The 2021 outlook for ESG and covenant – Navigating the new environment – what does this look like in 2021?

Thoughts from December 2020: Journey planning took on a whole new meaning this year, as unexpected bumps in the road became major diversions for some schemes through the twists and turns of 2020. The dash for cash of March; the scale of the global monetary and fiscal response; and the secular, structural shifts in the real economy accelerated by COVID-19 will have redefined the route ahead for many UK pension funds.

Against a challenging backdrop, the Pensions Regulator’s new funding code will lead to a change in the way trustees look at their scheme’s journey planning. The Regulator’s focus on reducing levels of reliance on covenant over time may seem at odds with the position in which some schemes currently find themselves.

For some, the New Year will be a critical period. There will be a lot of work to do for those schemes that had been moving in the right direction but may have found themselves veering sharply off course as the pandemic unfolded.

Yet, while the knock-on impacts of COVID-19 may have been acute for certain schemes, to date, the aggregate impact has been more limited than might have been expected, walking through the empty streets of towns and cities during lockdown.

Cracks to emerge

That impact is still to come, as we heard from both the Chancellor and the Office for Budget Responsibility at the end of November. The unprecedented scope and scale of the global policy response – of furloughs, quantitative easing and major corporate bailouts – have papered over cracks, which, at some point will inevitably start to creak and widen.

Eventually we will see stress evolve into distress, but for the time being, there are no bad bets for pension schemes. By and large, everything has worked after the initial crunch of March. Equity markets have continued to go up across the board – albeit some slower than others – with the MSCI defying gravity to close out November at all-time highs. Hedges have paid off; we have not seen hedging counterparties collapse and through the course the year we have seen bond spreads come in.

Journey plan

While we are yet to see substantive defaults, we are observing substantive yield-chasing – against which government and central banks’ backstops are unlikely to continue indefinitely. As some of that support comes away, some UK schemes will find that their technical provisions and journey plan are not as robust as may have been anticipated against a more benign backdrop, undermined by their exposure to the employer covenant.  As furlough schemes and government backing is wound down, pension schemes must think carefully about where their journey plan might take them over the coming months – and consider some contingencies.

There are of course both quantitative and qualitative components to planning ahead. Most of the analysis derived from stochastic modelling will determine that schemes are going the right way – after all, crises have historically been followed by a period of higher returns. Qualitative, scenario-based analysis must be a central component of how schemes and their advisors think about the future, ensuring robustness across both operational responses and investment portfolios.

COVID-19 has provided a tangible sense of what a global, systemic challenge looks and feels like, fundamentally changing the corporate backdrop in doing so. Material change tends to manifest itself through shocks, rather than a slow drift over time. Risks resulting from environmental, social and governance factors – an increasingly central risk to global order – also need to be understood in this context: they tend to defy good quantitative analysis; the risks of climate change and corporate failures are too complicated to model; risks will manifest themselves as sharp changes that are hard to predict.

Large scale change

The types of changes reconfiguring the corporate backdrop this year – the once in a generation shifts in working habits, travel, consumption – have come faster and at a scale that no-one anticipated.

This material disruption has allowed ESG and broader considerations of sustainability to take centre stage. In the midst of a new, galvanised focus on key risks in the here and now, ESG factors warrant systemic consideration – and schemes must assess how this much broader set of risk factors will impact covenant, assets and liabilities across a range of scenarios.

There are sound reasons for this analysis for trustees: the sustainability of an employer is the only aspect of a trustee’s role that is almost perfectly aligned with ESG. Pensions schemes, bound to their sponsor until the last pension is paid out, need a sustainable employer for the long term – an employer that has sustainable operations, policies, products and services in the very broadest sense. Trustees may be the only truly long-term stakeholder in the business. By contrast, investors may only hold equity or bonds for a finite time horizon, limiting the extent to which true sustainability in those investments (versus return) can be relevant.

For the UK’s legacy industries, hit particularly hard through COVID-19, trustees have a duty to engage with their sponsor on their sustainable transition. In 2021, ESG will be top of the agenda, and less of a focus all at the same time.

Michael Bushnell, Managing Director and Judith Anunda, Director

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The 2021 outlook for regulation

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