Covenant guidance published at last

The Pensions Regulator has published detailed guidance on the assessment of employer covenants. The guidance relates to valuations under the new DB funding regime, and to DB risk management generally. It will be important not only for trustees, but also for employers and advisers.

Key messages are summarised below.

Areas to consider when assessing covenant

A covenant assessment should cover two elements:

1. The financial ability of the employer to support the scheme in relation to its legal obligations

This element will include the following.

Identifying employers

• Trustees should identify the scheme's statutory employers. Entities which are not employers should not be directly considered.
• Trustees should understand any relevant powers which they have under the scheme (eg powers to impose contributions or trigger winding-up).
• In a multi-employer scheme, it may not be necessary to carry out a full covenant assessment for every employer separately. Trustees should understand the implications of any partial winding-up or "last man standing" provisions.

Assessing cashflow

• Trustees must assess the employer's cashflow. They should focus on forward-looking information supplied by management.
• Trustees should form their own view of management cashflow forecasts, taking account of the reasonableness of assumptions, recent trading performance, and the outlook for the relevant industry. Trustees should request access to any sensitivity analysis.
• Where the employer is part of a wider group, trustees should assess covenant support based only on the employer, unless the group provides formalised support.
• In a multi-employer scheme, it may be appropriate to aggregate cashflows, but care should be taken to avoid double-counting.

Assessing prospects

• Trustees should assess the extent and duration of reliance which can be placed on employers for support.
• Relevant factors will include the employer's market position and the market outlook; diversity of operations; financial resilience (eg capital and liquidity); ESG issues; and insolvency risks.

Assessing the reliability and covenant longevity periods

• Trustees must determine the period over which they can be reasonably certain of the employer's cashflows to fund the scheme (the reliability period). Normally this will not exceed three to six years.
• When determining the reliability period, trustees should consider the availability and reasonableness of management cashflow forecasts, profit and loss and balance sheet forecasts, and prospects as above.
• Trustees must determine the period over which they can be reasonably certain that the employer will continue to support the scheme (the covenant longevity period). Normally this will not exceed 10 years.
• When determining the covenant longevity period, trustees should assess the prospects of the employer, and of any wider group if there are interdependencies.

2. The expected support from any contingent assets, to the extent the trustees expect these to be legally enforceable and financially sufficient

• Trustees should factor contingent assets (eg parent company guarantees) into their covenant assessment only if they expect the contingent assets to be legally enforceable and sufficient to provide the specified support when required.
• Care should be taken when valuing any assets over which trustees have security – eg in some cases a "forced sale" valuation may be appropriate.
• The value which can be ascribed to a guarantee depends on whether it meets specified "look-through" tests. Trustees may need to obtain advice about how any guarantees are documented, and whether the look-through tests are met.

Recovery plans

• Recovery plans must be set with a view to making good deficits as soon as the employer can reasonably afford.
• For this purpose, trustees need to assess the employer's available cash (taking account of any look-through guarantees), the reliability of the cashflow, and any reasonable alternative uses which the employer may have for cash.
• The latter should be informed by the "reasonable affordability" principles in the DB Funding Code. For example, investment in the employer's sustainable growth may be reasonable if the trustees are confident of a resulting benefit to the employer and the scheme.

Covenant inputs to assess supportable risk

• For the purpose of journey plans under the new funding regime, the level of funding and investment risk which can be supported depends, in part, on the employer covenant.
• When assessing supportable risk over the reliability period, trustees should consider the recourse which they would have following a stress event: the maximum affordable contributions (derived from cashflows), and any contingent asset support.
• Assessment of supportable risk beyond the reliability period is largely qualitative. Trustees should follow the principles set out in the Funding Code.

Covenant monitoring

• The appropriate monitoring (between assessments) will depend on the circumstances of the employer and the scheme. However, there should at least be an annual update.
• Trustees should establish a monitoring framework. This will involve (a) identifying key covenant risks; (b) setting appropriate performance indicators; (c) setting tolerance thresholds for identified risks; (d) agreeing actions to be taken if thresholds are breached; and (e) periodic review of the appropriateness of indicators and thresholds.
• Trustees should look to agree a robust information-sharing protocol with the employer, including early-stage notification as to material corporate events.

Comment

The guidance is lengthy, with detailed commentary and numerous worked examples. At the same time, repeated mention is made of proportionality. The Regulator acknowledges that in some circumstances a light-touch approach may be appropriate.

But "light-touch" will be the exception, rather than the norm. Many schemes will need to take a more granular approach to covenant assessment going forwards. Trustees and advisers will have to look carefully at employer cashflow forecasts; insolvency risks and outcomes; and the enforceability, terms and value of any contingent assets.