By Helena Mules, Senior Covenant Adviser at WTW
Whilst the key changes had been introduced through the regulations and the Funding Code of Practice (the "Funding Code"), this does not mean that the Guidance didn't have a few surprises up its sleeve. Indeed, whilst the Regulator undertook a limited consultation within the industry, the Guidance was not subject to a wider consultation process (unlike the Funding Code). Now, a few months on, the industry has had a chance to digest the Guidance and can begin to consider the practical implications.
So - from look-through guarantees to supportable risk, maximum affordable contributions to reasonable affordability, reliability periods to covenant longevity - let's take a look at the key learning points.
01 Cash flows are king
Whilst sponsor cash flows have always been a key focus area for covenant, the changes in the Funding Code and Guidance mean that cash flows are now the key measure of employer support, with the balance sheet providing only an indirect underpin to sponsor resilience and liquid assets e.g. cash pooling balances, supporting affordability of contributions. Specifically, the Guidance outlines two key measures of affordability being 'reasonable affordability' to determine any recovery plan, and 'maximum affordable contributions' which determines the amount of supportable risk in the funding and investment strategy.
Reasonable affordability – based on employer's cash flows and its liquid assets. Used to determine what contributions the employer can reasonably afford
Maximum affordable contributions – based on employer's cash flows after deficit recovery contributions (DRCs) and excludes liquid assets. Used to determine ability to support funding and investment risk
02 Reliability and longevity: How dependable is your covenant?
Part of the new parlance in the Funding Code includes the concepts of:
Reliability period – the period over which trustees are reasonably certain about employer cash flows to fund the scheme
Covenant longevity – the period which the trustee is reasonably certain that the employer will remain able to continue to support the scheme
The Guidance goes into detail as to the factors to consider when making these assessments, but whilst "guidance" periods are given (three to six years for the reliability period and up to 10 years for the covenant longevity) this is an area where a significant amount of judgement is expected to be applied. For many it will be acceptable to agree on periods of "at least" x years where these periods are not limiting factors for scheme funding. However, where the scheme is operating with narrower risk boundaries, these judgements could be significant.
03 Goodbye Section 75 guarantees; welcome look-through guarantees
The evergreen Section 75 guarantee has long been the go-to for strong groups with weaker sponsors who were seeking PPF levy savings. Whilst in the early days the Regulator had to ensure that corporates didn't have their cake and eat it (by securing a weak funding basis and a long recovery plan), most trustees and advisors have worked on the basis that the existence of such guarantees meant that support would generally be made available to a scheme if needed. However, changes in the legislation and the new Funding Code mean that the emphasis is now on establishing a monetary amount available to the scheme from its contingent assets in a scenario when the scheme needs it, such as if a funding deficit were to arise. The lack of enforceability in such a scenario of a standard Section 75 guarantee means that the Regulator will no longer expect trustees to be placing material reliance on them to underpin funding and investment risk. Instead, the Regulator has advised that guarantees should have a "look-through" to the affordability of the guarantor in order to be able to reliably support funding and investment risk in ongoing scenarios. The question remains as to whether we'll therefore see a raft of Section 75 guarantees being upgraded to look-through guarantees, or whether improved funding levels, a trend towards de-risking and material reductions in PPF levies (potentially to zero) mean that trustees may simply decide they no longer need them.
04 Proportionality (within limits)
The term proportionate is mentioned nearly 50 times in the Guidance with the Regulator using terms such as "high-level assessment" and acknowledging that schemes which are fully funded on a low dependency basis (after a downside event) do not need to determine a period of reliability and can take a lighter touch approach to covenant assessment. However, the Regulator is also at pains to state that this does not discharge trustees from the need to undertake a proportionate assessment at each actuarial valuation and to continue to monitor the covenant, albeit with a narrower focus on cash flows and employer longevity. All trustees must aim to get comfortable that the covenant is "adequate" to support their scheme's funding and investment risks.
05 Limited affordability employers remain… limited…
For employers which cannot support scheme contributions and/or funding and investment risk there is limited further comfort in the Guidance. Once all covenant levers (e.g. ceasing covenant leakage and seeking contingent assets) have been pulled, trustees are left with the statements in the Funding Code that "trustees of such schemes may conclude that it is in the best interest of members for them to take some unsupportable risk". However, where trustees are unable to answer "yes" to the question "Is the strength of the employer covenant adequate?" (within the Statement of Strategy) we expect them already to be giving serious consideration to engaging with the Regulator as to how best to support the scheme.
Overall, the new covenant guidance is intended to drive better, more risk-focused assessments of covenant. The output from a covenant review under the new regime will no longer be limited to simple ratings (e.g. "Tending to Strong" or a mark out of 10) but will define reliability periods, maximum affordable contributions, covenant longevity periods, maximum supportable risk, contingent asset valuations and reasonable affordability; to be taken into account by the trustee (with the help of their advisors) to produce a coherent journey plan, actuarial assumptions and investment strategies. For many schemes, ascertaining what is proportionate and how, if at all, these outputs impact on funding and investment strategy is likely where the biggest changes and challenges lie.
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