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More contribution deferrals mean “Switch on” mechanisms are becoming increasingly important

Policy & regulation

For many sponsors of DB pension schemes, the financial disruption caused by COVID-19 has been significant.

In recognition of this, the Pensions Regulator issued guidance in March setting out criteria by which trustees could agree to employer requests to defer contributions for up to 3 months – or potentially a longer period if supported by robust analysis. (You can see more information in the guidance in Jon Camfield’s recent blog).

In order to defer contributions, companies need to establish a clear need for a deferral, show that it treats the scheme fairly versus other creditors (including stopping dividends) and put in place a clear plan for missed contributions to be made up.

Our initial analysis, now supported by a growing body of industry evidence, is that around 10% of companies and schemes have already agreed to defer contributions during March and April.

How might this evolve?

As we might expect, the initial wave was led by employers in industries worst affected by COVID-19, including leisure and travel, where the need to conserve cash was immediate and stark. However, for some more recent cases we have begun to see companies seek to discuss contribution deferral agreements as part of wider, but no less important, contingency planning.

This second group is likely to include companies that went into the crisis on a stronger initial financial footing, or perhaps suffered less significantly overnight from the impacts of COVID-19 but could be more materially impacted if disruption is prolonged. These cases might also include those where existing funding arrangements are more complex (for example involving existing contingent funding arrangements).

Polling evidence from our recent Webinar for scheme sponsors suggests that in addition to these first group of cases, a further 20% of companies are currently considering making deferral requests. Overall, this could mean that around a third of companies reach agreement to defer at least some contributions by the end of the second quarter of 2020.

Whether these additional cases do emerge remains to be seen but, if they do, this could mean over 1,500 UK pension schemes ultimately being affected, and a potential deferral of around £1.5bn in quarterly contributions.

How will schemes turn the contribution taps back on?

Importantly, each of these cases requires agreement between the company and trustees regarding how contributions will be restarted and, ultimately, made up. For companies that have already agreed short-term suspensions, this might also include whether and how suspensions might be extended. These contribution “Switch-On” mechanisms require significant planning, with regular covenant monitoring and open information sharing.

The “fairness” criteria highlighted in TPR’s guidance also suggests schemes should be looking to make sure they share in upside as and when it emerges. There is a direct read across here to wording in this week’s Annual Funding Statement from TPR, which gives guidance for trustees and sponsors currently undertaking triennial finding valuations. While not offering any new specific easements, the AFS included new guidance for schemes with sponsors affected by COVID19 that:

“in addition to deficit repair contributions (DRCs), where possible, we expect trustees to incorporate appropriate incremental increases in contributions, which track corporate health recovery, especially when the scheme has taken on additional funding risk while supporting the employer's recovery. Additional contributions should be based on appropriate triggers such as free cash flow and payments to other creditors.”

Taken together, this suggests an evolving picture in which many schemes begin to build significant contingent contribution mechanisms into their funding agreements, whether as a direct result of utilising TPR’s COVID-19 guidance or, over time, as part of business as usual principles for upcoming valuations.

However these events play out, this means the challenges of agreeing appropriate contribution agreements, including appropriate “Switch On” mechanisms, look set to increase.