As we keep hearing, we are living in unprecedented times. However, as we turn our attention to the future, what does the “new normal” mean for defined benefit pension schemes?
Once the initial crisis management has passed, companies will have a myriad of different issues to address. Unfortunately, one of these is likely to involve the funding, investment and governance of their defined benefit (DB) scheme. It may be tempting to ignore the DB scheme, at least for 6 months, because of its long-term nature. But that risks exposing the company to some significant challenges in terms of both company pension costs (cash contributions and/or accounting expense) and senior management time later in 2020.
In this Perspective, we consider the most common pension issues that companies are facing and how best to ensure that the company approaches these on the front foot.
It is, perhaps, best to start by considering the corporate pensions agenda through the lens of trustee reactions to Covid-19. Trustees will have seen potentially dramatic movements in some or all of the following:
- strength of sponsor covenant
- value of investments
- required level of future contributions (especially if some form of short-term deferral has been agreed).
For many schemes this means the trustees will have already ramped up their reporting requirements from the sponsor, requesting far more detailed and regular information on how the company is weathering the lockdown and resulting economic consequences.
Many trustees will be re-evaluating previous funding and investment strategies, in light of how they perceive the world to have changed due to the Covid-19 pandemic. For many companies the first item on the pension agenda will be to respond to potentially significant trustee proposals, which are likely to be quite unwelcome when the company is focused on getting its core business back on track.
The key is for the company to communicate regularly, openly, and in detail with the trustees, as this is the best way to ensure the trustees do not over-react to any concerns. This dialogue should be two-way, so that the company gets an early view of the trustees’ thinking.
Many companies will have been severely impacted by the lockdown. Even those businesses that have been affected less seriously will be facing significant uncertainty, as a result of Covid-19’s longer term damage to the economy and how this might affect future revenue and business plans.
Some companies have requested and achieved a temporary deferral of deficit contributions, which they justified on the basis of short-term financial pressures due to the lockdown. On the face of it, this was an entirely sensible step to take and within acceptable regulatory guidance, if properly presented.
“…. the frequency of updates and access to senior management are also key factors in maintaining trust…”
However, we have seen evidence that, even though trustees have largely agreed to these deferrals, this has come at the cost of unsettling them about the strength of the sponsor. In some cases this has triggered the trustees to think deeply about implementing lower risk investment and funding strategies. As a result, whilst companies may be pleased they have secured a contribution deferral, they have yet to realise that they are facing unexpected longer term consequences due to damaged trustee confidence.
For a number of companies there is no simple way to allay trustee concerns on covenant, other than to stick with best practice, specifically:
- share as much detail as possible
- be open about the challenges and the uncertainty in any projections
- recognise the need to treat the scheme equitably with other stakeholders, i.e. lenders and shareholders.
In addition to the quality of the information provided, the frequency of updates and access to senior management are also key factors in maintaining trust with the trustees.
The impact on investment markets has been volatile and complex since the start of the crisis, and that remains so. The impact on schemes’ funding largely falls into two camps:
- well-funded schemes, with significant interest rate hedging, will not have seen a material worsening in their funding position (and may have even seen a small improvement)
- schemes with sizeable funding deficits, and lower levels of interest rate hedging, will in general have experienced a significant reduction in funding levels.
Whichever camp a scheme may be in, everyone is grappling to understand the medium and longer term economic consequences of Covid-19 and how this should affect future investment strategy. This, of course, links directly back to the covenant discussion. Not only is there a big question mark over the future investment landscape, but also over whether the sponsor’s covenant still supports the pre-Covid level of investment risk taken by the scheme.
Companies need to evaluate the level of investment risk in their scheme with which they are comfortable post-lockdown. Investment risk is a luxury that should only be taken if the sponsor can afford to write the cheque that would arise from poor investment outcomes.
There will be a temptation for companies to feel that the worst has happened and that now is the worst possible time to de-risk and lock in recent losses. Whilst this may, with hindsight, prove to be true, there are two obvious counters to this logic. First, the company needs a covenant to support that risk and, secondly, the worst really may not be behind us yet in terms of investment prospects. In all honesty, no one will know the answer to that question for some time to come.
“investment risk is a luxury that should only be taken if the sponsor can afford to write the cheque that would arise from poor investment outcomes…”
For schemes that have weathered the storm well or whose sponsors have come out largely unscathed, the question is whether there are new opportunities to be taken advantage of? One possible answer is improved buyout pricing (see below). Some key asset sectors, such as property and other less liquid assets, may need careful review.
For companies facing a deterioration in their covenant or significant falls in their scheme’s funding levels, trustees will want to engage with the company to discuss some or all of the following:
- an increase in cash contributions
- a lower-risk funding target
- other forms of security
- negative pledges, for example restrictions on dividend policy and a block on additional security being granted to lenders.
Whilst pensions may be the last type of discussion the company wants to take part in, given everything else happening to the business, in our experience early and active engagement with the trustees will still be the best policy. The worst possible outcome for the company will be to develop its recovery plans for the business only to find that the impact of DB pensions has not been factored in correctly and so the financial models underpinning the recovery plans are flawed.
