As the conflict in Ukraine continues, trustees are urged to focus their attention on covenant strength.  How might pension scheme sponsors be affected?  

  

The invasion of Ukraine by Russia led to a slew of sanctions from the West aimed at hurting Russia’s economy. Global firms like Coca-Cola and McDonald’s have said they are closing their Russian operations, and the big four have cut ties with the Russian firms in their networks.   
In retaliation, the Kremlin said it would confiscate the assets of international businesses that have stopped operating in Russia, according to the Financial Times, but it is not just the direct exposure companies will have to deal with - there is a growing risk for businesses from a wider economic fallout.  

  

  

“In discussion with my trustees, covenant is the key perspective, and it’s a bit alarming that all the focus seems to have been on investment portfolio, which is obvious but largely irrelevant,” said Neil McPherson, the managing director of trustee firm Capital Cranfield.   

  

For the vast majority of UK schemes, their investment exposure to Russia will be minimal, he said, and in any case, selling is almost impossible at the moment – and would be guaranteed to crystallise a loss.  

  

“The covenant issue will be a longer burn,” he said, which ranges from the immediate impact of sanctions and the evolving impact on supply chains and commercial markets, to the more significant  longer term issue of potential structural change – such as energy supply problems and inflation among others.  

  

As well as complying with sanctions, the Pensions Regulator told trustees in early March to be “vigilant” and expects them to consider if the employer or sponsor of the scheme has been affected either directly or through higher inflation, rising fuel prices or foreign exchange risks.  

  

  

Macroeconomic factors will affect most sponsoring employers – and they come on top of an already worsening economic outlook. The global economy was just recovering from the pandemic and supply chain issues when the conflict started, and UK inflation stood at 5.5% in January, nearly three times the Bank of England’s 2% target. Central banks were expected to raise rates from their ultra-low levels.  

  

Cardano Advisory said central banks are so late to start tightening that they will be doing so into an already slowing economy, risking a recession. “Our base case was that a soft landing can be engineered, but that central banks will not be able to be anywhere near as hawkish as the bond market, and increasingly their rhetoric, currently suggests,” said Richard Farr, managing director and covenant specialist at Cardano.  

  

Inflation will be kept higher for longer due to the war in Ukraine - and economic growth is likely to slow down more quickly than was already the case, he predicted. “This increases the likelihood of a recession and also raises concerns around a stagflation... environment,” Farr said.  

  

Russia’s vast oil and gas reserves, which it exports to Europe among others, are the key reason for this. Energy prices already saw a sharp rise before the conflict, but the current war could lead to a further dramatic spike, ramping up production costs for businesses – which they will likely pass on to consumers. Supply chains will also be further disrupted, delaying the delivery of final goods. “We are already seeing that with closures of factories in Eastern Europe,” said Farr.   

  

  

However, “Ukraine is a European issue” that will not affect growth in the US much, he said, meaning it will be primarily a problem for those employers that are heavily dependent on European markets.  

  

A deep recession outside of Russia “remains unlikely”, he said – but “the risks are most certainly growing”. All employers should therefore monitor some key economic indicators very closely, including inflation and stagflation, interest rates, oil prices, consumer demand, employment, supply chain issues and supply chain price pressures, he advised.  

  

  

“This is just another shock just as business was starting to open up again,” said Andy Palmer, a pensions partner at consultancy BDO. He said it is too early to say what the impact will be; while the cost of energy is going up and will hit sectors with high energy needs hardest, many companies will have hedged their input costs in the short term, he noted. “It is... not until the fixed price deals fall away that they are hit by the burden of higher cost, but it adds to the uncertainty”, he said. The distribution and delivery of goods will also become more expensive as fuel prices increase, adding further to inflationary pressures.  

  

“What will happen to wage demands – they are unlikely in many cases to be fully offset by wage increase, which means consumers have less money to spend, which can lead to lower consumption,” he explained.    

The combination of these factors will make for an adverse trading climate and “could potentially hasten vulnerable businesses becoming insolvent” he said, “but I wouldn’t go as far as saying there is going to be a surge in insolvencies”.  

  

Palmer encouraged trustees to seek a dialogue with the employer so they get their perspective on how it might impact key elements of the covenant, whether that is related to investment or trading – not just looking at direct exposure to Russia, but at what it could mean for input costs in particular.  

  

Neil McPherson

Richard Farr

Andy Palmer