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Security and how to get it

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In PTL’s recent risk survey we noticed a sharp spike in concern around the strength of DB sponsor covenants: jumping from 14% in July to 24% in October. This article looks at what can be done about this.

“Covenant” can be defined as the sponsor’s willingness and ability to provide the funds needed to pay DB benefits as they fall due. A well-funded and viable company has a strong covenant as it is more likely to be able to provide that funding. A weak company will have a weak covenant.
What has caused this spike in concern is a matter of speculation, but it must be linked to greater uncertainty about the prospects for the UK economy, most probably due to the threat of Brexit. The future is unknown and, as a consequence, the prospects for many UK businesses (the sponsors) are also far from certain. Look no further than the recent, sobering case of Carillion for evidence of this.

The concern about those prospects, of course, is magnified by time. By definition, certainty reduces the further one looks into the future. I am reasonably confident that I won’t go bankrupt in the next twelve months. That’s because I can see no significant financial risks that I haven’t mitigated (my children keep asking me for money, but rarely significant amounts). I have to be less confident about avoiding bankruptcy within five years from now, because there will inevitably be events over that time that I can’t currently imagine and so won’t have mitigated. It is the same for a company. They can, for example, imagine the demand for their products next year, but that assessment can only become more vague as they project forward two, eight or twenty years. This can be a problem for a pension scheme, where the average deficit recovery plan has a duration of eight years, peak cash flow is perhaps 20 years away, and final cash flow perhaps 60-80 years away. Uncertainty at the front of that duration magnifies to become huge at the end of it.

So what can be done?  

Option 1: A weak, or weakening, covenant is only a risk in so far as the trustees have insufficient money. This being the case, the easiest strategy is to get more money. Except that, while this is conceptually easy, it is much harder in execution. A company with more uncertainty is unlikely to want to increase that uncertainty by committing its funds to the pension scheme.

Option 2: Funding uncertainty is caused by, well, a lack of certainty. Option 2, therefore, is to reduce that uncertainty by getting security on an actual or contingent basis. If the trustees can become the legal owners of a non-cash asset (for example, a building) or be given a charge over that asset such that they assume ownership in the future should the sponsor fail to honour their cash promises, they will have more certainty. The added advantage of security is that it allows the trustees to take more investment risk, if the sponsor agrees and this approach is consistent with their other objectives. An ancillary benefit is that this could potentially reduce the cash pressure on the sponsor.

Option 3: Hope for the best. The average DB scheme sponsor has a credit rating of BB+. This means that they have a 1-in-10 chance of defaulting on a payment over 10 years. This sounds terrible, except that it also means they have a 90 percent chance of making all of their payments. The odds are in the trustees’ favour, although they shouldn’t be complacent. Also, uncertainty is often based on an assessment of the sponsor’s situation as it is now. The demand for widgets will be strong next year and, while you can’t be certain about that demand in ten years’ time, there is equally no reason to doubt that the sponsor will have innovated and developed the world’s best-selling toggle in the intervening time. Companies are smart. Generally they want to survive and thrive!

So, there are several options open to trustees, but ultimately they are reliant on factors they cannot control. For this reason, there are three things that they must always do. Firstly they must ensure their scheme is as efficient as possible – wasting no money and taking no unrewarded risk (whether in funding, investment or operations). Secondly, they must monitor their employers – watch the covenant like a hawk and engage wherever they can. Thirdly, and last but not least, trustees should understand their own powers, and appreciate the opportunities to exert their leverage in pursuit of a deal.

Richard Butcher, Managing Director, PTL