Hymans Robertson is urging pension fund trustees to fully understand and consider the advantages of commercial consolidators to mitigate against covenant risk.

Covenant risk is far higher for members of defined benefit (DB) with B-rated sponsors as they could face a whopping 50% chance of a cut in benefits due to their sponsoring employer going insolvent before the pension scheme is fully funded on a buyout basis, the consultancy said.

Based on the average buyout funding level of 70% in the UK at the moment, Hymans Robertson has calculated that even those corporates with better credit ratings did not fare well.

For a scheme with a BB rated sponsor there is a 33% chance of a haircut to members’ benefits, while for a BBB rated company – the most common credit rating in the FTSE 350 – there is still a 15% chance of a reduction in benefits.

This risk of a ‘haircut’ continues even when the scheme is no longer reliant on sponsor contributions because an insolvency event triggers a wind-up of the scheme, forcing annuity purchase, it added.

Alistair Russell-Smith, head of corporate DB at Hymans, said: “In reality the position is likely to be even worse than this because schemes with weaker sponsors unfortunately tend to be more poorly funded.”

The Pensions Regulator’s 2020 funding analysis shows the average buyout funding level for schemes with weak or tending to weak covenants is only 62%. ”The likelihood of employer default and a haircut to benefits is therefore very real for the 32% of UK DB members in these schemes,” Russell-Smith said.

He believes consolidators can mitigate this risk because scheme wind-up is no longer triggered on the insolvency of the ceding employer, meaning members continue to receive full benefits.

“For example, if a scheme moved to a commercial consolidator there is only a haircut to members’ benefits if the consolidator’s wind-up trigger is reached,” he explained.

For DB consolidator Clara-Pensions, Hymans has calculated this risk at less than 3%. “The risk is so much lower because of the improved funding and lower risk investment strategy, and because wind-up is no longer triggered on employer insolvency,” Russell-Smith said.

“Trustees in these schemes should seriously consider transferring to a consolidator if the funding is available. It improves member security when taking full account of the exposure to covenant risk. In some cases this may even be without the need for a cash injection from the ceding employer.”

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