Coronavirus infects defined benefit funding ratios

29 April 2020

Michaela RizzoPension & Insurance Solutions

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Robin ThompsonHead of Insurance & Pension Content & Advisory

Mohammad Ali VehbAssociate, Insurance and Pension Content & Advisory

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3 minute read

Market reactions to pandemic heavily impact UK pension schemes.

As the world faced-up to the reality of the coronavirus pandemic, more than $18 trillion had been wiped-off global stock markets by the first week of Q2 2020.  

Across Europe, citizens are facing unprecedented periods of “lockdown”, shortages of supplies and extreme measures by governments to prop-up teetering economies, while policymakers moved quickly to support businesses and individuals through this period of uncertainty and allowing the banking sector to perform effectively at times of strain.

Markets began to stabilise towards the end of March, with long-term gilt yields close to the level they started the month, equities down ~15% and credit spreads much wider[1]. However, with markets first reacting in mid- to late-February, the moves over Q1 were even greater and have had a large impact on pension funding ratios, pension deficits and the deficit contributions calculated in their triennial valuations[2].

For this article we took a closer look at a selection of large corporate UK pension schemes to estimate the likely effect the current market moves have had and will have.

To read the full article, professional investors click here.

Taking account of deficit changes

Our analysis is based on the most recent publically available financial reports of randomly selected defined benefit (DB) schemes.

The chart below compares how the deficits have changed since these schemes reported their 2019 financial results, on an accounting basis. What we’re seeing isn’t altogether bad news:

  • Schemes that were further along their journey plan – with accounting surpluses, high hedging levels and less exposure to equity – have fared better
  • Schemes with smaller surpluses or deficits have seen little change in their pension scheme’s position. However, falls in equity have made the size of their deficits look worse when compared to their sponsor’s (the company behind the pension scheme) market capitalisation. We used the sponsor’s market capitalisation as a simple proxy for how the corporate has fared under COVID-19, which we then compared with its pension scheme deficit or surplus positions.
Changes in accounting surpluses and deficits since financial reporting date with comparison
to market cap

Source: NatWest Markets. Data is from the 2019 financial reports for each sponsor[3]

 

The Pensions Regulator has indicated that pension trustees should engage with their corporates if corporate dividends have been scrapped in recent weeks, to discuss delaying pension scheme contribution schedules if needed. In a worst case scenario this could help avoid the insolvency of the company – and as a consequence a pension scheme having to be transferred to the UK’s Pension Protection Fund (“PPF”) due to COVID-19.

Funding view of deficit changes

With many triennial valuations starting at the end of March, we also wanted to understand the impact on Technical Provisions (“TP”)[4], which pension schemes use.

The prudence in the cash flows and the discount rates used to value the TP liabilities depend on the pension scheme.  We’ve used reported sensitivities for simplicity[5]

Now looking through this TP pension scheme lens, we’re seeing a more concerning picture:

  • Deficits have substantially increased, caused by falls in rates and equity, and the widening of credit spreads. At the same time, TP surpluses have reduced.
  • Schemes with large allocations to equity and credit and with low levels of hedging are particularly badly hit. The interest rate moves are offset to some extent by the falls in inflation we’ve seen in Q1.

This analysis assumes a haircutted risk premium for each asset class. As credit spreads are much wider and equity indices at much lower levels, the risk premia are likely to have changed. If we update these[6], the increase in TP liabilities is lowered and the increase in TP deficits is less pronounced. This is particularly noticeable for schemes with a high allocation to credit.

See the chart below for the changes due to the market moves:

Changes in TP surpluses and deficits since financial reporting date with comparison to
market cap

Source: NatWest Markets. Data is from the 2019 financial reports for each sponsor[7]

 

Pension updates with a COVID context

COVID-19 has ultimately seen many pension scheme funding levels drop – the extent is largely driven by the level of hedging and equity allocations.

From a corporate perspective, for many schemes this has increased surpluses and had made little difference to those schemes in deficit. When we look through a TP pension scheme lens however, we see substantial increases in deficits caused by falls in rates and equity, and the widening of credit spreads. This emphasises the different perspectives between schemes and their sponsors.

This is particularly unfortunate for corporates with March end triennials, as the level of contributions to be negotiated may therefore need to be higher.  From a COVID-19 perspective, two points may be added to the pension scheme agenda: 1) Possible deficit contribution holidays/deferrals as agreed with the sponsor, and 2) With the sponsors’ market capitalisation possibly having changed, trustees need to reconsider the covenant risk. 

Looking at contribution holidays, a recent survey of experts[8], representing 200 schemes, estimated that at least one in 10 schemes are likely to see their sponsors delay payments by at least three months. With data from the Office for National Statistics showing around £5.5 billion paid into defined benefit schemes each quarter, the deferrals could therefore account for around £500 million.

However, as long-term investors, pension schemes are well positioned to ride out current volatility and refresh their strategic view, asset allocations and hedging decisions.

Footnotes

[1] Non-Financial 10Y+ AA spreads were ~60bp wider than the start of the month

[2] Triennial valuations refer to the process that UK pension schemes go through with their corporate sponsor, at least every 3 years, in order to agree the deficit and contributions payable into the pension scheme.

[3] We have made pragmatic simplifications where needed to ensure comparability between different sponsors and have rolled forward to ensure consistency of dates, to end of Q1 2020. We have not adjusted for different prudence assumptions between accounting and TP basis, nor have we adjusted for any sponsor contribution announcements/delays. M&B = Mitchells and Butlers.

[4] Technical Provisions discount the liabilities based on the haircutted expected returns of the assets invested in

[5] The extent to which these report the effects of hedging strategies (where applicable) may vary.

[6] Risk premia / spreads to the Gilt curve differ from the date of the underlying financial results, to the end of Q1 2020. For simplicity, we’ve assumed a 0.5% increase to equity, 0.25% increase to growth funds, a 0.5% increase to credit spreads and an increased spread for inflation-linked gilts by 0.15%.

[7] We have made pragmatic simplifications where needed to ensure comparability between different sponsors and have rolled forward to ensure consistency of dates, to end of Q1 2020. We have not adjusted for different prudence assumptions between accounting and TP basis, nor have we adjusted for any sponsor contribution announcements/delays. M&B = Mitchells and Butlers.

[8] https://www.pensions-expert.com/DB-Derisking/Multibillion-pension-sponsors-among-vulnerable-to-demand-shock

Pensions
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