As many schemes have higher allocations to bonds than equities, the benefit of that impact has, however, been constrained. As result, the size of company liabilities has grown rather than shrunk, making schemes more reliant on the covenant sponsor.
Bourne says: “The demand for funding from the covenant sponsor has increased.” Not only has Brexit already created problems for defined benefit schemes, it has also created problems for the sponsoring company too. The economic uncertainty created by Brexit undermines their financial strength.
Butcher says: “In the short term most commentators expect the UK will perform worse than if we had stayed in the European Union which could increase the risk that some employers will fail.”
Even if businesses do not go bust but struggle to grow, they will have problems maintaining their defined benefit funding promises, Butcher adds.
Datta agrees: “Economic weakness does make it harder for companies to keep their cash promises to defined benefit schemes.”
FIGHTING BACK
An uncertain economic outlook coupled with concerns over a company’s credit worthiness could create a perfect storm for trustees. But trustees are not entirely powerless: there are steps which can be taken. Butcher says: “Trustees need to take a close look at the short and medium-term financial prospects of a company.”
Pensions and Lifetime Savings Association policy lead in engagement, EU and regulation James Walsh agrees: “Trustees are right to be thinking about the impact of Brexit on the sponsor covenant.”
The uncertainty surrounding the Brexit negotiations make it difficult to predict the overall impact. Walsh says: “But trustees must try to get a really good understanding of the potential effect of Brexit on the sponsor covenant.”
That impact will vary not only for different industrial sectors but also from company to company within the same sector.
Walsh says: “Trustees need to discuss with their employer what they think the impact of Brexit – including the possibility of no deal – will be on the employer’s business and from there they can assess the possible impact on the covenant.”
For example, if the sponsoring company is a manufacturer with a complex supply chain in the aerospace or automotive sector, it might be significantly affected by Brexit, if it involves the introduction of tariffs.
But if an employer operates in a service sector which is focused on the domestic economy and is not affected by Brexit, there might be limited impact.
Walsh adds: “Some companies might benefit from adjustments in regulatory regimes or exchange rates.”
Trustees should not only focus on Brexit’s impact for the defined benefit scheme but also on its impact on the defined contribution scheme. Walsh says: “It’s equally important there is sufficient cash to ensure a good level of future contributions.”
But the trustees should view the company’s assessment of the impact of Brexit with a degree of scepticism. Steve Delo, managing director of PAN Governance, says: “It’s not in the interest of the company to paint the worst case scenario because that could force the trustees to demand more cash.”
It may well be tricky for the trustees to assess the true impact of Brexit on the business. Delo says: “It might be better to ask the sponsor covenant advisers to give the trustees an assessment.” But that might be difficult for them to do as there is still so much uncertainty, he adds.
If it’s not clear cut, then trustees could work with company executives to identify different scenarios and assess the impact these will have. Walsh says: “This gets trustees to assess the possible impacts on the sponsor covenant.”
Walsh says: “While it might not make the future any clearer, it allows the trustees to have a better informed discussion about what they should do next.”
There would be a range of options available to trustees. Walsh says: “They might decide to adjust their valuation assumptions or review their hedging arrangements.” A scheme could also decide to review its international investments.
Delo adds: “Trustees should be more conscious about the level of risks in the scheme and should consider reducing them.” That could include mitigating the exposure to interest-rate risks, introducing greater diversification and more hedging.
