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U.K. covenant impacts of COVID-19

U.K. covenant impacts of COVID-19

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The COVID-19 pandemic is a once-in-a-generation global emergency. Across the world, businesses are struggling to operate as governments restrict citizens’ movements in desperate attempts to slow the spread of the virus, protect fragile healthcare systems and save lives. Surveys have shown sudden, rapid declines in economic activity that rival or exceed those experienced after the 2008 financial crisis. For those with access to the right technology and income-generating work that can be done from home, these may prove minor and temporary inconveniences. Others will have livelihoods wiped out.

It is impossible to fully predict just how deep and long-lasting the economic effects will be. However, I would like to suggest some covenant themes that employers and trustees of UK defined benefit schemes need to think about, as they navigate through this crisis and out the other side.

Short-term cash crunch, long-term weakness
It increasingly appears that the UK ‘lockdown’ will be a long one. Different companies and organisations will experience problems at different times as impacts ripple through supply chains and the global economy. It only takes one critical link of a supply chain to break for the whole chain to fail. For example, a car manufacturer may be able to source all the engines, wheels and tyres it needs – but if it can’t get any handbrakes it can’t complete any cars. In which case it will cancel orders for other parts too, and a whole industry grinds to a halt. Many car manufacturers have suspended operations, with knock-on effects throughout their supply chains; similar effects are being seen in other industries.

Businesses go bust – even profitable ones – when they run out of cash. Companies experiencing or anticipating cashflow pressure will look to delay payments wherever they can. Many will want to accelerate the collection of debts and delay payments to suppliers. By definition, not everyone can do both at the same time: there are two sides to every transaction and the system depends on the continuous circulation of cash.

With reduced cash receipts, many companies will need to resort to borrowings to service fixed costs that cannot otherwise be cut. The government has put business support measures in place, including loan guarantees and delayed tax collection. Only some of the support measures are grants, such as the furloughed workers scheme (the details are still unclear). Loans, including delayed tax collections, will need to be repaid. So many companies will come out of the crisis more heavily indebted but with no investment to show for it. They will have higher financial risk and interest costs for no benefit, other than having survived.

Getting moving again
Whenever restrictions are eased, it will take time for many businesses to get back to normal levels of activity. When you are struggling up a gradient, it is much easier to stop than it is to get moving again. Restrictions may be eased in different places or for different categories of worker at different times. Backlogs will need to be cleared and perishable supplies replenished. The more complex and geographically spread a supply chain is, the longer it may take for the different parts to get back to full operation.

Where borrowing has been used to cover running costs, there will be limited scope for borrowing for investment in projects that might otherwise have grown the business.

There is also a big question of how and when government support measures will be withdrawn and what will happen when they are. It is easy to announce measures in a crisis, less easy to implement them effectively and very difficult to find an exit route.

Brexit hasn’t gone away
Speaking of exit routes, Brexit has not gone away but continues to hang over British business. At the time of writing, there have been only three and a half days of formal negotiations on the future relationship. A second round of meetings in March was postponed because of coronavirus and there has been no news on a third round due in April. The lead negotiators on both sides have had the virus. While it is easy to hold small meetings by video conference, these negotiations can involve numerous officials and are likely to be far more logistically challenging.

At present the UK effectively remains in the Single Market and Customs Union under a transition period through to the end of this year. Under the Withdrawal Agreement, the transition period may be extended by one or two years, i.e. to 31 December 2021 or 31 December 2022, if both sides agree by 1 July. The UK government has said that it will not agree to any extension (indeed it legislated to prevent itself from doing so), but this is seen as increasingly untenable.

Nevertheless, as things stand, companies that are struggling with the pandemic are also supposed to be preparing for new trading arrangements from 1 January 2021, when these have yet to be agreed. A decision on the Brexit transition therefore needs to be made quickly to ease some of the uncertainty affecting business.

So what is to be done?
If there is a positive to be drawn from the crisis, it is that many businesses have been able to implement existing contingency plans for supply chain disruption, which they developed in anticipation of a possible ‘no deal’ Brexit last year. While such plans won’t have covered the full effects of a widespread ‘lockdown,’ those businesses who did plan for supply failure and transportation delays will have had a head start in dealing with the current situation.

It is important that trustees ask questions of employers to understand the covenant risks and what is being done to address them. If there are signs that the company is in distress (for example, asking to delay deficit recovery contributions), then trustees should urgently request detailed financial information, as recommended in the Pensions Regulator’s statement of 20 March.

However, for many the first stage is to ask for a narrative explanation of the effects of the pandemic on business operations and finances (staffing, suppliers, customers, logistics, cash flow) and what use, if any, the company expects to make of government support schemes. This will lay the groundwork for more detailed discussions that may become necessary if the situation worsens.

Learn the lessons
Some managers and trustees who thought that they had stable business that could be relied upon for the long term are finding out that they do not. While undoubtedly some companies and sectors will thrive in this crisis, others that survive will come out of the other side weaker, more indebted and with greater long-term risk. Whenever this crisis is over, employers, trustees and advisers should work together to learn the lessons and update integrated risk management plans. We will then be better placed to accelerate the fixing of defined benefit pension schemes before the next storm hits.

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