Covenant strength will be a key issue in this year’s valuations and will likely dictate contribution levels. Employers need to plan now to get ahead of the game.

As we head into the 2022 defined benefit (DB) pension valuation season, CFOs and finance directors need to start planning their approach sooner rather than later.

We expect funding levels to have improved for many schemes because, while liabilities will be higher due to increased inflationary expectations, most asset returns have been strong over the period since April 2019. Funding levels have fallen back a bit in recent weeks with markets reacting to the situation in Ukraine, but generally funding should still be ahead of plan.

However, employer covenants have never been more complex and uncertain so they will be a key discussion point for trustees and corporates in this year’s valuations. It will be important to understand not just the current strength of the employer covenant, but also how it has changed over the three years since the last valuation.

Challenges to covenant strength

We discussed the challenges for employers in our recent webinar: Getting to grips with your 2022 valuation. We heard from John Hubbleday, Head of Pensions M&A,  in BDO’s Pensions Covenant Advisory team, who told us how the impact of challenges including Brexit, Covid-19, higher inflation and interest rates, climate change, and the cost-of-living crisis will factor into the forecasts used for employer covenant assessments.

These factors will also be key drivers of the affordability assessment of employers, and therefore how much they can pay in pension contributions.

If the covenant has deteriorated since the last valuation, “the trustees might push for increased prudence in the technical provision assumptions and potentially seek to reduce the investment risk as well”, says John.

Covid-19 impacted almost all companies, but it has been far worse for some sectors – such as leisure, travel, and high street retail – than others. Employers in some sectors may need to invest more in their business to keep up with the post-pandemic rebound in demand for services, so they need to carefully consider the affordability of pension contributions as they look to manage their future cash position.

Increased inflation may have materially affected wage and salary demands, as well as overall revenue and input costs. It will be important to consider the aggregate impact of inflation and not just its impact on the pension liabilities.

Many companies have been impacted by Brexit, including encountering supply chain issues such as the shortage of lorry drivers and labour, and higher costs. Is the impact of this on the employer just a one-off, or will it continue?

Preparing for the covenant discussions with the trustees needs to be done early in the process alongside an actuarial assessment of the DB scheme’s funding and investment position.

What are my options?

If employers are concerned about the affordability of pension contributions, or need to invest cash in their business, there are several options.

Employers should consider how best to utilise free cashflow in the context of the obligations to the pension scheme, says John.

He explained: “It may be possible to reduce deficit contributions to allow capex, provided sponsors can demonstrate the future upside for the scheme. Trustees will also look at dividends or other forms of covenant leakage in the context of the contributions to the scheme.”

Employers could also consider contingent contributions, which may allow companies to agree on a lower base level of contributions in the short term and higher contributions when the employer can afford to pay more. 

Contingent contributions can include triggers, so that deficit reduction contributions rise when the company’s earnings or dividends increase. But, if affordability is a much longer-term problem, some form of security would be required, such as a charge on a property or a letter of credit to underpin lower-for-longer contributions.

Consider inflation risk premiums

Companies will also want to consider inflation assumptions in their 2022 valuations. My colleague, Andrew Udale-Smith, who also joined the webinar, says if a DB scheme is not fully hedged against inflation, the employer could consider pushing for an inflation risk premium to be introduced into the 2022 valuation basis.

“The trustees may not welcome that, but there is a growing body of economic evidence that allowing for an inflation risk premium from 0.3% to perhaps as high as 0.5% is entirely reasonable,” he says.

Given the amount of change in the pensions world and wider economy, 2022 valuations are likely to be a very different exercise compared to those in previous cycles.

Take the lead

We think it is a good idea to proactively engage with pension trustees well ahead of a scheme’s 2022 funding valuation. Before negotiating with the trustees, finance directors and CFOs should also engage with the other relevant stakeholders – from lenders to parent company directors and shareholders – while assessing their options.

At Hymans Robertson, we believe it is important, from the corporate’s perspective, to take the lead on pensions valuations and take proposals to the trustees, rather than wait for them to settle on their position. This will help employers have much more influence over the direction and ultimate outcome of negotiations.

To discuss any aspects of your own 2022 valuation please get in touch.