Covenant & Investment – The evolution of the relationship

Jonathan Wolff

Partner and Head of Covenant

A brief history

After years of preparation, the new defined benefit (DB) pensions regulatory regime is nearly upon us and will apply to all triennial valuation dates from 22 September 2024 onwards.

A big part of the new regime is a greater focus on employer covenant. As a brief recap, the employer covenant is the ability of a DB scheme’s sponsoring employer to support its funding and investment risks. Since the current scheme specific funding regime came into play in 2005 there have always been linkages made by The Pensions Regulator (TPR) on how trustees should consider covenant strength when setting investment strategies. The general idea is that a stronger employer can support a riskier investment strategy, ie because it can afford to make good on investment underperformance if things don’t go to plan.

Source: The Pensions Regulator

However, there has been a lot of subjectivity in this link, which in certain cases has led to investment strategies being set with little regard for the sponsor’s ability to underwrite the risk being taken.

TPR has been left frustrated in the past that its underlying powers and the existing funding code have left too much wiggle room for the system to be abused, and it has had little power to enforce changes to scheme strategies where it thinks that too much risk is being taken.

A big part of the new regime is a greater focus on employer covenant.

Where are we now?

This frustration and some high-profile employer failures (eg BHS and Carillion) were the catalysts for the Pension Schemes Act 2021 (PSA 21), which has provided TPR with new enforcement powers. PSA 21 itself has been the precursor for the new DB Funding Code of Practice (the Funding Code) which is the blueprint for the new regulatory regime. The Funding Code is currently in draft and is expected to be issued in final form over the summer months.

The concept of covenant has also been defined in law for the first time, within the DB Funding and Investment Strategy Regulations which were finalised in January 2024.

All of this will mean that there needs to be a more evidential link between trustees’ view on the strength of the sponsoring employer and the maximum level of risk they are able to undertake in their investment strategy.

New concepts

A key part of the draft Funding Code is the requirement for trustees to have a clearly defined long term, low-risk target and a journey plan for their scheme. In terms of covenant, they need to consider and agree:

1. What is the maximum supportable risk that the sponsor can underwrite for the foreseeable future?; and

2. What is the covenant reliability period?

Maximum supportable risk

Broadly speaking, trustees must be comfortable that the discretionary cash flows of the sponsor and/or legally pledged contingent assets are sufficient to cover both a downside investment scenario and any expected future contributions that the sponsor needs to make. The draft Funding Code has suggested that investment volatility is measured by at least an asset and liability “value at risk” of a 1 in 6 downside event. This will allow the trustees to understand whether the employer has sufficient affordability over the period of reliability to remedy any deficit from the downside scenario.

Covenant reliability

Trustees must also arrive at an evidence-based conclusion as to how long they have reasonable certainty over the employer’s ability to support the scheme from its expected cash flows. Although essentially a brand new concept, this “reliability period” is a very important aspect of the new regime – as it influences how long schemes can take investment risk, how long recovery plans can be, and even how long open schemes can make allowance for future accrual and new members when thinking about their journey.

Bringing it all together

The interaction between covenant and investment

Source: The Pensions Regulator

When each actuarial valuation is submitted, trustees will need to submit a statement of strategy that sets out the scheme’s longer term objectives and how they will get there taking an appropriate amount of risk.

In simple terms, Trustees will need to have concluded upon and documented:

What they think the period of covenant reliability is.
What the sponsor’s maximum capacity is to support investment risk until the covenant reliability period ends.
How quickly the scheme needs to taper down to a “low dependency investment allocation” – this is broadly a low-risk strategy where reliance on the covenant is low – this must be no later than when the scheme is expected to reach “significant maturity” (this will be based on an actuarial measure called duration, with the final detail to come in the final Code).

Although a lot of schemes will have been thinking about these kinds of concepts in the past when developing existing strategies, the ante has been upped massively in terms of the level of covenant analysis work required to evidence the amount of risk that can be taken and level of documentation that will be required to justify the trustees’ approach. For some schemes, this will mean they need to take independent covenant advice for the first time, and it would make sense to start thinking about this sooner rather than later for valuation dates late this year or early next.

Practical points

Prepare, prepare, prepare

We are getting closer and closer to the effective date for the new funding regime, and at the time of writing neither the final version of the Funding Code or its accompanying covenant guidance have been issued. TPR’s consultation into the statement of strategy required to accompany valuation submissions has also just closed. To have so much up in the air so close to the start of the new regime is not helpful.

What is clear is that schemes with valuation dates between 22 September 2024 and mid-2025 will be the guinea pigs for the new regime. They are therefore strongly advised to plan their valuation processes very carefully to make sure that all of the new TPR requirements are met. More than ever before this will involve lots of collaborative working between trustees, sponsors, actuaries, and crucially covenant and investment advisers.

It is a saving grace for many schemes that they have become much better funded as a result of increased gilt yields following the Truss/Kwarteng mini-budget in September 2022. It is therefore likely that lots of trustees will no longer need to take significant investment risk across their journey plans in order to meet their strategic objectives.

However, there remains a very significant number of schemes which are not yet funded to low dependency levels and which will be reliant on their sponsoring employers for many years to come. For these trustees, there could be a steep learning curve at their next valuations.

Conclusion

Surplus sharing: More collaborative working!

As advisers we are seeing more of our better funded clients question whether the common default of an insurance buy-out transaction is the right thing to do. There has been a mindset shift recently for FDs who have previously only seen their DB scheme as being a problem, now looking at them as potential sources of value.

If sponsors can share in a surplus, e.g. using it for paying for defined contribution schemes for current employees, and DB members can be provided with enhanced benefits without any compromise to their security, then this really could be a win-win.

In these circumstances, there will also be a strong reason for covenant and investment advisers to work closely together going forwards, to ensure that the possibility of downside outcomes on any given investment strategy are well covered by sponsor strength and contingent support.

In short, there have never been so many good reasons for investment and covenant to be considered so closely together, and for advisers to collaborate and understand each others’ ways of thinking. We expect this relationship to evolve significantly in the coming months and years, with the closer links benefiting trustees, sponsors and pension scheme members.