The employer covenant review has continually evolved since the concept was first introduced, and it is time for another iteration. Covenant advisors need to move away from just giving trustees a rating of covenant and instead provide advice to better help trustees consider a level of supportable scheme investment risk, an appropriate time period to target full funding, and the affordability of the scheme’s potential current and future cash requirements for the sponsor. The old covenant review is dead, let us now embrace the accession of this new era of covenant.

Employer Covenant reviews still place significant weight on proprietary rating scales, but as trustees aim to project forward their journey plan to full funding, they are now demanding an output that helps them make decisions off the back of the review. That requires another reinvention of the employer covenant.

The rating is helpful in allowing trustees to assess the likelihood of the member’s benefits being paid in full, and therefore in guiding them to the appropriate funding target. However, it is less helpful in then assisting them to make decisions off the back of it.

Firstly, advisors currently talk in different languages, making it hard to translate how one piece of advice should influence actions in another area. For example, covenant advisors require their rating scale to be translated by the actuary and investment advisor.

Instead, Covenant advisors now should be talking the language of risk, longevity, and funding.

This requires a deconstruction of the covenant review into 3 constituent parts:

a. Sponsor risk capacity and risk correlation with the scheme – giving the trustees a clear view on how much downside risk the sponsor could support, and the extent to which any correlation between scheme and sponsor increases or mitigates this risk;

b. Longevity of covenant – Can a view be given on the period over which the trustees can place reliance on the covenant? Some sponsors have characteristics that allow for a longer term view to be taken;

c. Affordability of cash now and in a downside scenario – what is the sponsor’s capacity to meet a fall in funding levels over the scheme’s lifetime? What is the payment profile of the scheme over its life and are there any shortfalls in scheme liquidity that need to be considered? How might the covenant be impacted by increasing funding towards the scheme

These terms fit better with the 4 key levers that trustees have at their disposal

1. Changing investment risk;

2. requesting increased cash from the sponsor;

3. changing the time period over which the scheme targets full funding; or, ultimately,

4. accepting that a lower target might be required.

As a result, trustees get better information about the relevant factors impacting the sponsor, leading to greater confidence over the longterm future of the scheme.

By understanding the covenant/investment/funding drivers of a particular strategy this also allows trustees the possibility of creating a genuinely integrated risk management framework (not just one that plays lip service to integration by presenting 3 separate monitoring frameworks in the same document and hoping no one will notice they don’t integrate)

As more and more schemes enter run off, there is a need for ever greater integration amongst trustees, sponsors and advisors. Covenant advisors have a responsibility to help this dialogue by focussing on the needs of the trustees, and by helping trustees articulate to management the benefits of greater collaboration between scheme and sponsor.

Long live the employer covenant – there are exciting times ahead.

By James Berkley – Associate Partner EY

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