The British Steel and BHS cases have drawn attention to structural flaws in the UK’s defined benefit system when it comes to the sponsor covenant, writes Gill Wadsworth 

At a glance

• Persistent low Gilt yields and on-going market uncertainty following Brexit threaten the stability of DB schemes.
• Employer covenant assessments have been neglected by some defined benefit scheme trustees.
• Trustees need to work with their sponsor to secure formal protection for the scheme in the trust deed.
• The government faces criticism for considering special measures for certain schemes in isolation.

Irrespective of where you stand on the outcome of the EU referendum, there can be no denying the devastating impact on defined benefit (DB) schemes.

UK scheme sponsors are on the hook for £2.3trn (€2.7trn), according to Hymans Robertson, and the consultancy says the cost of funding DB liabilities has risen by over 50% in the past 12 years thanks to low yields on UK Gilts. 

The result of the EU referendum has only complicated matters by creating market volatility, unsettling the Bank of England and creating widespread uncertainty.

The timing of this latest shock to the financial system could not have been worse for DB schemes. Their plight is well known – closure, wind ups and a march into extinction – but several high profile cases including the pension scheme of the now insolvent high street retailer BHS and the British Steel Pension Scheme (BSPS), whose main sponsor is Tata Steel – have made clear the tensions between employers, trustees and the Pensions Regulator (TPR) when it comes to funding.

At the heart of the matter lies the employer covenant and the sponsor’s ability to meet benefit obligations. 

In spite of its importance, nowhere in trust law are trustees obliged to undertake a review of their employer’s current and future financial prospects. 

The Pensions Regulator, meanwhile, introduced integrated risk management as part of the DB code of conduct in 2015, which encourages trustees to consider the strength of the employer alongside investment and funding risks. TPR also suggests trustees carry out a covenant review but this is only guidance with no legal recourse.

But Janet Brown, partner at law firm Sackers, says trustees have no excuse for failing to assess the strength of their sponsor. “[Reviewing] the employer covenant doesn’t appear in legislation but TPR code says it is quite pivotal in setting investments and valuation assumptions. It is important trustees look at this as part of the [integrated risk management] triangle of funding, investment and covenant to make sure they do not make decisions in a vacuum,” Brown says.

Even where trustees do conduct an employer covenant review there is some concern these may be done without the thoroughness required to garner a clear picture of the sponsor’s health.

Martin Jenkins, pensions partner at law firm Irwin Mitchell, says some trustees have paid lip service to the review process to appease the regulator.

“There is a tendency to say ‘let’s keep the regulator quiet by paying for a report’ and then [the trustees] can say it’s been done. There has been a lot of box ticking on [sponsor covenant reviews],” Jenkins says.

Standing in the way of control

There are several obstacles trustees must overcome if they are to understand their sponsor’s financial health, not least of which is the employer itself.

The CEO or finance director is often best placed to provide the financial information – both current and forward looking – to build an accurate picture. Yet in providing that information, the employer is invariably lining itself up to pay more contributions into the fund. 

In the period that liabilities have doubled, Hymans Robertson reports sponsors have paid an additional £30bn in contributions, apparently throwing good money after bad.

And while commentators welcome the inclusion of senior company employees on the trust board, conflicts of interest must be managed. Jenkins says: “Having someone from the finance team, including the CFO, as a trustee is valuable but at the same time they put themselves into unmanageable conflicts. It is a balance between having sufficiently senior, informed and skilled people on the trustee board who are in touch with business but not to the extent you set off conflicts at every meeting.”

Understanding the employer’s structure is a second challenge for trustees. In numerous cases where issues have arisen between sponsor and trustee, a change in parent company following a takeover or merger has played a part.

Brown says it is critical trustees understand where they feature in the creditors’ pecking order. “The starting point is to ask who has legal responsibility for the scheme. If there is a takeover, what happens to the corporate structure, are you being loaded with debt,” he says.

Given the shaky ground on which trustees stand when it comes to securing their due share of sponsor financing, tightening trust deeds and getting formal agreements in place gives them more security.

Richard Farr, managing director at Lincoln Pensions, which specialises in covenant assessments, says: “Trustees need to know what power they have got to enforce their rights. If they’ve got a powerful trust deed they can be more relaxed in the event something is going wrong with the employer. However, if [the deed] is impotent then there is not much they can do apart from threatening to whistleblow to TPR.”

