Perspectives

Covenant is king in the wake of China’s Black Monday

Trustees should review covenant strength in times of market volatility

August 2015

What happened?

Global markets have taken a hit in the wake of Chinese stock market woes. The Shanghai Composite, China’s main stock exchange, fell 7.6% on Tuesday 25th August - after losing 8.5% the day before.

This has led to comparisons to “Black Monday”, the day in 1987 when the Dow Jones fell by nearly 22% in just one day, leading to a global stock market decline.

The comparison may be apt as stock markets across the globe fell between 3-6% at the news of China’s troubles, including the Dow Jones, the FTSE 100 and key markets in France and Germany.

Pension scheme trustees may have been more worried than most as deficits increased by £30bn in one day due to fears of a global slowdown, according to Hyman’s Robertson.

John Walbaum, partner and head of investment consulting at Hymans Robertson explained, “World stocks sank further yesterday due to mounting fears of a Chinese-led global slowdown. Here in the UK the FTSE100 has fallen around 5%. Bond markets have been affected too, with yields moving south.

“This has led to the aggregate deficit of UK private sector defined benefit (DB) pension schemes widening by c£30bn in one day.”

What does this mean for trustees?

Some trustees may need to re-evaluate the risk profile of their schemes, said Walbaum. “Monday’s market movements send a strong message to companies and pension trustees to place greater emphasis on managing the risks in pension schemes. Volatility in capital markets is a fact of life. As we’ve seen yesterday, market sentiment can turn very quickly.

“Many UK DB schemes are taking more risk than they need to” – a fact that yesterday’s market movements will have brought into sharp focus. In this context, companies providing DB pensions and the trustees running them should focus on two key questions.

“First, is your allocation to equities and other growth assets appropriate?… Second, have you got appropriate protection in place to safeguard your scheme through the inevitable bumps in the road?”

“Pension fund trustees should be conscious of the volatility that is currently prevalent in markets but not necessarily worried. Any knee jerk reactions are likely to be the wrong ones and as we’ve already seen today, markets have a habit of correcting to some extent when they’re over-extended.

“As long as they’ve got sensible long term strategies in place, short term movements shouldn’t be the basis for decision making, especially ones that can be explained by underlying macro themes in markets,” he said.

However, this doesn’t rule out the possibility of taking advantage of market opportunities, especially for trustees with the frameworks in place to take advantage of these movements.

“These could be in the form of pre-agreed trigger levels, moving to add either hedging or return-seeking on an opportunistic basis, as well as longer term de-risking. When markets move this quickly, it underlines the importance of making the decision (of setting a trigger) in a careful and well thought out manner, to avoid being caught out by short-term sentiment or emotion,” said Parry.

Schemes with weaker sponsor covenants may need to act, said Kew. “If the increase in deficit is significant enough that the current recovery plan is potentially no longer viable, trustees should question if it would be appropriate to seek increased deficit contributions from employers with a stronger covenant.

“For weaker employers, trustees should consider whether the extent of further downside risk given the current investment strategy could be borne by the employer, and reviewing their options and powers if it could not.”

However, for most trustees the answer will lie in the strength of their employer covenant, said Simon Kew, an assistant director in Deloitte’s pensions advisory team.

“Where we see market volatility, the recent Chinese stock market slide being a contemporary example, it is natural for trustees to show concern. They should remember though that funding a defined benefit scheme is a long-term prospect for most sponsors, so understanding the strength of their participating employers in times of economic stress is hugely important,” he explained.

“If the employer covenant is strong, the ability to ride out these issues is greater than those with weaker a covenant. Trustees should seek clarity, either from the employer or from the scheme’s covenant adviser, as to the impact on the sponsor (in tandem with looking at the funding position of the scheme) then assess if any change of plan is required in their investment strategy.”

William Parry, an investment consultant at Buck Consultants agrees that trustees should not panic. He argues that impulsive reactions will often leave schemes in a worse off position.

“Pension fund trustees should be conscious of the volatility that is currently prevalent in markets but not necessarily worried. Any knee jerk reactions are likely to be the wrong ones and as we’ve already seen today, markets have a habit of correcting to some extent when they’re over-extended.

“As long as they’ve got sensible long term strategies in place, short term movements shouldn’t be the basis for decision making, especially ones that can be explained by underlying macro themes in markets,” he said.

However, this doesn’t rule out the possibility of taking advantage of market opportunities, especially for trustees with the frameworks in place to take advantage of these movements.

“These could be in the form of pre-agreed trigger levels, moving to add either hedging or return-seeking on an opportunistic basis, as well as longer term de-risking. When markets move this quickly, it underlines the importance of making the decision (of setting a trigger) in a careful and well thought out manner, to avoid being caught out by short-term sentiment or emotion,” said Parry.

Schemes with weaker sponsor covenants may need to act, said Kew. “If the increase in deficit is significant enough that the current recovery plan is potentially no longer viable, trustees should question if it would be appropriate to seek increased deficit contributions from employers with a stronger covenant.

“For weaker employers, trustees should consider whether the extent of further downside risk given the current investment strategy could be borne by the employer, and reviewing their options and powers if it could not.”

What next

Schemes are unlikely to get any reprieve in the short-term. Black Monday was a bit of an outlier, but the movements this year and the frequency of the change in direction of trends are symptomatic of continued volatility.

Trustees who have not recently reviewed their covenants should seek to do so, to understand how future volatility may affect investment decisions.

They may also wish to review the triggers they have in place, to best take advantage of any future market movements.

This article was originally published by Engaged Investor

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