The role of employer ‘covenant’ is set to become increasingly important as the Pension Regulator (TPR) introduces a new DB funding code which encourages schemes to place less reliance on the long-term survival of their sponsor when coming up with journey plans.
Under the new rules, trustees seeking to incorporate a reliability period of more than six years into their journey plan will be expected to provide a strong rationale for why they view their covenant to have a particularly long and stable outlook relative to most.
Key concepts which TPR expects schemes to consider when looking at covenant are:
Reasonable affordability: schemes need to be fully funded “as soon as is reasonably affordable”, so trustees will need their sponsor’s financial forecasts to understand the dynamics over the “covenant visibility” period.
Covenant reliability: the period with reasonable certainty about the level of cash generated: one of the most critical aspects to grasp, as it will determine how long a scheme can run greater levels of investment risk and the maximum length of time over which the sponsor must repair any funding deficit.
Covenant longevity: the timeframe over which the sponsor is reasonably expected to continue to exist. This will be influenced by sector outlook, competitive position, strategy and diversification, financial resilience and longer term types of risks like those to relating to climate and the environment
The LCP survey found that whilst 1 in 3 respondents thought that they could depend on the strength of the employer covenant for ten years or more, nearly half thought that they could not rely on the employer’s survival for more than five years. Scheme funding levels have generally improved considerably since last year’s survey, but where a scheme sees a combination of a funding shortfall and weak employer covenant, it could face big challenges in ensuring member benefits are paid in full.
The increased importance of covenant in the new funding regime is reflected in a further survey finding that around a third of respondents expect to devote greater attention to covenant issues, with some appointing an independent covenant adviser for the first time. The focus on covenant is likely to increase when TPR publishes further guidance on this issue later this year.
Commenting on the results, LCP Partner and covenant specialist Francesca Bailey said: ‘In the new DB funding regime, it is especially important that schemes embrace the concepts of covenant reliability and visibility when drawing up their long-term journey plans. The Regulator’s general view is that schemes should not rely on the long-term strength of their sponsor to underpin their plans, but our survey shows a surprisingly high number of schemes who have limited confidence in the reliability of their sponsor’s cash generation even in the relatively short-term. Although most schemes have enjoyed improvements in their funding position in recent times, there will still be many whose ability to achieve target funding levels requires the ongoing support of their sponsor, and a realistic assessment of the strength and durability of that sponsor covenant is increasingly vital’.
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