Make it formal

Carrying out a formal and thorough covenant assessment affords the opportunity not only to identify where the sponsor is looking weak but also to recommend a course of action to resolve the problem.

Such reviews have been criticised for being expensive, and Farr says there is no doubt trustees have been disappointed by quality and price. However, he says, trustees need to be clear in the scope of the review and pay a fair price.

Richard Farr

Farr continues: “It is up to market suppliers to create value for money, and the customer is always right, but the trustees need to give a fair brief and pay a fair fee. There is no point complaining [the assessment] is a waste of money if they push the fee down to a low level and limit the scope.”

Refusing to pay for a comprehensive covenant review may be a false economy especially if trustees need help in securing the scheme’s future and avoid falling into the Pension Protection Fund.

The PPF offers existing pensioners 100% of their current benefits, but for members yet to retire, pensions are capped at 90%, meaning the lifeboat fund should be a last resort. At the same time, TPR is anxious to avoid more schemes calling on the PPF since its mandate is to protect the fund.

It is no surprise then that in cases where multi-billion pound schemes such as the British Steel Pension Scheme are knocking on the PPF’s door, that TPR is willing to consider alternative action.

The Department for Work and Pensions is considering options to secure the benefits of the scheme and help find a buyer for Tata Steel after its Indian parent Tata said it was selling the beleaguered company.

A consultation into the future of the BSPS closed on 23 June 2016, the same day the UK voted to leave the European Union.

Among the possibilities for a deal, DWP proposes reducing liabilities by cutting member benefits.  

Farr welcomes the possibility of cutting benefits if it saves an employer, but he is less enthusiastic about any special deals agreed on a scheme-by-scheme basis.

Farr says: “It’s disappointing that [DWP] can create a special case for one scheme. What it should be doing is setting that as a precedent. The idea of cutting benefits under certain circumstances has to be allowed but it should done before things go badly wrong rather than waiting for the PPF to come in.”

Failure to recognise the importance of employer covenant assessment and enshrine this in law has undermined the stability of DB schemes. Parent companies have shirked responsibilities, while TPR has been slow in offering new ways to fund schemes to the benefit of both sponsor and trustee.

Farr predicts 1,000 DB plans are on the brink of collapse and says unless more is done to help save sponsors and rejuvenate funding positions, many members can expect a hefty cut to benefits.

BHS case highlights governance inaction

The frosty exchanges between Sir Philip Green, former owner of the now defunct BHS, and the Work and Pensions Select Committee made fascinating viewing.

Having paid millions in dividends to his tax-exile wife, Green then sold the retailer to Dominic Chappell for £1, only for the new owner to pay millions more out in family loans before the company fell into administration. The scheme was left with a £571m shortfall and fell into the PPF.

In his evidence to the select committee in June, Michael Hitchcock, former finance consultant at BHS, told MPs: “It is important to note that there were so many advisers advising TPR, the PPF, the business and [Retail Acquisitions Limited] that in some of these meetings it was like a tea party. There was just a mass of people. You were never going to find a solution [to the deficit] with such a huge number of people in the room. It was never going to happen.” 

And a solution was not found. The BHS trustees appear to have been unable to secure support from their sponsor when it ran into difficulties, and while millions of pounds were paid to outside parties, the scheme struggled to get additional contributions.

While the government did not intervene to save BHS from insolvency it may yet do so for Tata Steel’s remaining UK operations.

Parent company Tata is selling the business but, since the British Steel Pension Scheme (BSPS) has a deficit of £1.5bn on a buyout basis, the operation looks unattractive to buyers.

The government does not want the failure of this industry, resulting in the loss of 4,000 jobs in a deprived part of Wales, so it is consulting on a plan to separate the scheme from the business.

This is creating consternation to industry commentators who consider special treatment for BSPS unacceptable.

Joanne Segars, chief executive of the Pensions & Lifetime Savings Association, says: “It is inconceivable the government can realistically consider these changes for the British Steel Pension Scheme without also considering amendments for all schemes, given that many defined benefit schemes face very similar challenges.”

The Work and Pension Select Committee continues to hear evidence in its BHS inquiry, while the DWP is yet to respond to the British Steel Consultation.