Defined benefit trustees are becoming increasingly concerned about the strength of their employer covenants, a new survey has revealed, as Brexit uncertainty feeds into broader concerns about the future of sponsors.
24.8 per cent of trustees surveyed by independent trustee company PTL ranked employer covenant among their top three risks, jumping from 15.2 per cent in June.
Increases in longevity and the implications of Brexit for investment were unchanged as the second and third most important risks among the survey population.
DB scheme health as measured by funding levels has improved in recent months. The PPF 7800 index found an aggregate deficit of £158bn at the end of September, down from £220.4bn a month earlier and £413.1bn at the end of August last year.
We’ve been talking too much about deficits and not enough about risk management
Darren Redmayne, Lincoln Pensions
However, the PTL survey indicates that the long-term viability of sponsoring employers may be of greater concern than these short-term funding measures.
Richard Butcher, managing director at PTL and chair of the Pensions and Lifetime Savings Association, said the increased importance of covenant could be due to employer-specific circumstances.
But he added: “Or it could be a reaction to continued business uncertainty around Brexit and the long-term prognosis for UK businesses.”
The threats to sponsor covenant
The decline of Britain’s traditional industries has already seen the British Steel Pension Scheme and others put into a position where they may not be able to pay out the full benefits originally promised to members.
Now experts are highlighting the dangers faced by scheme trustees linked to companies such as oil and gas extractors, which are themselves undergoing legislative change to drop their carbon-intensive activities.
Butcher illustrated this problem with the story of a scheme on which he sits, which has peripheral ties to the oil industry.
The sponsor has doubled its contributions and the scheme could reach full funding on technical provisions within eight years, but Butcher said he still had “residual uncertainties” about the impact of legislation such as the phasing out of diesel.
Sankar Mahalingham, head of DB growth at consultancy Xafinity, said the jump in concerns probably reflects an increased awareness of covenant risk, rather than any 10 per cent deterioration in the health of UK companies over the past quarter.
However, he agreed trustees should take care to analyse their employer’s strength: “More people are realising that... having a good strong employer is probably the best thing a scheme can have now.”
Brexit feeding into covenant worries
The UK has committed to leaving the EU by March 2019, and as yet trade talks with the bloc have still not started.
Jeremy May, UK head of pensions at PwC, said the increase could have been spurred by Brexit uncertainty: “There’s some – perhaps heightened – uncertainty in the market at the moment for UK businesses.”
Of course, some businesses may stand to benefit from the impact of Brexit. But, as May pointed out, pension scheme trustees are exposed to multiple covenants in investment markets where companies are beginning to look overvalued.
“You’re either reliant upon the business which operates in the background… or you’re reliant on the assets which you’re investing in, and if those assets have any risk associated with them then you’re sort of back to the covenant piece. It’s not your covenant, it’s somebody else’s covenant.”
Once schemes with struggling employers have fully understood the health of the sponsor and its sensitivity to changes in economic conditions, they can then decide whether to aim for full funding by the end of the business cycle, or whether to seek other assurances.
Schemes in need of alternative sources of funding often look to contingent assets, or guarantees such as a claim on outstanding payments upon insolvency.
Industry is waking up
Of course, sponsors in dire straits may not be able to give even these assurances, and the scheme may have to begin discussions with the Pension Protection Fund and explore restructuring, said Darren Redmayne, managing director at covenant advisory Lincoln Pensions.
However, he said that via the covenant advisory process, schemes can discern whether a sponsor is in a situation of “worried wealth” or genuine crisis, and explore alternative funding tools to avoid slipping into catastrophe.
“You don’t have to go back more than a decade to a period where covenant risk wasn’t even considered,” said Redmayne, who praised the industry for moving its focus away from deficit figures.
"We’ve been talking too much about deficits and not enough about risk management,” he said.
