VIP VIEWPOINT Clouds on the horizon

Is a covenant risk bubble developing in the defined benefit landscape? – wonders Darren Redmayne, Lincoln Pensions

In a nutshell: 
  • a risk bubble may be developing in the defined benefit space
  • a lack of proper understanding of covenant risk persists in the market
  • improving trade performance may not mean a stronger covenant
  • sponsor covenants are taking too much of the strain in preference to increasing contributions.

Without wishing to be a doomsayer, I fear a risk bubble developing in the defined benefit scheme landscape. The bubble that is developing is different from prior funding challenges, which have related to interest rate and longevity risks. This time, the issue lies in the sponsor covenant – a risk that has only been formally considered for the past decade.

Current received wisdom appears to be that while deficits have grown as a consequence of the low interest rate environment, thankfully, a better economic environment (relatively speaking) is delivering better trading performance, enabling higher deficit contributions to address funding needs. That all makes sense, but it is not happening in practice. Evidence from analysing the deficit recovery contributions of public companies shows that contributions are falling while deficits are rising, so that more reliance is being placed on the sponsor covenant. If the bubble is left unchecked and it bursts, we will have a significant rise in cases falling into the Pension Protection Fund.

But why are deficit recovery contributions falling, while deficits are rising? Companies typically like schemes to use investment performance, rather than contributions, to fund deficits. Companies also tend to associate improving trading performance with “our covenant must be stronger” and deploy this argument to obtain longer recovery plans and/or lower contribution levels.

Furthermore, the additional statutory objective given to the Pensions Regulator – to consider sustainable growth as a response to the economic crisis – has tipped the argument back towards sponsors. Trustees, feeling less justified about seeking contributions when corporate performance is improving, are providing flexibility through accepting lower contributions and longer recovery plans.

The covenant conundrum

This all leads to the pensions covenant funding dichotomy: when times are good, trustees may become more relaxed about covenant risk and accept a sponsor’s wish to maintain lower levels of contributions. This leads to deficits not being funded and risks not being reduced. However, when times are challenging, the sponsor cannot then financially afford the level of contributions required, meaning that deficits remain unfunded and risks increase further.

A lack of proper understanding of covenant risk persists in the market. The fact that improving trading performance does not necessarily mean the covenant is stronger is often misunderstood by sponsors and tustees alike. The problem is that, in very many cases, the risks in the scheme have outpaced operational performance improvements in the past
few years.

The Regulator’s funding code (paragraph 43) states:

“In particular trustees should understand the extent of the scheme’s reliance on the employer covenant over time on the basis of a range of plausible future scenarios ... This is because the employer underwrites both the short- and long-term risks to which a scheme is exposed.”

Without trustees seeking a deeper understanding of whether the covenant is “good for the risks it is being asked to take”, there is developing risk in the system. I believe we are in a phase of the market where the sponsor covenant is being asked to take too much of the strain in preference to increasing contributions, which could develop a potential “risk bubble”.

I believe we are in a phase of the market where the sponsor covenant is being asked to take too much of the strain in preference to increasing contributions.
Darren Redmayne

To ensure that your sponsor or scheme is not part of this wider developing industry issue, consider the following:

  • Can the covenant underwrite the funding and investment risks we are taking? Ensure you understand your covenant’s ability to underwrite risk and not just the operating business.
  • Covenant is part of your overall risk budget If you maintain risk in your investment strategy, be sure your covenant can take the strain. Most flight plans ignore covenant.
  • In which direction is our covenant headed? Is greater or lesser reliance on the covenant involved in the decisions being taken? Covenant does not boil down to a static descriptor like “strong” or “weak”.

Darren Redmayne is head of Lincoln Pensions (a covenant advisory firm).