Many defined benefit (DB) scheme sponsors will be facing this challenge over the coming months and years. Trustees must be well placed to spot the warning signs and should act to mitigate the risk to member benefits as well as the potential entry of schemes into the Pension Protection Fund (PPF).

So, what are those early warning signs? And what mitigation actions can trustees take?

In line with The Pensions Regulator’s (TPR’s) recent guidance on ‘protecting schemes from sponsoring employer distress’ the following are some key warning signs to consider:

• Financial performance – declining revenues, margins/ profitability, cash flow constraints and loss of key customers can be indicators of pending distress. Further down the financial deterioration curve, failure to make creditor payments as they fall due is potentially a sign of impending insolvency. 
• Financial arrangements – high financing costs can show that a business is more susceptible to a downturn in its fortunes whereas breaches of banking covenants or the withdrawal trade credit insurance may indicate imminent failure.
• Sponsor events - such as credit downgrades, a rapid fall in share price, profit warnings and even the loss of key personnel within the business. 
• Scheme events – missed scheme payments and deficit repair contributions (DRC) deferral requests are further flags. As is a failure to provide information requested or in line with agreed protocols.

So what action should the trustees take when faced with these circumstances?

The answer to this question depends largely on the level of financial distress being suffered by the sponsor with the trustee’s options ever decreasing with each uptick in the risk of insolvency.

There are, however, some key actions which trustees can consider:

• Information – to ensure the flow of information which is critical in monitoring a sponsor’s financial standing and trading performance, guaranteeing early awareness of covenant issues and no unnecessary covenant leakage. As far as possible, trustees should have robust information sharing protocols in place with scheme sponsors.
• Professional covenant advice should be sought, as appropriate.
• Understand the sponsors’ legal obligations to the scheme. 
• Review their scheme’s creditor standing – to understand the likely scheme realisations in the event of sponsor insolvency. Does the scheme have the benefit of security and/or third party guarantees? Is it possible to improve that position as part of any restructuring negotiations?
• Review the position of other creditors – as stated in TPR’s guidance, to require equitable treatment between the scheme and other creditors as an absolute priority – the scheme’s position should not be worsened to the benefit of other creditors.
• Investment strategy – to review asset allocation and whether general de-risking of investment strategy is prudent. With sponsor insolvency pending, to look to the medium or long term may not be appropriate.
• The PPF – to consider and implement the PPF’s contingency planning measures, where appropriate.

Sponsor financial distress is one of the more difficult issues faced by a trustee board. It is also a time when early, quick and effective action can dramatically improve member outcomes and reduce the likelihood of PPF entry. Spotting covenant weakening early through effective information sharing between trustees and their scheme sponsors is central to those aims.