Andrew Palmer looks at why employer covenant is an increasingly important issue for schemes
In December 2015 The Pensions Regulator (TPR) published its guidance on Integrated Risk Management (IRM), giving a clear indication as to how the three key risks to defined benefit (DB) scheme funding (employer covenant, funding and investment) should be considered.
Now, with so many global economic and political uncertainties, it is perhaps worth reminding ourselves of the reasons why TPR attaches such importance to covenant assessment as part of an integrated approach to risk management.
Unless a scheme is exceptionally well funded then it will continue to rely on support from the employer to deliver the benefits earned by members.
For many schemes, although the level and duration of this support will already be significant, more rather than less sponsor support will be required in the future; a scheme's biggest risk is likely to be sponsor failure, and the sponsor's biggest financial risk could well be its scheme.
While the mutual benefits of consensual funding agreements are clear, the competing demands for available cash can result in difficult negotiations.
A challenge to scheme funding is that there is no sign of light at the end of the tunnel in terms of either reduced liabilities or materially improved investment returns. Scheme funding levels continue to be depressed and deficits remain eye-wateringly high, while hopes of a 'normalisation' in interest rates and gilt yields are being replaced by an acceptance that current conditions represent a new norm.
The Bank of England appears to have little appetite for raising interest rates, while continuing global uncertainty could lead to a greater demand for gilts, further reducing yields. Expecting scheme liabilities to be offset by greater investment returns is little more than the crossing of fingers.
Combine these conditions with research that suggests many schemes are now cash flow negative and it is likely that increased contributions and/or extended recovery plans will be required. Longer recovery plans increase risk for members, so certain questions need to be answered; (given the competing demands for cash)… how much more can the sponsor afford and be expected to pay, for how long and how secure are these cash flows?
Understanding the sponsor's covenant is therefore key to reaching equitable funding solutions whereby schemes receive a fair and reasonable proportion of the cash generated by the sponsor, while allowing the sponsor to prosper and reward other stakeholders.
Achieving a balanced outcome isn't always easy. Businesses need to invest to grow and be sustainable, and investors want to see a return on their investment. While Carclo has recently joined the list of companies that are not paying dividends as a consequence of substantial pension obligations, there many sponsors who will continue to seek to reward shareholders despite ballooning deficits. Fully informed trustees will be best placed to ensure their scheme receives fair treatment.
There are also conflicting views on the basis on which scheme deficits should be calculated. These range from liberal approaches that question whether pension funds need to be ring fenced and challenge the use of discount rates, those who suggest a 'best estimate minus' rather than 'gilts plus' approach, to those advocating a 'risk-free' basis.
In the aftermath of BHS it is difficult to imagine that TPR will be inclined to allow soft funding targets to surface or that there will be a seismic shift in the approach to scheme funding. Understanding covenant strength will therefore remain a key consideration when determining prudence for actuarial assumptions and the acceptable risk for investment strategies.
Changes to the rhythm of the valuation cycle, as mooted by TPR, are unlikely to result in employers' covenants receiving less scrutiny either. One argument for greater flexibility is the ability to monitor scheme assets and liabilities on a real time basis however this is inconsistent with IRM if the strength of the employer covenant is not also being monitored regularly.
While it is perhaps unrealistic to expect trustees to continually assess covenant in real time, as part of good governance trustees should consider setting a number of KPIs that will enable them to track covenant strength closely and respond promptly to any variances.
A primary purpose of IRM is to consider the interrelationships of funding risks. While covenant advisers and actuaries have developed close working relationships, as have actuaries and investment consultants, the interaction between covenant advisers and investment consultants has been more limited.
Now is the time for this side of the triangle to be completed to enable trustees to understand the extent to which covenant and investment risks are correlated. One example of this could be assessing whether sector and market risks faced by the employer could also affect investments held by the scheme.
2016 was a year in which the unexpected happened, fuelling uncertainty and adding to the woes of DB schemes. Amid growing uncertainty there is one obvious certainty - the continued support of sponsoring employers will be essential if members' benefits are to be paid in full. It therefore follows that understanding the strength of the employer covenant and its relationship with funding and investment risk will be central to achieving a properly funded scheme, and demonstrating good governance.
Andrew Palmer is a partner at BDO Pensions Advisory Services
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