At its peak, one ran 94 retail stores nationwide; the other employed thousands across the UK in steel-related jobs. If both could be destroyed in part by their pension promises, how many other schemes and sponsors are at risk?

The BHS and Tata Steel cases have shown all too painfully what happens when the synergy between sponsor and scheme breaks down, and how defined benefit (DB) pension debt can affect a business’s ability to function effectively.

Tata Steel

The Pensions and Lifetime Savings Association’s (PLSA) recent DB Taskforce interim report synthesised many of the pensions community’s concerns about the viability of DB schemes. Scheme deficits made worse by low investment returns and interest rates, variable standards of governance, and severe tests of employer covenants have combined to raise the alert level for DB schemes to an all-time high.

Those are just the problems affecting schemes themselves. The ripple effects – impaired business growth, reductions in dividends, stalled merger and acquisition activity, limited contributions to DC pensions and in the worst cases the failure of the company – mean that DB pension deficits are far from just a trustee problem.

In figures

£31bn – the total figure that employers put into DB schemes in 2015…

…of that total figure, £11bn was paid to make good deficits

20% of schemes with ‘tending to strong’ covenants are expected to default over the next 30 years.

65% of schemes with ‘tending to weak’ covenants are expected to default over the same time period.

Source: PLSA DB Taskforce report

For the most distressed schemes, trustees’ options are limited. But for stressed schemes where there is a solvent sponsor but there are threats on the horizon, trustees still have options that could make the difference between a sustainable future and the Pension Protection Fund (PPF).

1. Understand the covenant

With covenant risk one of the three key tenets of the Pensions Regulator’s integrated risk management framework, understanding and acting on the strength of the covenant - the employer’s ability to support the scheme financially - is now vital for all trustee boards.

The best time to approach an adviser is when you don’t need to

“Covenant risk is a newer field,” says Darren Redmayne, chief executive of employer covenant specialists Lincoln Pensions. “Trustees still tend to seek advice when there is an issue – but prevention is better than cure. The best time to approach an adviser is when you don’t need to, and when you can have an informed conversation about risks.”

Transparency is absolutely key to understanding the level of risk that a DB scheme deficit poses to the sponsor. However, recent research by Lincoln Pensions into the transparency of FTSE 350 reporting showed that disclosures on the scale and volatility of DB schemes’ funding position were mixed at best. Only a third of companies discuss their funding position on a technical provisions basis – and none disclose the level of future funding risk.

With better information and greater transparency you will see risks sooner

“With better information and greater transparency you will see risks sooner and as they develop. There’s then more chance to intervene at an earlier stage,” says Redmayne.

James Auty, head of trustee consulting at JLT Employee Benefits points to Brexit as another risk to the covenant. “We have seen very different changes to the covenant dependent on whether a sponsor is an importer or exporter. The cases that are causing us most concern are where the deficit is already big and Brexit is not encouraging for their employer.” 

2. Consider consolidation

In the wake of BHS’s collapse, the Work and Pensions Committee has been investigating ways to avoid other companies suffering the same fate in the future. Giving evidence at a session in mid-October, former pensions minister Ros Altmann highlighted the limited options available to small schemes at present – and what could be done to help them. “Some SMEs and charities cannot cope with the costs of their DB scheme, but can’t get out of them without going bankrupt,” she said. “Admin costs are huge, but the amount might be small. Some costs transfer and liability management could work.”

For schemes in that situation, one option might be a DB mastertrust. The employer remains responsible for the scheme overall, in terms of making contributions and addressing recovery plans, but within an umbrella trust. The umbrella mastertrust is run by a single body of professional trustees and can achieve economies of scale with advisers and asset managers, thus reducing costs. It could also open the door to new options for smaller pension funds, such as liability driven investment, that would prove too costly as a standalone scheme.

Once a scheme has transferred, the existing board has no further input

Moving a scheme into a mastertrust means that the existing trustee board is discharged of its duties. “Once a scheme has transferred, the existing board has no further input. The trustees have to be comfortable with what we offer and that it protects member interests before the transfer happens,” explains Billy Wheeler, product and technical manager of TPT Retirement Solutions (formerly the Pensions Trust), a mastertrust provider.

DB master trusts don’t want schemes that are teetering on the brink of the PPF

However, this is not an option for schemes with a very weak covenant. “DB master trusts don’t want schemes that are teetering on the brink of the PPF,” says Paul Couchman, managing director of Premier Pensions, which also offers a DB mastertrust. “For each scheme we would look at the strength of the covenant and would have a power of veto over that.” 

3. Check scheme rules

Auty of JLT Employee Benefits recommends checking scheme rules, to see if there is any flexibility around indexation of benefits. “We are seeing schemes going back to review exactly what their rules say about paying CPI rather than RPI. Some schemes might have considered this years ago and decided to keep RPI, but funding positions may have worsened since then.” The switch might only change payments by 0.5% or 1%, but Auty notes “over the period of payment of a pension, that is a big difference.”

At present, decisions are variable and tend to be based on subjective interpretation

However, moving from one form of indexation to another may not be that straightforward, as the Barnardos scheme has recently discovered. The option to legally change from RPI to CPI can depend both on the wording in scheme rules and the judgment of an individual court. At present, decisions are variable and tend to be based on subjective interpretation.

4. Get involved with legislative change

Chris Martin, chair of the BHS board and professional trustee to a number of stressed schemes, argues that a broader range of options is required: “There is a real need to reappraise the legal framework in terms of enabling trustees to act effectively. Separation, equity stakes and benefit reductions, for example – there needs to be a way to empower trustees to do this without it taking years and costing millions of pounds.”

Regulated apportionment arrangements are very clunky, very expensive and destroy value

He adds: “The tools currently available to enlightened trustees are very limited. Processes such as regulated apportionment arrangements are very clunky, very expensive and destroy value in the sponsor company – the last thing you might want to do. There is no middle way where stakeholders can say ‘we promised x; we can only afford y - but that is sustainable’.”

We need to understand how we can open the door to flexibility and innovation

Help may be at hand. The PLSA’s DB Taskforce has set its sights on investigating broader options for stressed DB schemes. Speaking at the recent PLSA conference, taskforce chair Ashok Gupta outlined the problem: “Our approach to scheme resolution is too inflexible. We need to understand how we can open the door to flexibility and innovation and by doing so reduce pressure on sponsors and mitigate risk better.”

While those solutions are being debated and brought to market, there is still plenty that trustee boards can do to ensure that they have the right quality of governance, mix of skills, corporate data and relationship with sponsor and regulator. In a challenging economy, the balancing act of protecting members’ interests, while ensuring that the sponsor remains willing and able to support the scheme for the long term, will not get any easier.

TPR sees red over Green 

Things can get acrimonious when schemes and sponsors go bust, but the BHS saga has stirred up particularly bitter recriminations.

This month, the Pensions Regulator stepped up its efforts to force the former owners of department store chain to pay hundreds of millions of pounds into its pension fund.

The watchdog outlined its case against Philip Green, who owned the department store chain until 2015, Dominic Chapell who bought the firm from him for £1, and a number of related companies.

Green had pledged to “sort” the scheme’s £571m deficit when appearing before MPs in June, but after months of negotiations the regulator appears to have lost patience.

The billionaire tycoon said he had offered a “credible and substantial” deal to secure member benefits above Pension Protection Fund level, but TPR said it had “yet to receive a sufficiently credible and comprehensive offer”.