The coronavirus has triggered a domino effect across the UK economy. While the initial stock market and liquidity shocks seen in March have abated, prompted by unprecedented monetary and fiscal policy, the more profound and potentially enduring economic impacts are beginning to move through UK Plc and the wider economy. Early in May 2020, the Bank of England forecast that the coronavirus crisis will push the UK economy into its deepest recession in 300 years. After a quarter of intense pain, companies up and down the country will be bracing themselves for what lies ahead.
Recent actions by the credit rating agencies provide a useful proxy for current levels of corporate stress; the below chart shows the proliferation of rating actions globally.
The scope and scale of these impacts have major implications for UK defined benefit pension schemes and their sponsors.
Many companies have already taken steps to manage liquidity by temporarily suspending deficit reduction contributions, following unprecedented guidance from the Pensions Regulator, which advised that sponsors could opt to suspend or reduce scheme payments with the agreement of scheme trustees.
The suspension of deficit contributions will make a difference to companies facing major cash flow constraints but, beyond the short-term reprieve, the reality is that the balance sheets of many pension schemes are also be under increased pressure. The economic downturn will make them more reliant on financial support from their corporate sponsors over the medium-term.
Pension scheme investment returns
Credit rating actions and downgrades may also have material implications for pension schemes’ investment returns, particularly for schemes running cash flow driven investment strategies, which are reliant on coupons from investment-grade companies.
Ahead of the current downturn, the investment-grade corporate debt market had grown rapidly, with global capitalisation reaching over $10trn in 2019 from just over $2trn at the start of 2001. Over the same period, the lowest rated segment of the investment-grade market – the BBB universe – grew even quicker, today comprising over 50 percent of global investment grade instruments versus only 17 percent in 2001.
Clearly, the trip into junk bond territory is shorter from the BBB rating, and such an action would make some schemes forced sellers where their mandates forbid sub-investment grade holdings. The spate of downgrades seen so far threatens the outlook for investment returns reliant on a stable performance. Corporate sponsors and financial directors need to be alert to the possibility that scheme investment return expectations and asset values may need to be revised down over the short- to medium-term.
Third party exposures
Sponsors should also be cognisant of the third-party exposures and operational risks that may arise across their pension scheme. Schemes transact and do business with multiple third parties day-to-day, whether it be with counterparties on derivatives trades, or insurance providers partnering on bulk annuity and other de-risking transactions. In the current environment, we would encourage sponsors to adopt a stress-test mentality to assessing the potential risks of distress or collapse of one or more of their scheme third-party providers.
We have already observed some stress among pension scheme administrators. The collapse of a scheme’s administrator presents an unlikely but potentially high-impact operational risk; a ‘tail risk’ event undoubtedly, but one that sponsors should factor into their wargaming or business continuity plans.
The impact on bulk purchase annuity providers
This is also relevant for sponsors and schemes that have completed a buy-in, an insurance policy that covers a portion of or all long-term pension obligations. Under a buy-in arrangement, the sponsor remains “on the hook” for pension liabilities until the point at which the scheme is legally wound up and the responsibility is formally discharged. While insurers are currently well-capitalised and closely regulated by the PRA, their balance sheets are, like pension schemes, also heavily invested in the real economy.
Future investment returns from investment-grade corporate bonds and property instruments make up a large proportion of the capital base of a life insurer in the UK. At a time when credit spreads are being supported by emergency bond-buying programmes rolled out by major central banks and the property market has been at a standstill, there is increased uncertainty over the intrinsic risk carried and value of these assets. Prominent figures, including Sir John Vickers, have started airing concerns over the reliance placed by some life insurers on future investment returns and the continued payment of dividends in the current environment.
We expect there to be a considerable time lag, possibly over 12 months, before we are able to gauge the full extent of recent policy decisions on the real economy. As the full extent of both the economic damage to date and the pathway to recovery becomes clearer, UK sponsors and financial directors have an opportunity to reassess both the current position and long-term strategy for their schemes. In the near-term, the approach must be cautious and forensic, with the aim of mapping out what may be a complex set of risks across assets, liabilities and external partners. Only by scoping out the true scale of the covenant, investment and operational risks, can corporate sponsors gain comfort that they have left no stone unturned.