On 12 November, the Pensions Regulator published guidance outlining actions trustees of defined benefit (DB) schemes should take to protect their scheme where their sponsor is experiencing financial distress. The guidance, issued amid the backdrop of an unprecedented economic downturn, makes clear that trustees are the first line of defence for members. As such, it emphasises the importance of trustees taking early action to mitigate the risks associated with sponsor distress, including engaging early with sponsors and other creditors, taking steps to improve the position of the scheme and adopting an integrated risk management (IRM) approach.
The Regulator acknowledges the impact Covid-19 has had, and continues to have, on the UK economy and individual businesses and reminds trustees to consider the impact Brexit may have on top of this. The guidance also notes that the new procedures under the Corporate Governance and Insolvency Act (CIGA) 2020 may present risks for DB schemes. Therefore, trustees should not delay in putting robust protections for their scheme in place, as other stakeholders, such as lenders and other creditors, may otherwise be in a better position to exert control over and extract value from a distressed sponsor, potentially to the detriment of the scheme.
Integrated Risk Management
The guidance outlines a number of actions trustees should be taking to protect their scheme against sponsor distress as part of their ongoing Integrated Risk Management:
- Understand legal obligations owed to the scheme – trustees should seek to understand their employer’s obligations (which should already be considered as part of a regular covenant assessment) and outcomes for the scheme in a hypothetical insolvency. Annex 1 of the guidance contains details on assessing a sponsor’s legal obligations to a scheme.
- Ensure effective risk management processes are in place – the Regulator recommends that trustees seek to put in place legally enforceable contingency plans with their scheme’s sponsor with agreed triggers. Where this is not possible, specific actions should be taken if such risks arise. Annex 4 contains a checklist for trustees on key actions to reduce scheme risks.
- Review scheme governance – trustees should frequently review the skills and experience on their trustee board to ensure they have the right mix to deal with new and unfolding scenarios, identify and manage conflicts of interest before sponsor distress arises, maintain robust record keeping and agree information sharing protocols with their scheme’s sponsor.
- Monitor the covenant to identify and mitigate sponsor risk – understanding the employer’s ability to meet future banking covenant tests is a key area of employer covenant monitoring as well as reviewing and challenging financial forecasts and stress test assumptions. The trustees should also carry out their own scenario analysis and consider how these would impact their sponsor covenant.
- Seek advice – The Regulator reminds trustees of the importance of taking specialist advice where necessary (and at an early stage), even if it seems costly, as expert advice can help to maximise the outcome for their scheme. Appointing one or more trustees with experience of managing distress scenarios may also help improve the outcome for the scheme.
The guidance contains a detailed overview of the signs of potential financial distress (in Annex 2). Key warning signs include:
- cash flow constraints,
- loss of key customer contracts, and
- credit downgrades.
Where a corporate transaction takes place as a result of corporate stress or a reduced share price, trustees should review the impact of this on their sponsor’s ability to continue to pay contributions and support the scheme. Trustees should seek mitigation if a transaction will cause, or has caused, material detriment to the scheme’s position. Annex 3 of the guidance contains examples of how corporate activity can impact a DB scheme.
Key actions identified in the guidance for trustees to take when their employer is in financial distress include:
- Increase the frequency of covenant monitoring – whilst the frequency will be based on the risk profile of the sponsor, it is important that trustees do not wait for a formal confirmation of covenant downgrade as part of an actuarial valuation before taking action.
- Perform a detailed review of scheme’s position – if the employer is part of a complex group structure, trustees may need to get specialist restructuring advice. Trustees may want to consider obtaining analysis with other creditors on a common platform basis, as this may help to save costs.
- Review investment strategies – because sponsor insolvency can crystallise short-term investment losses, trustees should review their scheme’s investment strategy and consider:
- the value at risk
- what level of investment risk is supportable
- the level of interest rate/inflation hedging in the scheme and whether this should be increased, and
- contingency plans if the level of risk in the scheme needs to be reduced.
- Understand the position of other stakeholders – trustees need to properly assess how other stakeholders may respond such as by reducing the undrawn amount of cash or credit from a banking facility, agreeing different schedules of debt repayment, or seeking security for existing debt and consider how this may impact the scheme and how any risks to the scheme could be mitigated.
- Consider employer requests for easements – this may include requests to defer deficit repair contributions. Trustees are reminded to consider the Regulator’s Covid-19 guidance for DB trustees if they receive such requests.
- Information sharing – the Regulator emphasises that the pension scheme is often one of the most significant creditors for employers and should be treated as such. Trustees and employers should work together and provide information to each other in a timely manner.
- Communicate with members – it is important trustees consider how they will communicate with members effectively where an employer is experiencing financial distress, particularly if the employer’s financial difficulty has been reported publicly and is known to employees. Members will be worried about whether their pension is safe and may be targeted by scammers.
- Remain alert to scams and unusual transfer activity – trustees should monitor transfer activity and report any concerns. They should continue to alert members to the risk of pension scams and issue the template warning letter to all members requesting a CETV quote.
Dealing with insolvency
Finally, the guidance considers what trustees should do if their sponsor is facing the prospect of insolvency. This includes:
- considering enforcement options if their scheme has security structures in place, and
- familiarising themselves with the practical steps needed to prepare their scheme for PPF assessment, which are set out in the PPF’s contingency planning guidance.
The new procedures for distressed companies introduced by CIGA 2020 may present risks for DB schemes. These new procedures include:
- a new moratorium – during which a financially company can secure a payment holiday in relation to most of its debts, including deficit recovery contributions, and
- a new restructuring plan for companies – under which it is easier for a distressed company to compromise the debts of dissenting creditors.
Trustees should seek specialist advice on these new procedures and the risks they pose to their scheme as well as seeking specialist restructuring advice on any turnaround plan that is proposed.
Trustees should also be familiar with their reporting obligations under the notifiable events regime and ensure that processes are in place to comply with these.
Most commentators agree that we are in the calm before the economic storm.
In light of this gloomy forecast, the Regulator’s guidance is timely, reminding trustees of the steps they should be taking to protect the interests of their scheme. Many of these actions should form part of ordinary good governance, such as understanding the nature and extent of their scheme’s employer covenant (including the scheme’s position on a hypothetical insolvency), actively and regularly monitoring this and taking steps to protect the position of the scheme in the event the sponsor’s covenant deteriorates.
The reality is that a sponsor’s covenant can decline rapidly and, once a sponsor has become distressed, it is usually too late for trustees to take action to improve their scheme’s position. Therefore, trustees should consider these issues while the sun is shining, so that they are not left out in the rain when the storm hits.