Coronavirus has led to sharp falls in equity markets, a reduction in UK interest rates and reports of major upheavals in supply chains and other economic drivers affecting business performance.
Gilt yields have fallen markedly, with the 20-year fixed interest gilt yield down almost 40bps from 1.3% at the start of the year to just 0.91% at the end of February, and as low as 0.5% in early March. Defined benefit (DB) pension schemes will be directly affected by some, if not all, of these developments. Depending on who their sponsors are and the trustees’ approach to investment and funding, DB schemes may be facing a perfect storm of a weaker covenant, reduced investment values and higher liabilities. Some well hedged schemes with strong sponsors may be barely affected, others may face very considerable challenges.
The duration and impact of the virus on DB schemes is not known. Some speculate that markets are vastly over-sold, others that the measures being taken across the globe could stimulate widespread recession. Meanwhile, the Chancellor announced a massive fiscal stimulus package through infrastructure investment, which could benefit many sponsors a good deal over time.
All of this may be putting integrated risk management (IRM) plans - which consider how risks to sponsor covenant, investments and funding might be managed individually and in combination - into very sharp focus.
From discussions with clients, there do seem to be a number of trustee considerations emerging, depending on specifics.
Understanding a range of possible sponsor outcomes, even at a high level, is informative. Put simply, does the sponsor have a problem and, if so, how big might it be? Even rudimentary stress testing, subject to refinement over time, can help scale the potential impact of the current outlook on the sponsor. Management teams may be 'soaked' responding to the impact of the virus, but it is reasonable to assume that they will be undertaking scenario analysis, cash forecasting and borrowing stress-testing. If possible, ask to see it and discuss it with your covenant adviser.
For DB schemes with financially leveraged sponsors, it is important to understand the risks of any covenant breach as soon as practicable, to become familiar with the creditor protection rights attached to the scheme, and to determine how trustees can get a 'seat at the table' in any inter-creditor negotiations.
Trustees may be asked to defer or reschedule contributions. Clearly, before agreeing to anything, they will want to see evidence of compelling need and to take legal and covenant advice. Consider creative 'clawback', contingent funding or security structures.
DB schemes addressing the impact of possible transactions may find those transactions put on hold, or the terms or impact change. What might have seemed appropriate mitigation in better times might need to be revisited before any deal is settled, given changes to sponsor dynamics and funding positions.
Where there is fundamental uncertainty in the covenant or other areas, DB schemes in valuations may need to consider 'parking' the position pending clarification. If this looks as if a statutory deadline might be missed, engage with legal advisers and scheme actuaries around a possible approach to The Pensions Regulator to discuss the position.
How we can help
Our IRM gateway tool can help to illustrate the potential impact of different sponsor cashflow scenarios and investment/liability stress tests, using a range of specific assumptions, on a scheme’s funding position. We are actively involved in a range of discussions with trustees and employers across a wide spectrum of outcomes, whether valuation or transactional.
To discuss any of the issues raised above, contact Paul Brice.