Deficits and “the Donald Trump tariffs” – potential double trouble for UK corporates

Covenant strength

Where schemes have been funded to buy-out levels or just generally super well-funded, in recent times there has perhaps been less focus or concern with the strength of the sponsor’s covenant to the scheme. After all, the security is in the funding level for the buy-out of benefits. DB pension schemes are often the largest creditor of the company (where there is a deficit) and the key role of the trustee is to protect against the risks of the failure of the sponsor – in which case many schemes will turn to the Pension Protection Fund to pay compensation to members in place of their accrued benefits in the scheme.

This compensation is valuable but not as generous as the value of their full scheme benefits, including pension increases. Where schemes are funded above Pension Protection Fund (PPF) compensation levels they will instead wind up outside of the PPF. Both scenarios will not produce the same security for members’ benefits compared to a solvent buy-out with an insurer.

Trustees need to consider with their sponsors the potential adverse impact of the US tariffs on the business of the sponsor, to understand the exposure and manage any knock-on trading and financial risks. Schemes need to be treated equally fairly to other unsecured creditors (unless the schemes have security or guarantees in place to guard against these covenant risks).

Trustees need to understand the impact of any concerns on their scheme funding plans in place with the sponsor. Trustees will need to find ways to effectively monitor the impact of these tariffs on the financial covenant of the sponsor and this will include putting together effective information sharing protocols with the sponsor. The sponsor may engage with this process and where impacted, seek to reduce its own costs – it may look to re-negotiate recovery plans and/or defer the payment of deficit recovery payments (a process last seen during the Covid crisis a few years’ back now). It will be key for trustees to get the engagement of the sponsor to these issues, which may not be easy if the sponsor is impacted by these adverse trading conditions, as it will be focused on running the business in this stormy weather. This may involve the trustees instructing covenant advisers to undertake an analysis of various economic and trading scenarios to understand the best outcome for the scheme and members in each scenario. It will be key to prepare ahead of time for each such risk testing scenario.

For trustees, this storm coming from the US markets is perhaps a lesson to ensure that effective information sharing protocols are put in place with sponsors to effectively review the strength of the employer covenant on an ongoing and continuing basis. It may also make trustees more wary about sponsor proposals to run on a scheme where there is a buy-out surplus or where only a small cash injection would be required to reach buy-out. It could be a lesson on the volatility of pension scheme funding generally and the risks associated with running on schemes and potentially gambling with the security of member’s benefits.

The route to buy-out takes a few years for most schemes – a relevant factor here will be how long will this US economic policy last? There are rumours that President Trump may somehow apply for a second consecutive term in office, so watch this space! If you require advice in respect of private and public sector pension schemes, regulatory compliance, pension disputes and life assurance, see how our Pensions team can assist.