The risk of social distancing between defined benefit plans and their sponsors
There are broadly speaking three categories of plans that we need to consider in this COVID-19 environment:
- Plans that were already in a weak position with a high risk of their sponsors not making it out of this crisis (but not during it because of moratoriums). Some commentators estimate that up to 20% of plans may fall into this category;
- Plans that were just about OK and which were hoping for significant asset returns and sponsor growth that may now find themselves below the water line (perhaps another 20% of plans); and
- Plans that were well funded but will now have to make reactive decisions such as extending journey plans or introducing higher investment risk in order to remain on track. Some of these plans may find TPR’s proposed “Fast Track” approach to funding challenging.
From a funding perspective, the key difference from the previous black swan event (the 2008 credit crunch) appears to be that a larger proportion of plans are better hedged against inflation and interest rate risk. This dynamic could soften the downside arising from the current market volatility. Those plans with high investment performance expectations may find themselves particularly exposed while those that have implemented risk-focussed investment strategies will be better placed.
We are seeing some un-hedged schemes face significantly lower funding levels in the current climate. With uncertainty levels having by no means abated, this could get worse.
So, depending on previous funding levels, the level of hedging, and the presence or not of risk-focussed investment strategies, one can deduce who might be most affected. And, that is before we get to the damage being done to the employer covenant – both now and during the critical ‘bounce-back’ phase.
On the company side, many sponsors have been critically affected by the pandemic. Although there are a few winners such as household cleaning suppliers, logistics and supermarkets, where their covenants have taken less of a beating, sectors such as manufacturing (especially automotive), high street retail and construction/property are facing significant challenges.
When the bounce-back does arrive, you will find that CFOs will be desperate for cash to fund that speedy recovery that their boards are demanding. In this dash for capital, the pension plan must be very careful not to be left behind in the stampede.
In other words, we suspect some schemes will be staring at a more medium term funding crunch in order to support their recovering employers.
And how strong is the “bounce-back-ability” of these businesses? Many plans are linked to legacy sectors whose corporate culture isn’t used to adapting and growing at pace. This could heighten the risk of failing to capture the benefit of a recovery.
The new paradigm?
Also of potential concern is the market environment post COVID-19. In the UK, and abroad, we could see fundamental changes that reshape the way we live, work and spend.
Pre-existing supply chains and customer behaviours are just a few examples of areas that could look very different post COVID-19. Sponsors may find that there is a lot more volatility and risk in the environment in which they do business. Overlaying this is TPR’s new Funding Code (currently in consultation), which could see cash demands on sponsors increase as a by-product of the Regulator’s renewed expectations around long term funding objectives.
This is all assuming COVID-19 eventually disappears and does not return – by no means certain.
A number of plans may face distress in 2020/21 and many more sponsors may struggle to meet the increased funding needs of their plan going forward. Previous analysis has suggested that perhaps 1-in-6 UK pension schemes (c.1,000) could fail in time and current events may be the catalyst for some of these failures.
So what can trustees and sponsors do to best protect their scheme?
- Recognise that cash is king and carefully decide how the marginal £ is spent (investment in the business, de-leveraging, or payments to the plans);
- Take a hands-on approach to managing the plans’ assets and liabilities (consider whether current scheme governance is effective in this scenario);
- Tightly integrate your risk assessment of covenant, investment and actuarial liabilities;
- Recognise the inevitable and accelerating regulatory shift towards low dependency funding targets and plan accordingly;
- Introduce / revise and implement contingency plans having brainstormed potential scenarios from where we are today; and
- Make sure your pensions advisers talk to each other (of course, remaining 2m apart!).