The Pensions Pod S5:E5 – TPR’s updated covenant guidance

Chris Flood, Managing Director – Interpath

Hi.

Chris Brown

Hi, great to have you with us. Chris, I’ll come on in a minute to what we’re going to be discussing today but do you just want to quickly tell our listeners who you are and the type of work you do?

Chris Flood

Yes, I’m Chris Flood. As you’ve said I’m a managing director at Interpath. I lead our Employer Covenant team across London and the south of England. I work across the market with large schemes, small schemes, multiemployer schemes, and the like so pretty broad experience.

Chris Brown

Yeah fab, thanks ever so much. And so that then probably gives a teaser as to what we’re going to be talking about today. Chris, I wanted to ask you, and the reason why will become apparent in a minute, do you like doing jigsaws?

Chris Flood

Love them actually, yes I do.

Chris Brown

Good, good. Right, so I should also say, Chris, that this episode feels different for me because my co-host Helen Norman is not here with us. She’s on maternity leave and has been celebrating the recent arrival of her beautiful baby girl. So Helen, if you’re listening, we wish you all the best with your new family life.

Chris Flood

Congratulations.

Chris Brown

Yeah, thanks Chris.

So today, what are we going to be discussing? Well, on the 4th of December the pensions regulator published its updated Covenant Guidance and it said it was the last piece of the jigsaw to help schemes carry out valuations under the new DB funding code. And when they published it the regulator said that for many schemes the guidance is simply baking in good practice, but there are undoubtedly lots of new concepts and lots to get to grips with. So Chris, we’ve got a number of questions about it to put to you today. [Music]

Okay Chris, so the purpose of today is not to talk in detail about how the regime works but I think it would be helpful at the start of this episode, could you give our listeners a brief overview of covenant in the new funding regime and the new Covenant Guidance please?

Chris Flood

Yeah absolutely, I mean 4th of December, it was an early Christmas present for the industry, a big big moment for our industry. I suppose the code, the guidance, they go together. The code tells you what you need to do, the guidance builds off it and tells you how to do it, and the guidance in particular provides lots of examples lots of case studies that will help people apply it in practice. But as I say covenant really, it’s an evolution, rather than a complete rewrite of what we do. The underlying work, the analysis that we do is not particularly different following the new code and guidance, but there is, as you touch on, lots of new terminology and what we need to report particularly has changed. Ultimately covenant remains focused on what the sponsor can reasonably afford to pay.

Chris Brown

Yeah.

Chris Flood

The regulator wants schemes to be funded as quickly as possible, that’s not changed. The reliability of cash flows, the longevity of the business, are there risks to the continuing existence of the business over the period the scheme has a journey plan for? And what’s the sponsor’s ability to support the risk being run as part of that journey plan? And I guess in essence the regulator is wanting recovery plans to be no longer than the period where you have reasonable certainty over the cash flows being generated by the sponsor. They want the risks that the scheme is seeing to be supportable by the Covenant, so for instance if a VAR event occurs over the recovery plan period they want you still to be able to reach your technical provisions period within that reliability period and they want trustee to look forward and make sure that there aren’t risks to the existence of the Covenant over the journey plan that could cut short that Journey. So yeah, that’s really a bit of a snapshot.

Chris Brown

Yeah, no that’s really helpful and from the conversations I’ve been having I think that’s right, that it’s an evolution of, you know, good practice from before.

I suppose one change to the whole regime is that the concept of the Employer Covenant is now legally defined in the funding and investment strategy and amendment regulations 2004 regulation 7 and the definition essentially underpins all the points you were making just there about focusing on the statutory employers and the financial ability to support the obligations, looking at the level of support, looking forward as well, from contingent assets to the extent they’re legally enforceable and then looking at cash flow and the resilience of the business, going forward the insolvency likelihood and all those things you would just saying.

So I suppose question for our listeners then is if it’s an evolution what are the biggest changes to, sort of, the previous regime or before we had the code in the guidance?

