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A new funding
regime – what does this mean for assessing covenant strength?

Our viewpoint

On 3 March 2020, the Pensions Regulator published a consultation on the principles it proposes to adopt in regulating DB pension scheme funding and investment strategies. You can read more about the new regime in our News Alert. Whilst the detail of the new regime won’t be clear for some time, there are some immediate implications for assessing the covenant strength of corporate sponsors that some trustees and sponsors will need to consider. This is because the new constraints on funding and investment are expected to depend on the strength of the sponsor’s covenant, most likely using the Regulator’s covenant classification system. This means that the way in which the covenant is assessed will take on more significance in the future.

The Regulator classifies covenant as follows, and we have illustrated some of the Regulator’s expectations of a scheme of being classified in each box:

  • Strong – c15% of schemes
    Under the new regime, such schemes are expected to be able to invest with more freedom and have less prudent funding targets, but sponsors may have to meet deficits quickly, perhaps with a maximum of 6-year recovery plans (although the Regulator is seeking views on whether a maximum of 3 years should be appropriate).
  • Tending to strong – c45% of schemes
    The acceptable levels of funding and investment risk for these schemes will be constrained a little more, with lower prescribed discount rates, and lower prescribed investment stress tests. However, maximum recovery plan lengths are likely be similar – with the current indications being 6 years. Dividends paid by sponsoring employers may also receive some scrutiny.
  • Tending to weak – c25% of schemes
    Such schemes will have further constraints but may have up to say 9 years to pay off deficits. In addition, for these schemes there may be tougher guidelines on the acceptable level of dividends that a sponsor can pay.
  • Weak – c15% of schemes
    These schemes are in the weakest position. They are likely to be steered towards considerably reducing investment risk, and sponsors stopping or minimising dividends and other covenant leakage, and maximising contributions to reduce any deficits. Where relevant, such schemes may also be effectively required to cease future accrual of benefits.

What can be seen from the above is that the classification of covenant strength is likely to matter more in the future, and sponsors may look to providing schemes with additional forms of covenant support, such as parent company guarantees, escrow accounts or letters of credit to allow more flexibility to be taken in funding and investment decisions. Though somewhat perversely there may also be some cases where sponsors argue that they are a weaker covenant, in order to help support a longer recovery period.

What does not appear to have changed is the Pensions Regulator’s language around affordability, with the Regulator stating that technical provision deficits should be recovered as soon as affordability allows, whilst minimising any adverse impact on the sustainable growth of the employer.

Trustees are expected to have to report their covenant strength to the Regulator, using the four point system set out above. The Regulator is likely to ask for confirmation of whether the trustees have obtained independent covenant advice or assessed the covenant themselves. If the latter, further questions about the way in which this was done, and the way in which conflicts of interest on the trustee board were addressed, are likely to be forthcoming. And in every case, the Regulator is expected to undertake its own simple checks, using public information such as the insolvency risk scores used for PPF levies, and published accounts, to check against the trustees’ assessment, and ask questions if the differences appear large.

Whatever the covenant grade, in line with the Regulator’s focus on long-term objectives and ensuring that schemes focus upon the risks along the way, the Regulator has said that trustees will need to assume a reducing level of reliance on the covenant over time. It has also proposed that some limits could be placed on that reliance based on covenant visibility, with indications that this should not extend beyond three to five years unless there are mitigating reasons.

Taking all the above factors into account, we therefore expect there to be much more scrutiny on covenant advice in the future and it is likely that more sets of trustees will need professional support in this area. And where independent covenant advice has not been taken by trustees, we expect such scrutiny to become the norm.

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