Covenant advice in the new funding regime

Key Takeaways: Covenant advice in the new funding regime - our recent experience

Executive Summary

The LC PS webinar on Covenant advice in the new funding regime, chaired by Fran Bailey, provided comprehensive guidance for trustees and employers navigating their first valuations under the updated framework. Expert speakers Helen Abbott and John Wolf discussed the significant changes introduced by the new DB Funding Code and covenant guidance effective from September 22, 2024. The new regime emphasizes a future-focused approach, integrated risk management, and a more prescriptive framework for assessing covenant reliability, longevity, and maximum affordable contributions. Helen Abbott recapped key elements of the DB funding code and shared strategies for employers to prepare for valuations, while John Wolf highlighted the importance of effective planning and stakeholder engagement. The session offered practical insights into different approaches for covenant assessment, including handling guarantees and understanding the new legal requirements. The webinar concluded with a Q&A session addressing common concerns and emphasizing the need for early engagement and collaboration among trustees, sponsors, and advisors to ensure a smooth transition and long-term success under the new regime.

Speakers

Francesca Bailey, Partner, LCP
Helen Abbott, Partner, LCP
Jonathan Wolff, Partner, LCP

Key Takeaways

1. Future-Focused Funding Regime: The new DB funding regime, effective from September 22, 2024, emphasizes a future-focused approach, prioritizing future covenant, investment, and funding, and requires integrated risk management.

2. Covenant Reliability Assessment: Trustees must now assess and report on covenant reliability, longevity, and maximum affordable contributions, ensuring their covenant can support scheme risks in the statement of strategy.

3. Stakeholder Engagement Crucial: Effective planning and engagement with key stakeholders, including scheme actuaries and investment advisors, are crucial for a comprehensive covenant assessment under the new regime.

4. Prescriptive Covenant Guidance: The new covenant guidance outlines a more prescriptive framework, focusing on cash flows, prospects, and contingent assets, and introduces the concept of a look-through guarantee for assessing affordability.

5. Evaluation Planning Approaches: Three main approaches to planning for evaluation under the new code include starting with the covenant assessment, a proportionate approach for stronger covenants, and a collaborative, iterative process for significant covenant risks.

6. Early Collaboration Essential: Early engagement and collaboration between trustees, sponsors, and advisors are essential to navigate the new requirements and ensure strategies reflect the scheme's unique circumstances.

Key Quote

So it's all about future covenant, future investment and future funding. And I think this forward-looking mindset really puts covenant considerations squarely at the heart of a schemes funding and investment strategy.

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Webinar

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Meeting Trustee Covenant Assessment and Reporting Requirements Under the New Regime

The evolving landscape of pension scheme valuations under the new funding regime presents a series of challenges and opportunities for trustees and employers. The updated covenant guidance and the DB Funding Code now emphasize a future-focused approach, prioritizing the trajectory of schemes over their current status. This shift requires a comprehensive understanding of covenant considerations, integrated risk management, and the alignment of funding and investment strategies. As stakeholders prepare for their first valuations under this new framework, proactive steps and strategic planning become essential. The new regime also places greater importance on detailed covenant assessments, demanding a thorough understanding of the employer's financial health and the scheme's risk exposure. This necessitates a more collaborative approach between trustees, employers, and advisors to ensure robust and well-supported pension schemes.

Trustee Covenant Assessment and Reporting Requirements

The new regime mandates trustees to assess and report on the covenant, now legally defined. This involves evaluating the employer's cash flows, prospects, and contingent assets to determine the scheme's risk support capability. Trustees must confirm in their strategy statement that the covenant can support scheme risks, regardless of the scheme's funding status. This confirmation, along with other covenant information, must be submitted with the valuation. Therefore, trustees need a thorough understanding of the new requirements and how to meet them.

The new covenant guidance introduces several key concepts for trustees, such as covenant reliability and longevity periods, and calculating maximum affordable contributions. These concepts require a longer-term view on covenant, which is necessary for effective risk management. The guidance emphasizes quantifying risk capacity in terms of pounds and time periods, moving beyond traditional covenant gradings to a more detailed assessment. This shift requires a deeper analysis of the employer's financial health and future prospects, as well as a clear understanding of the scheme's journey plan and investment strategy.

Engaging with key stakeholders, including the scheme actuary and investment advisor, is crucial for a successful valuation process. Effective planning sessions and clear communication help ensure all parties are aligned and working towards the same objectives. This collaborative approach facilitates the collection of necessary information from the employer, essential for a comprehensive covenant assessment. Building trust and maintaining open lines of communication with the employer helps mitigate potential challenges and ensures a smooth valuation process.

Setting Affordable Contributions and Assessing Covenant Reliability

Establishing maximum affordable contributions to support investment risk under the new regime is a complex task. This requires a detailed assessment of the employer's forecasts, assumptions, and external factors impacting the company's financial health. The objective is to determine the cash flow that can be generated to support the scheme during investment stress. This assessment is more detailed than traditional affordability evaluations and necessitates a thorough understanding of the employer's financial position and future prospects. The iterative nature of this process means that initial conclusions may need to be revisited and refined as new information emerges.

A primary consideration under the new regime is the approach to covenant assessments. Trustees must now quantify covenant reliability, longevity, maximum affordable contributions, and supportable risk, marking a shift from previous practices. This requires a more detailed analysis of the employer's financial position and future prospects. For schemes with strong covenants, a lighter approach may suffice, focusing on confirming risk capacity around the existing strategy. In contrast, schemes with weaker covenants will likely need a more detailed and iterative process to ensure adequate support.

Early engagement with key stakeholders is crucial under the new regime. Trustees, employers, and advisors must collaborate from the outset to anticipate challenges and streamline decision-making. This collaborative approach helps avoid last-minute surprises and ensures alignment in understanding the scheme's funding and investment needs. By starting discussions early, stakeholders can identify potential gaps in the current covenant and consider options for additional support if necessary.

The new regime also emphasizes the role of guarantees in supporting pension schemes. Trustees are encouraged to critically assess the support provided by current guarantees and consider introducing look-through guarantees. These guarantees ensure that the guarantor mirrors all the obligations of the employer, offering more robust support. This is particularly important for schemes with weaker covenants, where reliance on the guarantor's financial strength is more significant. By aligning guarantees with the new requirements, trustees can provide greater security for the scheme.

The new funding regime marks a substantial change in pension scheme valuations, emphasizing future-focused covenant assessments and integrated risk management. Trustees and employers need to proactively align their strategies with the new framework, engage key stakeholders, and conduct detailed assessments of covenant reliability and contribution capacities. By adopting these measures, stakeholders can effectively navigate the complexities of the new regime, mitigate potential challenges early, and ensure long-term success for their schemes. Collaborative efforts and early engagement are crucial to understanding the new requirements and maintaining robust support for the schemes in the face of future challenges.