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Should you expect a pick-up in companies becoming insolvent? Three covenant experts provide an assessment of what trustees should prepare for, including a materially weakened Pension Protection Fund.
In the third quarter of this year, profit warnings by UK companies have reached 77, the highest since 2008, with 32% citing sales being short of forecasts and 30% delayed or discontinued contracts. Brexit, at 17%, was the third most-cited reason, according to consultancy EY.
Total profit warnings for this year up until Q3 are now at 235 – Q4 data, which is usually when the highest number of profit warnings are issued, is still to come. Compared with last year, when the total was 287, there could well be an increase, which does not bode well for 2020.
Government insolvency statistics are also showing an upward trend. Given the stresses that sectors such as retail, automotive, construction and support services are under, some trustee boards could be in for a difficult start to the new year.
More companies issue third profit warning
Karina Brookes, a transaction advisory partner in EY, has more bad news. “What we can see is more companies are on their third profit warning,” she notes, adding that “most don’t survive past that point”.
The good news however is that trustees have not been blind to these developments. Most are looking at scenario and contingency planning. Brookes says this can range from a protocol about getting people to the table, to basic things like having a separate bank account. A growing number of trustees are also putting place information sharing frameworks to make sure they know what is going on with the sponsor.
‘Now we have certainty, things will happen’
Brexit and the last election had left many things hanging in the balance, but “now we have certainty, things will happen”, says managing director at covenant advisory Lincoln Pensions, Richard Farr. This will act both ways – some companies will improve, others will be tipped into the red by this new certainty, he explains. Overall, he predicts a pickup in insolvencies next year. “There's a bow wave of insolvencies coming through,” he forecasts.
Retail is suffering and could have a knock-on effect on landlords, while “automotive is going to be really interesting”, with the switch away from diesel.
One new development next year could be private equity firms being more willing to take on pension risk. This could reduce the number of schemes having to undergo Pension Protection Fund assessment. “It's not mega flows here, but I think there will be a subtle change next year on the horizon,” says Farr, adding that he has seen much more interest from private equity companies specialised on the stressed segment to take on pension funds.
Farr stops short of saying that private equity schemes handle DB schemes well, but “they know what they’re doing and are not afraid of the risk at the right price”.
A struggling retail sector will hit the owners of out of town retail parks hard, agrees Simon Kew, a director at consulting firm Deloitte – even before a retailer goes under. Insolvent companies could seek support for a company voluntary arrangement, where the creditors, including the landlords, accept a lower repayment rate over a fixed period. If a landlord has to accept such credit repayment schedules from several firms, it could come under pressure itself.
“I think it’s going to be an interesting time for schemes. If ever there was a time when they needed to understand where their sponsor is and is going, it’s now,” says Kew. While they will not be able to influence what the company does in its business, they will need to keep a dialogue going, he says.
Could the PPF absorb a rise in insolvencies?
Even if the worst happens, the Pension Protection Fund is well placed to absorb a potential rise in insolvencies, says Kew, pointing out that it has already taken on “sizeable” schemes.
The lifeboat fund reported a surplus of £6.1bn for 2019, being 118.6% funded as at March.
However, large underfunded schemes falling back on the PPF remains a big risk. “In extreme adverse scenarios future claims could be well above our current reserves,” the PPF said in its latest annual report, which is easy to believe given the aggregate deficit of underfunded DB schemes was £208.9bn at the end of November.
The other issue that could seriously put the PPF at risk of failing is a judgment by the Court of Justice of the European Union, expected on Thursday. This should determine whether pension lifeboat funds in the EU are obliged to replace 100% of the benefits of all members, as recommended by the advocate general.
The PPF currently guarantees 100% for retired members but only 90% for non-retired members, with caps applying on payments and increases. An increase in benefit payments would almost certainly lead to higher levies, but it is unclear if levies alone could cover a potential shortfall in case the CJEU follows the advocate general’s opinion.
A PPF spokesperson said: “We note the Advocate General’s opinion. We await the outcome of the case with interest.”
Previously, the PPF had said that “if the judgment follows the opinion, it could have a material impact on the PPF and its funding position”.
How are you preparing for any deterioration in the strength of your sponsor covenant, or even an insolvency?