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Covenant-led de-risking: why covenant must be at the heart of all de-risking plans
13 November 2020

Covenant-led de-risking: why covenant must be at the heart of all de-risking plans

Insight Partner

To say defined benefit (DB) schemes have been on a journey over the last decade is an understatement. Most private sector schemes have closed and become a legacy liability, while falls in market-expected returns have caused many deficits to spiral.

High-profile corporate failures have put the focus firmly on the risks contained within DB schemes, not just for members, but also for the corporates left to pick up the pieces if investment or funding risks crystallise. It is not surprising that the core theme underlying The Pension Regulator’s (TPR) recent consultation on a new DB funding code of practice is low-covenant dependency end games - and how to get there.

The need for covenant-led de-risking

Ultimately schemes need to reach a position of zero (or low) reliance on their sponsor. The best example of this is an insurance buyout (where risks are passed to the insurer), but other options exist, such as low risk ‘run-off’ investment portfolios or solutions now being put forward by pension fund consolidators.

By the time schemes reach their end games, they should have limited investment risk relative to their liabilities; be fully funded even if assuming accordingly limited investment returns; and have contingencies to cover future expenses and residual demographic and other risks (e.g. data quality issues or regulatory changes).

Few schemes will be able to reach this position in one go. Instead, most will need to gradually transition towards their target. Key to getting this right will be understanding three key aspects of the employer covenant.

1. Covenant affordability: funding and near-term risk capacity

Good covenant practitioners typically focus on understanding sponsor affordability based on cash flows and liquidity. This reflects that schemes look to sponsors to provide ongoing cash funding, both for current deficits but also for deficit increases in the future. Therefore, the key question for trustees is: what can their sponsor afford to contribute to the scheme in addition to existing funding commitments?

This affordability for additional funding is the risk capacity of the sponsor and should determine the maximum level of investment risk that the scheme should be taking over the near term.

2. Covenant visibility: de-risking time horizon

Each sponsor’s covenant will change over time depending on a wide range of factors (including industry, leverage and product diversification amongst many others). In its consultation, The Pensions Regulator suggested that trustees may only have visibility over their covenant, for perhaps, three to five years.

As a result, trustees need to think about how stable they expect covenant affordability to be and for how long (scenario testing can be a helpful tool here). After this time frame, as covenant risk is assumed to increase, trustees should be planning to reduce investment risk. The pace of de-risking is likely to be a balanced judgement based on the level of covenant concern, but also the resulting contributions that would be required from the sponsor.

The reality is that many schemes will need to place material reliance on their sponsor for many years, even though there is insufficient covenant visibility over this timeframe. This is where contingent support (either assets or funding structures) can help by providing schemes with additional support, independent of the sponsor, should their covenant weaken sooner than hoped.

None of this is to say that all covenants will weaken – many won’t - and it may become reasonable in the future to change plans to take more investment risk for longer.

3. Covenant reliability: longer-term end game planning

Over the long-term, covenant support can be unreliable. Whilst some sponsors and industries provide greater comfort than others, nearly all schemes will be exposed to material long-term covenant risks. Trustees should remember this when setting their end game. Where they are planning to retain any reliance on their sponsor (e.g. by not seeking an insurance buyout) they need to recognise the risks that remain and ensure that contingency plans are in place to cover a correlated deterioration in covenant and funding at that point in time.

Covenant, scheme maturity and de-risking

There is no one ‘right’ way to transition the investment strategy – some schemes may choose to de-risk sooner and increase sponsor contributions to replace foregone investment returns, while others may rely on investment returns for longer (supported by the covenant on a contingent basis, as above) and then reduce risk when desired funding levels are met.

In most cases, the most pressing concern for a scheme (and the most pressing reason to de-risk) is likely to be the employer covenant. The maturity of a scheme’s liability profile is a significant factor in understanding a scheme’s risk – but de-risking plans based solely on increasing scheme maturity are liable to miss either a more pressing covenant risk, or the fact that increased maturity can be supported by a strong sponsor covenant. For most schemes, maturity is an issue that will likely become more relevant over the next ten years but for now, remains a far less pressing issue relative to covenant.

The role of good governance

It’s important to recognise that there are inherent limits when setting a journey plan. The future is highly uncertain and no analysis can remove the risk that a scheme’s journey doesn’t go to plan.

Managing risk well is as much about good governance as it is about setting funding and investment strategies. The most important action for trustees looking to de-risk is to adopt sound governance practices, monitor the covenant and their investments, and be ready to change plans quickly if circumstances require.


This article was featured in Pensions Aspects magazine November/December edition.

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Last update: 27 January 2021

Michael Bushnell
Michael Bushnell
Lincoln Pensions
Managing Director

Assistant Pensions Investment Consultant - Berkshire

Salary: £31500 - £37000 pa

Location: Berkshire

Senior Pensions Governance and Secretariat Consultant

Salary: £70000 - £90000 pa

Location: Hampshire

Senior Pensions Analyst

Salary: £55000 - £75000 pa

Location: London

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