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Will Covid-19 undermine companies’ ability to sponsor defined benefit pension schemes?

29 May 2020

It’s understandable why so many in the private sector feel their defined benefit pension is gold-plated. These provide a high-quality retirement income – matching either final or average salaries – which are paid for life and keep pace with increases in inflation.

But the fragility of these plans is often under-appreciated. These schemes depend on there being sufficient funds from their investment portfolio to pay the promised benefits. And if there is a funding gap, the employer provides the cash to top it up.

The economic impact of the Covid-19 crisis has made The Pension Regulator nervous about the ability of companies to maintain this financial underpinning.

In April TPR noted the economic impact of Covid-19 will create uncertainty about the strength of covenant sponsors and their ability to address pension funding deficits over the short-term.

But the uncertainty created by Covid-19 could be more profound that creating short-term concerns – it could cause a spike in the number of schemes which tip into the Pension Protection Fund. This pays benefits to members when companies go bust and schemes can no longer afford to pay the benefits.

Whether a scheme will end up in the PPF is dependent on the size of the gap between the value of the assets and liabilities as well as the strength of the covenant sponsor.

Mind the gap
In a recent performance review of almost 200 clients funding levels from 31st March 2017 to 31st March 2020, Aon found a considerable variation in funding levels.

Matthew Arends, head of UK retirement policy at Aon, says: “The top 25% of saw their funding levels improve, despite the significant market downturn this year.” But the bottom 25% had seen their funding level fall by more than 6% over the same period.

Even if a scheme has a weak funding level, if has a strong sponsor covenant which can cover the short fall, it will remain solvent. But the economic crisis sparked by Covid-19 has exacerbated the risk of credit defaults.

John Wilson, independent trustee at Dalriada Trustees, says: “Employers which were in quite a fragile position before the crisis will not have been helped by the Covid-19 crisis.”

Arends says: “For some schemes, the combination of a deteriorating funding level in combination with the impact of Covid-19 on the company sponsor has been critically damaging.”

For others the position is less clear cut. Arends adds: “There are schemes with a strong funding level and a weakened sponsor and vica-versa.”

Those which are in a strong funding position are likely to have hedged their interest-rate and inflation risks and had a low exposure to equity assets. Some of these schemes could also have a sponsoring company which has been untouched by the crisis.

Sharp spike
Given this divergence, is it possible to assess how many schemes could risk being dragged under by the Covid-19?

Guidance from TPR gives a clue. Arends says: “The regulator said 5-10% of employers with DB schemes had deferred deficit contributions.” In other words, around 250 to 500 schemes are already facing difficulties getting cash from companies to cover gaps in the funding level.

Arends says: “This gives us a sense of the number of schemes already facing hardship.”

Further clues can be gleaned from the impact of the global financial crisis on the viability of UK defined benefit pension schemes.

Wilson says: “There was a sharp spike in the number of defined benefit schemes entering the PPF in 2010.” The economic impact of Covid-19 could cause a similar spike, he adds.

“We could see hundreds of schemes enter into the PPF, as we saw in the aftermath of the last crisis,” adds Wilson.

But the fallout from the Covid-19 is likely to be much worse than the global financial crisis.

Richard Williams, director of policy and communications at Clara Pensions, says: “Low interest-rates and a willingness to lend to business meant corporate insolvencies stayed at low levels in the aftermath of the 2008 crisis.”

Despite the monetary and fiscal policy measures which have been announced to minimise the impact, it’s far from certain they will be able to mitigate the unprecedented supply and demand shock of Covid-19.

Williams says: “It’s not certain whether government interventions will be able to keep business going which would have otherwise collapsed.” It may be that business failures are postponed rather than prevented.

Certain sectors are more likely to see more schemes fold. Wilson says: “Those sectors which have been hardest hit by Covid-19 such as the hospitality sector are at greatest risk.”

Smaller firms more at risk
And while some large employers in hard-hit sectors may well be incapable of surviving the impact of Covid-19, the impact is likely to be more pronounced on smaller companies. Wilson says: “They lack the deeper pockets of larger firms.”

Smaller schemes make up the majority of private-sector DB schemes.

According to the PPF’s Purple Book, there were 5,436 schemes eligible for its protection in 2019. Schemes with more than 5,000 members make up around 75% of total assets, liabilities and members, while only forming 7% of the total number of schemes.

Conversely, schemes with fewer than 1,000 members make up 80% of the total number of schemes but only around 10% of total assets, liabilities and members. And 36% of schemes have less than 100 members.

As more than a third of the schemes in the PPF have fewer than 100 members, the disproportionate impact of Covid-19 on smaller companies is likely to lead to a high number of schemes entering into the PPF.

Accelerating entry
Last year the PPF announced the 1000th scheme had entered its protection after its establishment in 2005. Richard Farr, managing director of Lincoln Pensions, says: “The next 1,000 schemes are likely to enter more rapidly because of Covid-19 and Brexit.”

Farr says Pareto’s principle – which says 80% of the effect will be from 20% of the causes – is likely to apply to the impact of Covid-19 on pension schemes. “I expect around a fifth of defined benefit schemes will be sucked into the PPF,” he says.

Another fifth will be unaffected by the impact and the remaining 40% will see their funding plans derailed, he adds.

“The fifth which will be sucked into the PPF are more likely to be those smaller schemes because their employers are undercapitalised,” says Farr.

It might seem counter intuitive but trustees may decide triggering a collapse in the sponsoring company might be the best option. Many have the power make this happen.

Farr says: “Some trustees can demand contributions from the company, even if those contributions are so high they trigger a financial collapse.”

From the trustees’ perspective, however, it could be better to cause the firms to collapse now rather than to let things drift. Farr says: “The longer a badly financed firm continues to operate, the harder it becomes for a scheme to repair the funding shortfall.”

That’s because more cash leaches away leaving less available to repair the damage and the liabilities continue to grow as the number of members retiring continues.

The change in the proportion of deferred to retired members is important because the PPF caps the benefits of those who have yet to retire but pays the full benefits of those who have not.

Farr says: “By crystallising the bankruptcy, the trustees may be better able to capture whatever surplus they might have in the scheme to execute a buy-out at a reduced level of benefits of members.”

This is likely to provide better benefits for most members than allowing the funding position to deteriorate further and end up in the PPF with fewer benefits for deferred members.

Change in future risk assessment
The impact of Covid-19 on strength of covenant sponsor is likely to alter the way sponsor covenant risk is viewed. Williams says: “In the past, trustees might have looked at covenants by assessing the impact of a business losing a major contract or revenues drop 10%.”

But sponsor covenants will now need to be assessed against a much stronger set of criteria. Williams says: “Up until now, few trustees had considered the possibility of revenues of their sponsoring company disappearing overnight to be a real risk.”

With other possible big risks like climate change, increased geopolitical risk and another pandemic, this could change attitudes towards sponsor covenant risk.

Williams says: “In the future, covenants will need to be stress tested for more extreme events such as revenues falling to zero.”

Stress testing for such an extreme event with a low probability of occurring will give trustees a better understanding of covenants. Williams says: “This could challenge the future viability of the sponsoring company and allow trustees to prevent any unpleasant shocks.”

Charlotte Moore - post author

Charlotte Moore has been a freelance journalist since 2006, with a solid technical understanding of a broad range of financial topics along with a previous incarnation as an investment analyst. Along with journalism, she has experience of producing written material for corporates and is seeking to expand this part of her business portfolio.