Do UK DB schemes have a covenant problem?

Concerns have grown over the strength of outsourcing companies in particular. The Cabinet Office announced it has set up a team to monitor Interserve following a profit warning in September, although at £44.9m on an IAS 19 basis its deficit is far smaller than Carillion’s, which could cost the Pension Protection Fund as much as £900m.

On a UK aggregate basis, the prospects for UK pension schemes reliant on corporate sponsors does not look much brighter.

The key imperative for trustees is to plan for contingencies and to engage and inform management, and where relevant third parties

Paul Jameson, Penfida

Over the course of 2016, consultancy PwC’s pension support index, which looks at FTSE 350 obligations in the context of key indicators of sponsor strength such as net assets and operating profit, dropped more than 10 percentage points.

Punter Southall’s “Risk of Ruin” report found in July that around one in three schemes are at risk of not paying full benefits. It said covenant had a far bigger impact on the scheme’s chances of success than trustee actions such as derisking assets and even demanding large cash contributions.

“[Schemes] need an employer to stand behind them for 20, 30, 40 years into the future,” said Martin Hunter, principal at the recently merged consultancy Xafinity Punter Southall.

Reasons to be cheerful

Others have questioned whether the outlook is really this gloomy.

David Robbins, senior consultant at Willis Towers Watson, said these models tend to focus on the chances of paying benefits in full, which can distort public perception.

Examining the claim by the Pensions and Lifetime Savings Association’s DB taskforce that around 3m people are in schemes with only a 50 per cent chance of paying benefits in full, he pointed out that this insolvency could happen in 30 years’ time.

In that case, a large majority of members would have received their benefits in full or be pensioners protected by the PPF, which does not cut core benefits for retirees.

All funded DB schemes are backed by the PPF, and many might pay some, but not all, of their benefits under a restructuring, often referred to as a ‘PPF-plus’ deal.

“‘In full’ is an important part of that, because most people who do lose something… are not going to lose everything,” said Robbins. “Generally, the magnitude of that potential haircut is limited.”

IRM helps navigate covenant woes

Whatever the broad health of the UK’s schemes, the demise of Carillion less than two years after the collapse of retailer BHS demonstrates that trustees of specific schemes will still have to face unexpected deteriorations in their sponsor covenant.

The Pensions Regulator’s DB funding code encourages trustees to use integrated risk management to assess the likelihood of these situations arising.

“The key imperative for trustees is to plan for contingencies and to engage and inform management, and where relevant, third parties, such that efficient and timely decisions can be made,” said Paul Jameson, a founding partner of pensions corporate finance advisory Penfida. “Covenant risk may be challenging to eliminate but it can frequently be mitigated.”

In an unusual turn, trustees for the scheme of engineering group GKN recently took their communications to third parties public, announcing their £1.9bn deficit on a solvency basis, or £1.1bn on a gilts-flat basis.

GKN is subject to a hostile takeover bid by turnaround specialist Melrose, which plans to raise the company’s leverage, with that new secured debt potentially taking precedence over the scheme’s claim.

When things turn ugly

Schemes do not have the power to block detrimental changes to their covenant, according to Hunter, but they can make life significantly more difficult for their sponsor.

“The trustees ultimately have control over the investment strategy,” he said, explaining that reducing risk would therefore increase the deficit that the sponsor has to fund. In certain cases, schemes have the power to wind up their scheme, triggering a full solvency deficit to be paid by the employer.

Trustees and sponsors should of course try to retain a good working relationship, and collaborative measures like granting contingent assets can have a marked impact on the ‘risk of ruin’, according to the Punter Southall report.

If that relationship breaks down, as long as trustees can show that they have taken appropriate measures they should be confident of the regulator’s support, said Hunter.

“That was demonstrated in the BHS case quite clearly, that the moral hazard powers are very strong,” he said.