Why is a forward-looking covenant framework important?
A holistic approach to covenant assessment combines both quantitative and qualitative factors, including the development and analysis of risk scenarios affecting the sponsor and the scheme on an integrated basis. A key element of this framework involves an assessment of the sponsor’s likely future profitability and cash flow, considering the outlook for the business, the market in which it operates and the position of the scheme relative to other stakeholders.
Whilst understanding the historical financial performance and the balance sheet are important, and indeed schemes can rely to a certain extent on the sponsor’s assets, if one were to solely focus on these elements, there is a risk of overestimating the level of covenant support without taking into consideration the potential headwinds in a given industry. A pertinent example currently would be high street retail where future cash flow generation may never return to historical levels and balance sheet value could be overstated in stressed scenarios.
How can a forward-looking covenant framework be implemented?
A best practice approach is to consider several financial forecast cases, including more prudent and downside scenarios, recognising that the future is inherently uncertain. The estimated future free cash flow generation can demonstrate how the asset base could be maintained in the future and how different stakeholders including schemes might be funded. Future cash flows can also be discounted to arrive at an estimated net present value of the covenant, in a similar way to how an actuary discounts a scheme’s future cash outflows to determine the present liability.
The value of the covenant can then be compared on a like-for-like basis against the scheme’s deficit and a measure of investment risk (e.g. a value-at-risk measure). The relative size of the covenant compared to the scheme’s deficit can provide an immediate quantitative measure of relative covenant strength. Overall covenant strength will also need to take account of qualitative factors.
What about an integrated risk management framework?
Building on the forward-looking covenant assessment framework, this approach can also allow a scheme to assess its reliance on the sponsor covenant by analysing the impact of different scenarios and thus an acceptable level of investment risk.
For example, in industries where the sponsor’s profitability is sensitive to interest rate and GDP changes such as banks and insurance companies, one could align the sponsor’s financial forecast cases based on different interest rate and gross domestic product (GDP) projections for example, in industries where the sponsor’s profitability is sensitive to interest rate and GDP changes such as banks and insurance companies, one could align the sponsor’s financial forecast cases based on different interest rate and GDP projections with the same scenarios modelled for the scheme as assessed by the scheme’s actuary and investment adviser to identify the integrated nature of the risks and to test the scheme’s and the sponsor’s risk capacities.
The outcome will be an assessment and formation of appropriate journey plans, contingent protections and an integrated monitoring framework, including key integrated metrics to be measured on an ongoing basis.
To find out more On 26 October 2021, at Penfida’s PMI Academy training session, we will be exploring the concept of evaluating covenant on a forward-looking basis and how this can be used for integrated risk management. Find out more here.
This article was featured in Pensions Aspects magazine September edition.
Last update: 15 September 2021