I like the way that LCP are allowing their up and coming consultants to be expressing themselves so freely through blogs. And I like Robin Alexander’s blog a lot. That’s not me being condescending, it’s me saying I wish I could have written the blog Robin has.

The nub of his argument is that while high interest rates are creating pension surplus’, they are crippling the capacity of employers to service their debt to the pension scheme.

In terms even I can understand, many employers are having trouble affording their DB pension schemes and would greatly appreciate a bit of help. To put it more technically, Robin tells us

Noting that every company is unique and will have different business drivers and debt structures, generally speaking the higher interest rate environment will result in negative indicators for covenant strength, eg creating demand pressures through lower disposable incomes and increased spending on debt servicing (where a business is highly leveraged and interest rates are not fixed / suitably hedged).

It is likely that elevated interest rates for a prolonged period of time will result in an increased number of businesses coming under some form of strain in servicing their debt. The knock-on effect of this is that many companies will have less cash available for strategic projects, capital expenditure, deficit repair contributions to pension schemes, and in extreme cases may result in the need for insolvency or restructuring processes.

As noted in our previous blog ‘Are many DB sponsors at tipping points?’, Q2 and Q3 2023 have seen the highest levels of company insolvencies since 2009. While there are also other macroeconomic factors contributing to the higher levels of insolvency, increased interest rates have almost certainly contributed.

However, funding positions have improved for many DB schemes as a result of increases in gilt yields. So as a counter to potentially weakened covenants, the period and quantum of covenant reliance may have reduced for many schemes.

There is a simple answer to the issues that “higher for longer” interest rates bring to trustees and their sponsors and that is to work better together. Rather than the arm-wrestles that characterised a decade and more of underfunding, we are moving into a period where better understanding is the key driver to continued solvency.

LCP is arguing that the key is the sharing of information and the proper understanding by trustees of the debts that sponsors have and will take on.

Trustees should ensure that they have a solid understanding of how the business drivers, costs bases and debt structures of their sponsor could be impacted given a higher rate environment.

In particular regarding the debt structure, there are a number of critical matters to understand:

• The terms of the borrowing and cash flow impacts of changes to rates will help the Trustees to understand any upcoming liquidity pinch points.
• Whether increased interest rates or trading pressures could put banking covenants under pressure, which could give more control to lenders at the expense of other creditors.
• When the sponsor next needs to refinance, as this could be on notably more adverse terms (not only in terms of the cost of debt, but also with more restrictive banking covenants and / or the need for security to be provided).

There is of course an element of “they would say that wouldn’t they” and there are plenty in pensions who consider covenant advice  redundant. But it’s clear that LCP aren’t just talking its own book, most trustees are not specialists in corporate finance and do need the help of advisers to properly understand their relationship with their sponsor.

The key to understanding these matters is built upon the strength of relationships with sponsors and ensuring a transparent flow of relevant financial information. In our experience information sharing protocols with employers (ie formally documented checklists of what information will be provided to Trustees and their covenant advisers, and when), are an important part of any scheme’s governance toolkit.

These are new insights and they are born out of a renewed confidence among trustees and sponsors that they have an ongoing relationship with the pension scheme.

Put another way, would you really be bothered about your sponsor if you were pre-packing your scheme for buy-out? And would you really be talking to the trustees, if your primary objective was to sell your scheme, at a 20% discount , to an insurer.

So long as we have strong covenants and well managed pension funds, we can afford to pay higher pensions for longer. The role of the adviser in this is  noted.