Why covenant support remains at the heart of pension member security

The events in Ukraine are as harrowing as they are heart-breaking to watch. The war has exacted a terrible human toll and represents a magnitude of conflict not seen in Europe for more than 75 years. It is almost by definition, a “once in a lifetime” event from a European perspective that we wish had never arisen.

However, the propensity of such exogenous events, labelled “once in a lifetime” seem to be ever-increasing. Looking back over the course of the past 15 years or so, we have recovered from two global market crashes, withstood a worldwide pandemic, experienced major geopolitical dislocations such as Brexit, and with every passing summer, seemingly remain at the behest of escalating weather events. A relatively new term has emerged: perma-crisis.

While the term may be new, perma-crisis is not. If we were writing in 1945 the last three decades would have included two world wars, the great depression and a global pandemic in the Spanish flu. More “once in a lifetime” events.

Underestimating the frequency of supposedly infrequent events raises important questions with regards to risk management and, for defined benefit pension schemes, the vital importance of the sponsor covenant that underwrites such tail risks.

Schemes in their current assessment appear to be in a relatively healthy funding position. Highlighted in The Purple Book 2021, the aggregate funding ratio rose above 100% for the first time since March 2010. As a result, it is understandable to question the immediate relevance covenant still holds, with some pointing toward the reducing need for schemes to draw on sponsor funding.

However, such thinking risks a dangerous complacency because you do need the sponsor to underwrite the funding ratio for, typically, many more years and often decades as the assets and liabilities mature. Over this lifetime of the scheme sadly, as we have seen, things happen. Big things. Once in a lifetime things. Repeatedly.

We must be careful not to take covenant for granted. The Pensions Regulator cautioned in its Annual Funding Statement (AFS) that trustees ought to remain ‘alert to their scheme’s funding positions and covenant changing very quickly – especially in the current environment’.

The AFS also reminded trustees of the ongoing reliance on covenant up to the Long-Term Funding Target and beyond, to the point at which the scheme ultimately winds up. This is a shift of focus for some who consider covenant as a once every three years rating.

Darren Redmayne at Cardano

Darren Redmayne leads the advisory business of Cardano that provides speciality advisory services to sponsors, schemes and other key stakeholders (e.g. investors and regulatory bodies) with support on covenant, sustainability and pensions corporate finance matters.

Formerly known as Lincoln Pensions, the leading specialist provider of covenant advice, Darren co-founded the firm in 2008 as part of the mid-market investment bank, Lincoln International. Since becoming part of Cardano in 2016, the firm has broadened further becoming Cardano Advisory in 2021.

Many well-funded schemes have taken the opportunity to de-risk. But by de-risking you reduce returns and generally extend your expected covenant reliance time horizon – thereby extending your exposure to these frequent ‘infrequent’ events that may impact your sponsor.

Whether explicit or not, until you reach your end game (such as insurance) your sponsor is your only, and last hope when things go off course. It is therefore incumbent on scheme trustees to remain focused on understanding their covenant and its ability to support members through these ‘once in a lifetime’ events.

At Cardano, we are working with clients to holistically balance covenant risk with the investment risks in their scheme and their funding needs when setting a journey plan.

To understand the strength of that covenant involves analysis of the cash flows, prospects and the support available over time. Analysis of numbers is not enough – it is the qualitative factors that help us understand key risks and potential downside scenarios in times of uncertainty.

Over the last couple of years, many schemes have found themselves in a good position on investment and funding, and some are well ahead of where they expected to be.

But schemes cannot afford to become complacent as they work through their journey plans.

As part of monitoring covenant, we encourage trustees to consider plausible downside scenarios and assess how to better safeguard the journey toward their chosen endgame. In our view, covenant remains at the very heart of our pension schemes’ thinking and must not be taken for granted.

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