PMI Crest
PMI
Don’t de-risk for the sake of it: the role of covenant in setting journey plans
17 July 2020

Don’t de-risk for the sake of it: the role of covenant in setting journey plans

High profile pension scandals and insolvencies, increasing select committee focus, and years of guidance from the Pensions Regulator (TPR) all point towards a regime of increased prudence in Defined Benefit (DB) pensions strategies. This new regulatory paradigm was meant to become reality in 2020 with a new funding Code of Practice from TPR backed up by increased powers from the Pension Schemes Bill. But the COVID-19 pandemic is now putting the industry in a difficult position.

Pensions managers, in particular, are often caught between a rock and a hard place. On the one hand, COVID-19 has significantly reduced the affordability of many sponsors, often forcing them to cut back on essential investments, furlough staff and/or reduce salaries, cut dividends, and defer pension contributions.

On the other hand, the consultation on the new Code of Practice is making it clear that DB schemes will need a journey plan towards a low-risk funding target, over a short period of time, and often with reduced reliance on investment returns. All of which points to even higher cash funding requirements.

Furthermore, the Pension Schemes Bill currently moving through the House of Lords introduces the threat of criminal penalties for anyone (pension scheme trustees, directors and advisors) risking accrued scheme benefits without a reasonable excuse.

Taking scheme risk appropriately

At the heart of these conflicting pressures is the strength of the employer covenant and, specifically, its ability to afford recovery plan contributions and underwrite any investment and demographic risks of the scheme on top. This concept of sponsor risk capacity is crucial to navigating the new DB code of funding, yet few sponsors evidence it to trustees in a robust manner.

Sponsor risk capacity can be seen as having three fundamental components: current financial resources, ongoing cash generation after key expenditures (typically referred to as affordability), and extraordinary management actions. Typically sponsors focus on the former and are conscious to present a strong, but not too strong, picture, to avoid being asked to funnel all of their expected cash generation towards the scheme. This can have the side effect of suggesting that the capacity to underwrite the scheme’s risks is limited.

However, if we take one lesson from the COVID-19 pandemic, then it is that the level of management actions available should not be understated – from reducing payments to other stakeholders, dialling back investments, or even selling assets and operations; the number of levers in a worst-case scenario is large.

It is also important to consider how sponsor risk capacity is likely to change over time, especially when setting the scheme’s investment strategy over the course of its journey plan. Firstly, as long as any investment risk taken (and noting that scheme risk dynamics may deteriorate as a scheme becomes more mature) is supportable by the covenant strength at the time, near-term de-risking of investments implied by the Code of Practice consultation may not be necessary. In fact, there are many situations

where sponsor risk capacity could reasonably increase in future, be it after the repayment of amortising debt or other contractual obligations frees up cash flow, or even the post-COVID-19 economic recovery now expected by some commentators.

Taking business risk appropriately

A company exists to take risks which, overall, are expected to lead to a profitable undertaking for the benefit of all its stakeholders. However, the unlimited fines and up to seven years imprisonment for anyone risking accrued benefits being introduced by the Pension Schemes Bill, may cause directors and managers to start questioning their decisions. ‘Risking accrued benefits’ is a potentially wide-ranging definition, which could include many aspects of normal corporate activity that arguably weakens the legal entity that is the scheme’s employer (e.g. standard corporate treasury functions).

But this should not stop corporates from taking important business decisions or neglecting their obligations to other stakeholders – corporates just need to ensure that no action is taken without considering the impact on the scheme. While the current form of the Bill offers little explanation as to what this entails, this should include (i) weighing up the decision from a covenant perspective, (ii) taking appropriate advice, and (iii) engaging with the pension scheme trustee.

As part of this, sponsors should illustrate the expected consequence for the scheme’s covenant including sponsor risk capacity. For most strategic changes, this will involve balancing short-term risks with long-term gains. This is a trade-off which needs to be communicated clearly to make sure the trustee remains comfortable that any risks taken are ultimately in the interest of members. Formal upside sharing can help align the trustee’s views with those of management and can be useful in unblocking strategic impasses and helping to mitigate individual risks from the Pension Schemes Bill.

Ultimately, the regulatory direction of travel towards a low-risk funding target is both in the interest of members (through increased security) and sponsors (through reduced balance sheet volatility and future funding needs). The challenge is how to get there without putting further strain on the sponsor.

A mutual understanding of covenant strength and sponsor risk capacity will be key to achieving this through supportable investment risk, and without constraining the sponsor’s long-term growth. The same level of understanding – and evidencing – will also help corporates continue to take appropriate business decisions, while making sure to reflect on what these may mean for the scheme.

Notes/Sources

This article was featured in Pensions Aspects magazine July/August edition.

back to Pensions Aspects Magazine

Last update: 27 January 2021

Felix Mantz
Felix Mantz
Lincoln Pensions
Associate Director

Head of Professional Services

Salary: £65000 - £85000 pa

Location: Leeds, West Yorkshire

Pensions Transition Manager – flexible working

Salary: £40000 - £65000 pa

Location: East Sussex

Junior Project Manager 12 month FTC

Salary: £20000 - £25000 pa

Location: County Durham

You may also like:

Your scheme is bespoke... why isn’t your LDI solution?
09 April 2021

Your scheme is bespoke... why isn’t your LDI solution?

Liability Driven Investment (LDI) has become an increasingly important part of pension funding, with over half of UK pension schemes liabilities now hedged using LDI1.

Read more
Cyber justification - a question of security?
09 April 2021

Cyber justification - a question of security?

If I asked you about cyber security, what would come to mind? You might think about nineties-era fussy firewalls, or the guards from Tron with their laser-frisbees. And many of us will know someone for whom the term means sticking a bit of tape over the camera on their laptop.

Read more