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Article | Pensions Briefing

Five key covenant issues for trustees to ponder in 2018

What are the burning issues that may be front of mind for trustees?

Pension Board and Trustee Consulting
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By Adrian Bourne | January 24, 2018

Our covenant specialist Adrian Bourne sets out five questions for trustees addressing US tax cuts, Brexit, the evolution of The Pensions Regulator and balancing business needs.

In the first of a new series setting out five questions trustees should ask, Adrian Bourne looks at five topical issues related to employer covenant for 2018. Subjects such as US tax cuts and Brexit will vie for attention with balancing the scheme and sponsor needs, as well as learning how to work with The Pensions Regulator’s (TPR’s) demands as its evolution post BHS continues.  

1. What do the US corporation tax changes mean for my covenant?

In simple terms, the US is reducing its corporation tax rate from 35% to 15% but, beyond the headline reduction, the changes will mean different things to different schemes and sponsors.  Nonetheless, the type of questions that trustees should be asking include:

  • Will the tax cut mean a change of strategy for UK employers owned by US parents?
  • Will that translate into groups relocating operations and where they generate profits?
  • Will ‘trapped’ cash earned overseas, including by UK sponsors, be repatriated to the US through dividends as opposed to loans?

Invariably, tax is one driver for corporate decision-making but in our experience there are other practical influences. Factors such as where the customers are based and proximity to them, as well as what the prevailing foreign exchange rate is, play an equally significant part in determining where capital investment is made and how dividends are repatriated.

2. Will integrated risk management (IRM) be better understood?

IRM was one of the big covenant issues of 2017, but for many trustees it felt like déjà vu and a rehash of the previous financial management plans regime. One of the concerns relating to this, was the over-engineered process since this ignored the ability to pick from a menu of options. More pertinently IRM highlighted that, from a narrow covenant perspective, significant emphasis remains upon sponsor agreement to put in place a credible, contingent asset to fall back on, without which scheme risks are simply not underwritten.

Whilst there is some merit in the scepticism, IRM has helped trustees focus their thinking on how covenant and scheme risks interact with each other and in turn, how robust contingency plans actually are, as well as whether they can be augmented. 

Covenant assessment is an iterative process so the question to ask in 2018 is whether any contingency arrangements have gaps in and if there is scope, through say a valuation or corporate activity, to leverage better security with which to underwrite a scheme’s risks.

3. Will there be any Brexit clarity in 2018?

I am a little sceptical, but so what?! Each sector of industry and sponsoring employers will have their own particular concerns and these are likely to persist. Pharmaceutical sector risks differ from automotive, and UK universities have different demands to financial institutions. In addition, regardless of Brexit, there are other material risks at play as we have seen from the automotive sector with the impact of concerns about diesel engines.

Trustees should nonetheless begin to see greater clarity on a number of key issues for both the near and medium-term future for sponsors. Those questions might include the following:

  • Can I rely on this income stream beyond the immediate future?
  • Will the uncertainty of the investment for the new plan now be committed and put in place to secure my sponsor’s future?

These questions have been on the updated covenant agenda of trustees for a while and will now begin to crystallise. These will, in turn, inform views about the appropriate length of recovery plans and the extent of scheme risks that trustees can take. 

4. What were TPR’s New Year resolutions?

TPR may still be licking its wounds from the BHS saga but can draw confidence from the impact of the process on the overwhelming majority of trustees and corporates who noted the fallout from it, learnt the lessons of how not to approach mergers and acquisitions (M&A), but are acting in a responsible manner regarding their obligations to members.

Covenant advisors also learnt a lot of lessons about how a cumulative set of transactions over time can weaken a scheme’s position. It demonstrated how events can occur which leave a scheme without a seat at the table.

In 2018, trustees should reaffirm the precise nature of the structural support their covenant offers and should consider scenario testing what an M&A event may look like and how they may react.

5. Will there better understanding and legitimate severing of schemes and sponsors?

I expect to see more sponsors and schemes considering the options for looking to secure positive yet separate futures for both parties. 

Toys R Us has recently undertaken a well-publicised restructuring that involved a severing of ties. Under this, certain payments to the scheme and Pension Protection Fund (PPF) should ensure members’ benefits are optimised and at the same time the future of the company, albeit with a smaller footprint, is ensured.

Those schemes and sponsors that are out of kilter in terms of risks and scale should carefully consider the options. They should determine whether a ‘better’ outcome is a more assured one which ensures survival of both entities in some form, as opposed to the route of PPF benefits only for the scheme coupled with a value-destructive insolvency for the sponsoring employer.

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