group's strategic thinking around the location of its operations and this, in turn, could impact on the financial strength of a sponsor and the covenant.
The position of lenders and other key stakeholders
It is important for both trustees and sponsors to understand the perspective of lenders where their agreement is required to support a particular strategic outcome. For example, if a sponsor facing liquidity issues requiring the ongoing support of its lenders, then the lenders' approach may well have a bearing on discussions around DB pension schemes funding.
Lenders that are currently unsecured may seek security as part of their agreement to extend further credit or modify their facility terms. Depending on circumstances – including whether a scheme has security - the granting of security to another party potentially has a materially detrimental impact on the covenant supporting a DB scheme. In this case, both sponsor and trustees should consider the position ‘pre and post’ and evaluate whether the arrangements are such that mitigation is required.
One key issue relevant to these discussions will be understanding where the ‘value break’ arises. Where lenders obtain a material improvement in their position following the granting of security, but the returns to the scheme are weakened, trustees are likely to seek to obtain some form of mitigation. This could be by receiving ranking security themselves, through increased cash contributions, or some other means of contingent covenant support.
Key customers and suppliers can also be relevant when assessing a sponsor’s financial outlook and longevity and their perspectives - and risks - need to be understood by trustees in their analysis.
Understanding what powers trustees hold
Trustees may hold one or more specific powers, such as a unilateral power to set contributions or to wind up DB pension schemes - and these may play a crucial part in any negotiations with a sponsor. The nature and use of trustee powers is one where legal advice is critical - for both sponsor and trustees.
It seems unlikely that a trustee board would wish to set contributions that are unaffordable or which could, if paid, precipitate the sponsor’s insolvency. However, a power to set contributions may provide trustees with a means of bringing the management team to the table in a restructuring to ensure that the scheme's interests are properly considered.
It is worth remembering that even where contributions may be set at a level that, with hindsight, appears unaffordable for the sponsor, they might subsequently be reset by trustees following appropriate discussions as part of a later valuation process, so as not to trigger an insolvency.
A unilateral ability to wind up a DB pension scheme is also powerful but, depending on the scale of the scheme relative to the sponsor, there may be a risk of precipitating employer insolvency if the power is exercised. Considerable care is therefore needed in evaluating whether the use of this power really is in the best interests of a scheme’s members. Sponsors should be mindful of where such a power exists – and consider the risks of its being exercised.
Contingent asset support for DB pension schemes
Contingent assets can be a vital weapon in the armoury of trustees. For example, they could form part of a new solution to a restructuring or, where they are already in place, offer leverage to trustees in support of their negotiations where the release of, say, a guarantee or other legally enforceable arrangement may be required. Equally, they can be a useful tool for sponsors in finding a solution in trustee negotiations at times of financial challenge.
Contingent assets can take various forms, from relatively straightforward (but nonetheless effective) guarantees to more complex arrangements such as Asset Backed Contribution (ABC) structures.
Beyond contingent assets, contingent funding structures can assist with balancing demands on sponsor cash flows with the contribution needs of a scheme – aligning levels of sponsor contributions either with business performance and cash generation, or with the interests of other stakeholders (for example, through dividend-related contribution structures).
Practical considerations for DB pensions schemes
Receiving appropriate and timely information is key so that you can understand the issues being faced by a sponsor, assess alternative outcomes, and consider how any proposed transaction would impact both the scheme and other stakeholders. An information protocol between trustees and sponsor can facilitate a regular flow of information.
All parties should consider relevant regulatory guidance and statutory provisions, including the ‘moral hazard’ provisions of the Pensions Act 2004, and relevant provisions in the Pensions Schemes Act 2021. This latter legislation has introduced new notification requirements and harsher penalties for non-compliance.
If an insolvency process is likely, the Pension Protection Fund (PPF) will also need to be included in relevant discussions as it is the PPF that will hold the DB pension scheme's rights in the insolvency process.
Trustees and sponsors facing financial challenges can often be taken aback by how rapidly events can unfold, how fast they are required to make decisions, and how ‘hard-edged’ negotiations can become, especially in multi-creditor situations. Making sure that governance processes are in place for rapid evaluation and decision making is, therefore, also key.
Finally, although it's important to involve The Pensions Regulator and PPF (where relevant) on a timely basis, getting support in making your decisions from an appropriately qualified team working together with legal, finance, restructuring and actuarial experts on a multi-disciplinary basis is the best way for trustees and sponsors to ensure that they can make the difficult decisions necessary in these fast-moving and challenging situations.
For support and information on navigating the financial challenges facing DB pension schemes, contact Paul Brice or Phil Green.