Talking Head: Employer covenant has finally achieved the prominence it deserves in the assessment and monitoring of defined benefit scheme risks – in regulatory terms at least, following the Pensions Regulator's funding code in 2014 and its follow-up guidance this August.
Indeed it could be argued that it has moved centre stage with trustees being encouraged to “take investment and funding risks based on the ability of the employer to support the scheme”.
Wherever it sits in the pecking order, there can be little doubt covenant has now joined funding and investment as one of the key risk areas that trustees need to understand and manage. And the strong regulatory emphasis on integration means it can’t be viewed in isolation at any point in the funding cycle.
In a scheme-specific system, the point of equilibrium between these risk factors should be rooted firmly in the merits of each case, but there may be some market-wide signs emerging that, in overall terms, covenant is beginning to take rather more than its fair share of the DB funding strain.
There may be some market-wide signs emerging that, in overall terms, covenant is beginning to take rather more than its fair share of the DB funding strain
At its most simple, the argument should probably run along the lines of: funding deficits have grown but thankfully the economic environment is improving with better trading performances, enabling higher deficit recovery contributions to help redress the balance.
But in fact there is growing evidence that, in many cases, deficit recovery contributions are reducing, which must raise a concern about the extent to which an increasing reliance is being placed on sponsor covenants to underwrite the investment and other risks required to meet scheme funding targets.
The problem is partly one of relativity. Not the mind-bending sort that occupied Einstein for much of his life, but a more straightforward proposition: that covenants can certainly improve in a favourable economic environment, but that does not prevent scheme risks increasing disproportionately through lower deficit reductions, longer recovery periods or an ever greater reliance on investment performance – all set in the context of minimising the adverse impact on sustainable growth.
Trustees are struggling in funding negotiations
The Pensions Regulator will undertake an in-depth review of its 2014 defined benefit funding code next year, as trustees struggle to exert power against employers armed with the watchdog’s new strategic objective.
Risk is inevitably building up in the system now, which must surely place greater strain on the ability of sponsor covenants to underwrite it in the future.
More than ever, this places the onus on trustees and their advisers to understand and to be able to quantify and justify the risk capacity of their sponsor appropriately.
They need to be able to correlate and integrate covenant with funding and investment risks and they need to do this with a frequency that allows them to maintain an equitable balance between employer growth plans and the reasonable funding requirements of their scheme.
Tony Hobman is chair of the advisory board at Lincoln Pensions