Pensions Regulator perspective
The Covid-19 crisis has created significant challenges for TPR. On the one hand, and in a similar vein to the credit crisis of 2008, there is a need for the Regulator and trustees to show pragmatism and so not create short-term financial pressure on companies that might push a business into insolvency that would otherwise have survived.
“the current economic crisis merely underlines the need for schemes to have robust integrated risk management…”
Conversely, the current economic crisis merely underlines the need for schemes to have robust integrated risk management frameworks. It is clear that those schemes which have achieved relatively high levels of funding over the last decade, often because of their focus on a low-risk, long-term funding target, are weathering the current crisis in a way that many other schemes are not (and may also be in a position to benefit from movements in insurer pricing – see below).
The Regulator is clearly trying to steer a course between its competing objectives to not impede the recovery of companies, whilst at the same time pushing sponsors to treat the funding of their schemes more equitably when compared with other key stakeholders. Recent TPR statements clearly reflect this juggling act.
We would summarise this stance as giving trustees and sponsors some short-term latitude in managing down pension contributions, but not at the expense of long-term funding and risk management. TPR will clearly not accept Covid-19 being used as an excuse not to improve the longer term security of members’ benefits.
Of course, the impact of Covid-19 on investment markets may mean that some schemes which were targeting a bulk annuity deal in 2020 are now too far away, at least without a significant extra contribution from the sponsor.
However, it is also possible that, for schemes which had already hedged almost all of their interest rate and inflation risk relative to gilts and are already included within insurers’ pipelines, the terms which insurers may offer over the second-half of 2020 could prove even more attractive (at least for pensions in payment). This is because of the increased credit spread provided by corporate bonds, which is likely to more than offset the increased risk of defaults and downgrades on those bonds and additional reserving requirements for insurers. Having said that, insurers are being very selective about which corporate bonds they are willing to hold, so there is no certainty that terms have improved due to increased credit spreads, plus the credit spreads themselves have been volatile over the period from March to June 2020.
Mortality is the other key factor which Covid-19 will be changing, but it is too early to assess what this will mean for bulk annuities. In the short term, it is likely to mean additional deaths and so will remove some of a scheme’s liabilities before a transaction is priced. However, these additional deaths are likely to be older pensioners with existing health conditions, so insurers will be cautious about a possible selection effect for mortality rates looking forward. Initially, after the first wave of deaths from Covid-19, insurers and reinsurers are likely to assume higher future mortality improvements. There is a separate question about whether Covid-19 outbreaks will become an annual occurrence, like the winter flu.
What this means is that schemes which were targeting a significant insurer transaction over the next few years should be looking closely at current pricing and considering whether there is an opportunity to accelerate their plans.
In line with other financial control measures taken by companies in the last few months, many companies have severely curtailed their pension resource (whether by furloughing staff or suspending any discretionary budgetary spend). Whilst entirely sensible, we have already seen examples of two key issues:
- critical operational projects are being put at risk, which could well result in higher company costs that outweigh any savings from scaling back resources in the short term
- it is trustees who ultimately control the amount of spending on resources for the management of their schemes and, in some cases, trustees are choosing to exercise this control and over-ride the company’s views on what constitutes adequate resourcing.
Once again, the answer is transparent and regular dialogue between the company and the trustees. Understanding any trustee concerns over the scaling-back of scheme resource is the best way to find a cost-effective way forward.
“critical operational projects are being put at risk, which could well result in higher company costs that outweigh any savings from scaling back resources in the short term…”
Member exercises, such as encouraging individual member transfers or pension increase exchange, have proved to be a powerful tool in helping reduce a sponsor’s risks and liabilities. Logically, this should be even more the case following Covid-19.
Companies may, therefore, wish to revisit the value of carrying out such exercises, especially if approached by their trustees with concerns over future funding or investment strategy. The economic fallout from Covid-19 is also likely to mean that a higher proportion of scheme members will be reviewing their retirement savings over the next few years.
However, a word of caution: for some time now, both the FCA and TPR have been concerned about the options made available to members and whether their decision-making is based on sound advice and principles. This is particularly true for members choosing to transfer out of a DB scheme to a DC arrangement. The FCA has recently updated its guidance to IFAs, which is likely to make it more difficult for members to transfer out of DB schemes (and also mean there are fewer advisers willing to give transfer advice). In addition, there are currently warnings from all the financial regulators about a greatly increased incidence of pension scams, in the wake of Covid-19.
Nevertheless, in our view, member exercises/options will remain a powerful tool in managing DB pension liabilities in a post-lockdown world and something which trustees should be willing to entertain if they are focused on reducing risk and the size of a funding deficit.
The last word
Many companies will be facing their most challenging time in living memory and will be using all their resources to find a successful way out of lockdown. The last thing senior management may want to do is focus on pensions. Unfortunately, not doing so could prove very costly. You need to approach pension funding on the front foot. Then, with some careful planning and meaningful dialogue with the trustees, it should be possible to navigate a route through the pension challenges that does not derail the company’s recovery plans.