Chris Flood

Yeah I guess there are two that –

Chris Brown

Yeah.

Chris Flood

• particularly spring to mind. The first is reporting, so under the previous regime what you reported to the regulator on covenant was extremely limited. In fact it’s only in the last few years where you’ve had to put the covenant grading on the scheme return and I guess that’s going to fall away now because –

Chris Brown

• well I might ask you a question about that if that’s okay? I’ll let you let you finish the two points and then I think – so yes the covenant grading is falling away, but I’ll be interested to know, you know, do you think it’s still helpful to to have one? But yeah, sorry to interrupt come back to the two biggest changes from the previous regime.

Chris Flood

So within the code and the guidance there is no mention of covenant gradings anywhere and the regulator said they’re not going to be asking trustees for covenant gradings anymore. They do recognize that trustees may still want them.

Chris Brown

Yeah.

Chris Flood

Many of my clients do it’s familiar, it’s familiar to them.

Chris Brown

Yeah exactly.

Chris Flood

And in some respects it’s a simpler concept to some of the things that that we’re going to talk about, but the regulator is not going to be asking for covenant gradings and they’re not going to be using them like they previously used to. So instead –

Chris Brown

-maybe does it does it help clients with continuity from perhaps past covenant reports that they’ve had as well perhaps?

Chris Flood

Yeah absolutely, it’s that familiarity and it’s that understanding of aggression of covenant is definitely helpful so certainly from the conversations I’m having I’m not hearing anyone saying we don’t want a covenant grading, actually quite the opposite.

But now trustees are going to have to report some quite specific defined metrics and that goes on to the statement of strategy, but they’re also going to need to justify why they’ve got to the assessment of each of those metrics and how they’ve reached those assessments. So the new reporting requirements are definitely going to lead to differences in how we report, but also the interaction that’s going to be required between advisors. I think the code brings covenant much more into the centre for schemes. Advisors are going to need to be more joined up, more integrated. I think the code really brings out integrated risk management, it brings it to the fore. So that’s one change, I think reporting and how we report is going to evolve.

The other area I’d call out is really around where trustees are placing covenant reliance and why they’re placing covenant reliance where they are. I think the regulator in the past has been quite vocal that, you know, that they’re concerned that some schemes have been placing reliance where it may not necessarily be fully warranted, and they’re concerned about the risk that trustees are caught short when the chips are down they find that the support that they thought might be there, or would be there, isn’t actually there when it’s needed. So for instance where trustees are taking risk based on a sponsor being part of a group but they don’t actually have access to legal recourse to the primary trading entity, or the valuable parts, or where they have a guarantee but the guarantee doesn’t actually bite when you might need it.

So trustees are going to need to explain in the statement of strategy what they’re placing reliance on and why, and with guarantees what value can they place on that guarantee as part of their journey plan? Not just on an insolvency, but actually as you’re going through your journey plan and I think that’s going to place quite a lot more focus on what risk is actually supportable.

So the natural conclusion from that is that some schemes will find that their current funding and journey plan may need to change as a result because they’ve been placing reliance where it’s not actually legally there. Or they may need to negotiate new provisions, new covenant support with the sponsor to actually stitch back in place that what they had previously had assumed.

Chris Brown

Yeah and you mentioned guarantees there and making sure that you place the right reliance on those, perhaps we might come on to those in a moment and talk about, you know, this concept of a look through guarantee which is- that phrase might be new to our listeners, but just before that I think what you were saying about integrated collaboration between advisors, you know, and that integrated risk management piece is spot on because the Covenant, as you say, needs to take into account, well what are the obligations of the employers? Are we certain we’re looking at statutory employers and not, you know, the wider group that doesn’t actually have any obligation to the scheme? And alongside that it’s often helpful to look at the balance of powers in a scheme so the trustees understand, well what levers do they have at their disposal if they needing to, you know, negotiate support or so that they understand the context in which the cabinet analysis sits?

