Notwithstanding the economic support packages put in place, COVID-19 is continuing to challenge scheme sponsors and the pensions industry generally. The Pensions Regulator (TPR) has published guidance urging trustees of defined benefit schemes to be prepared for the possibility of their sponsoring employer experiencing financial difficulties.

Preventative action: TPR’s expectations on trustee integrated risk management

TPR has outlined the main actions trustees should be taking to reduce the risk of potential scheme losses due to an employer restructuring, refinancing or insolvency. Trustees should adopt a fully integrated risk management approach to their scheme to highlight problems early on, whereby they must:

  • Understand the sponsor’s legal obligations to the scheme and the possible outcome for the scheme in a hypothetical insolvency.
  • Ensure effective risk management processes are in place. This includes preparing workable contingency plans with specific trigger points. Where possible, legally enforceable contingency plans represent the best protection for schemes.
  • Review scheme governance protocols on an ongoing basis. This includes reviewing trustee skills and experience, conflicts on the trustee board, record keeping and the agreed information sharing protocol. Having a legally enforceable information sharing agreement agreed in advance can ensure heightened visibility of events affecting the scheme.
  • Monitor the covenant on an ongoing basis to identify and mitigate sponsor risk. This provides an opportunity to regularly engage with management in order to identify and understand key covenant risks and to review and challenge financial forecasts.
  • Seek appropriate advice. Professional advice can highlight options or problems that may not be clear and, by supporting good decision-making, can help save money in the long-term.

Taking advice on the above points before a sponsor shows signs of distress can help to secure a positive scheme outcome before other stakeholders compete for value alongside the scheme, when options may be reduced.

Spotting signs of sponsor distress

As the first line of defence for savers and their pension schemes, trustees must prepare to spot the warning signs of employer distress or insolvency. Specific warning signs will vary according to the nature of a sponsor’s business and the industry in which it operates. Key warning signs of financial distress can include:

  • Cash flow constraints
  • Credit downgrades
  • Removal of trade credit insurance
  • Disposal of profitable business units
  • Loss of a key customer contract

Responding to sponsor distress

The faster that trustees can respond to signs of sponsor distress, the more options there are available and the more time they will have to protect members’ benefits.

In a distressed scenario, TPR has outlined that trustees should:

  • Increase the frequency of covenant monitoring. Employer covenant strength may change quickly and trustees should not wait for formal confirmation of a covenant downgrade at an actuarial valuation before taking mitigating action.
  • Perform a detailed review of the scheme’s position. Trustees should take steps to understand the potential returns to the scheme in a theoretical insolvency and to understand the position of other creditors (including contingent liabilities that will fall due in a default scenario).
  • Review the scheme’s investment strategy. Trustees should consider a Value at Risk assessment, what level of investment risk is supportable and whether the level of hedging in the scheme should be increased. Trustees should also consider a contingency plan if the level of risk in the scheme needs to be reduced as a result of a sudden deterioration in covenant.
  • Understand the role of other stakeholder interests. Other stakeholders, such as lenders, will be better placed to exert control over and extract value from a distressed sponsor, potentially to the detriment of the scheme. In the case of any refinancing agreements, or where a sponsor has complex financing arrangements, specialist advice should be taken.
  • Consider employer requests for scheme easements. See our earlier article on regulatory easements.
  • Maintain a continual dialogue with management and align information requests with the enhanced information that the employer will be producing during stressed circumstances. Where possible an upfront information sharing protocol should be agreed.
  • Be wary of transaction activity. TPR has highlighted that financial stress or reduced share prices can trigger corporate transactions, some of which may cause a material detriment to the scheme. For example, injection of additional debt into the scheme sponsor, refinancing or sale of a scheme sponsor to a third party. Trustees should seek mitigation where they consider that a transaction will cause, or has already caused, a material detriment to a scheme. If the sponsoring employer indicates that it is considering a restructuring, such as a company voluntary arrangement (CVA), trustees should contact TPR and the Pension Protection Fund (PPF) as soon as possible.
  • Communicate with members. If an employer is in financial distress this may come to members’ attention in media reports. Let members know the protections that are in place and the steps that the trustees are taking, to alleviate any members’ concerns.
  • Be alert to scams and unusual transfer activity. Members may become concerned about their pension and request cash equivalent transfer values (CETVs). Such requests may not be in their best interests and may expose them to pension scams. Trustees should actively monitor these requests and which advisers are supporting the members’ requests. Any unusual or concerning patterns should be reported to the Financial Conduct Authority.

Situations of sponsor distress are often time pressured, complex, and may well be unfamiliar to trustees. If trustees do not possess the skills and understanding to manage sponsor distress or insolvency, they should seek appropriate professional advice.