Covid-19 crash widens FTSE350 DB funding chasm

• Covid-19 crash widens FTSE350 DB funding chasm
• The Covid-19 crash has caused a huge fall in market cap for FTSE350 firms with DB pension schemes – at the end of May, market cap had fallen 21% from the start of the year
• The cost of settling DB pension obligations has also shot up, with scheme deficits on a solvency basis worsening
• At the peak of the crisis, the FTSE350 solvency deficit exceeded 17% of the companies’ total market capitalisation – double the proportion at the start of the year
• In five months, the solvency deficit increased £45bn to £210bn
• Sector impact has varied hugely, as shown by the divergent experiences of consumer discretionary and consumer staple firms

FTSE350 companies with defined benefit (DB) pension schemes have been hit especially hard by the economic crisis caused by Covid-19, according to new research from Barnett Waddingham. As market cap values have plummeted, DB pension obligations have shot up, leading to a widening funding gap.

The UK stock market  has struggled to deal with the dramatic economic fallout of the pandemic, leading to a decline in market capitalisation. Looking specifically at FTSE350 companies with DB schemes, month-end market cap fell by 21% from the beginning of the year to the end of May, and even that showed a slight recovery from the end of March. Delving into the detail, DB sponsors in the consumer discretionary, financials, and energy sectors suffered the most, with the latter’s market cap falling by close to 40% by the end of April as the oil price tumbled, while healthcare, utilities, IT and consumer staples companies performed relatively well.

As the economic value of these companies fell, the cost of ultimately settling their DB pension obligations skyrocketed. Barnett Waddingham has calculated the estimated change in the overall deficit on a solvency basis to reveal that at the peak of the crisis, the solvency deficit for the FTSE350 exceeded 17% of the market cap, double the proportion at the start of the year, before settling back to 14% at the end of May.

This equates to a £45bn increase in the solvency deficit for FTSE350 companies over the first five months of the year, a huge proportion of the current £210bn total.

A tale of two sectors

The differing experience of the consumer discretionary and consumer staples sectors is a good illustration of the sectoral differences underpinning the impact of the Covid-19 crisis. Consumer discretionary companies have been hit hard by declining high street footfall and plummeting consumer confidence, while consumer staples have weathered the crisis relatively unharmed – the change in the month-end market cap of each sector can be seen here.

At the start of the year, the solvency deficit as a proportion of market cap was around 6% for the consumer staples sector and 8% for the consumer discretionary sector. These increased to 8% and 13% respectively at the end of May.

As we start to emerge from this crisis, the contrasting performance of the two sectors and the strength of any recovery is likely to have a significant bearing on future DB pension scheme funding strategy.

For the consumer discretionary industry, a key metric is likely to be the duration of each company’s DB scheme. The Pension Regulator’s consultation has proposed that schemes should be fully funded on a low dependency basis once the scheme’s duration reaches 12-14 years. The average duration of the schemes in this sector is around 18 years, so for most schemes this might suggest closing the gap to self-sufficiency over the next decade.  Given that the solvency deficit for this sector currently stands at an estimated £19bn, careful thought will be needed to bridge the funding gap at a time of clear difficulty for the sector.

The consumer staples companies could be facing a different challenge.  While there will of course be competing demands for any additional cash generated during the last few months, some companies might see an opportunity to close the sector’s estimated £26bn solvency deficit.  Based on current contribution levels, around 30% of the consumer staples companies could buyout their DB scheme within 5 years.  However, a trebling of contributions could result in around half of the consumer staples companies being in a position to buyout within 5 years.

Simon Taylor, Partner at Barnett Waddingham, said: “The Covid-19 crisis has caused severe disruption across the world economy. The UK’s pension landscape is no exception, and with the peak of the crisis seemingly behind us, those responsible for pension scheme funding will now be taking a deep breath and looking to the future.

“A combination of plunging equity markets and the continued downward march in gilt yields has pushed funding levels further into the red, though the fall in inflation expectations will have provided some respite. Of course, DB pension scheme funding is a long-term enterprise, and this shortfall will not need to be met any time soon, but the regulatory direction of travel will be causing concern for some companies.  TPR is not pushing for schemes to reach buyout funding levels, but the aim for schemes to fund up to a low dependency basis will require a material proportion of the current estimated £210bn FTSE350 solvency deficit to be covered over the coming years.

"Unfortunately some organisations will not recover from this crisis - achieving security for the benefits promised to members will be of paramount importance when some of these difficult discussions commence. 

“Those responsible for endgame funding strategy should be carefully reviewing the impact of the recent crisis, and where necessary rethinking their journey plan to reflect the changed environment, incorporating the changes to covenant strength and funding position within the overall funding and investment strategy.”