Consultation Response #4: Capturing Covenant

TPR’s consultation on a new code of funding looks at ways to simplify how covenant is featured in Fast Track (if at all) and the implications for a scheme’s journey plan.

Covenant is a multifaceted concept that is complex to evaluate, and sometimes awkward to incorporate into traditional scheme decision-making.

As an actuary, I can understand the appeal.

But we need to remind ourselves of the underlying risk dynamics, before dismissing covenant entirely. After all, covenant helps schemes through underwriting investment risk (reducing the cost of accrual), demographic and data/legal risk (looking at you, GMP equalisation), and making deficit repair contributions to fund past risk events (including recent COVID-19 shocks).

Replacing this dynamic with an arbitrary covenant assumption in Fast Track would either hinder schemes with strong covenants from taking investment risk, or allow schemes with weaker covenants to take undue risk. Instead, covenant ratings need to evolve to become more user-friendly. Embracing integrated risk management, a scheme’s journey plan – both for Fast Track and Bespoke – should be defined by reference to covenant factors including:

  • Affordability – answers the short-term question of what level of deficit repair contributions is affordable, and what headroom there is above this to underwrite investment and other risks.
  • Visibility – informs how affordability varies over the medium term, i.e. when will the current level of investment risk become unlikely to be sustainable and need to be reduced? At what point should the long-term objective (“LTO”) be reached?
  • Reliability – considers whether it is appropriate for the LTO to place any reliance on the covenant in the long term, given a solvent sponsor is usually required for the scheme to run on.

With journey planning being fundamentally about managing a scheme’s exposure to covenant risk, an approach such as the above is far closer to answering ‘what is really going on here’.

A first conclusion – scheme maturity only matters for journey planning once trustees are sure that long-term covenant support is available. Where it’s not, trustees need to be ready to reduce risk sooner if the covenant weakens.

Felix Mantz, Associate Director

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