Chris Flood

Absolutely, and actually I think it can be quite complex understanding that and you sometimes find that when you get into a transaction project and start looking at certain bits of detail you identify things, within the group structure for instance, that means that the access that you thought was there wasn’t actually there for instance because there’s an in there’s a big intercompany that means that value circumnavigates a sponsor and ends up somewhere else.

So it’s something that is not always straightforward and I think is going to need more thought and because you’re going to need to justify what you’re doing within the statement of strategy and the regulator is going to look at that and seems pretty focused on that.

Chris Brown

Yeah. Yeah well then let’s jump to talk about contingent assets and look through guarantees then. So there’s been a lot of talk about the value and the value being placed on them. Is the regulator’s approach going to mean that sponsors are less willing to provide guarantees in the future do you think, or will it have an impact?

Chris Flood

For me I don’t think so. For me guarantees are normally put in place for a reason. They’re there to mitigate detriment. They’re there to enable trustees to take a particular approach, to take a certain amount of risk or whatever, so I think what we will probably see is that the terms of guarantees may evolve so that they within the guidelines that the regulator has set out, while still unlocking the issue that they’ve been designed to deal with.

I suppose, you know, take look through guarantees, which is this sort of new concept. Although the regulators talked about it for a number of years it’s definitely coming to the fore with the code and the guidance. I’ve actually negotiated a few over the years but they weren’t easy to negotiate and I think that’s because they’re quite unusual, they’re not the norm and people tend to like to stick to the standard form, the norm. So most guarantees I see aren’t currently look through guarantees, but I expect will become more-

Chris Brown

-do you think they will become more? Yeah.

Chris Flood

Yeah absolutely. I think they’ll become more common because in some situations they’ll be required to provide the support that is needed for the existing journey plan. I mean what do you think on that?

Chris Brown

Well no I think you’re right and I think, I mean you know, there’ll always be points for negotiation and there will be guarantees and, you know, we see plenty of, you know, non PPF standard guarantees that are on bespoke terms. But I think where an employer group has the means and wants to put in place support and its objective and driver is to support pension risk then, you know, it will accept that it needs to put in the gold standard and if that becomes a look through guarantee then that’s what will be put in place.

I suppose one thought is that there’ll be a number of guarantees at the moment that are full Section 75 they cover DRC’s, plus insolvency, insolvency debt, but, you know, they’ve got no caps or time limit so that they’re evergreen. But one thing they might not have, which is required to be there to be what the regulator calls a look through guarantee, is a legal mechanism allowing the trustees to look through to the guarantors cash flows when the trustees are setting contributions and looking at the affordability of employers. So what I suppose what we might see is some trustees with a guarantee like that, perhaps on PPF standard terms, might now need to negotiate a new guarantee or perhaps a side letter, an amendment to the to the existing guarantee in order to insert that legal mechanism to make it look through for the purposes of the code and the guidance.

Chris Flood

And yeah, and certainly the ones that I’ve seen have been done through side letter, legally enforceable sort of side letter rather than on the face of the of the guarantee, that’s certainly my experience to date.

But yeah you’re absolutely right, the key thing about a look through guarantee it is all monies and all that, it’s evergreen, but the key thing that doesn’t tend to exist in the normal course now is that look through to the guarantor for affordability purposes. Even though actually in many situations you have a standard form more monies guarantee it doesn’t provide that legally enforceable right to look at affordability, but the sponsor is willing for that to happen. It just hasn’t been written down, it’s not legally enforceable.

Chris Brown

It hasn’t been written down, exactly.

Chris Flood

That’s the regulator’s point on that really.

Chris Brown

Yeah yeah. Okay, so we jump forward there to talk about guarantees a bit, but I suppose I wanted to ask you, we’ve been talking about changes the regime, what do you envisage to be the biggest challenges for trustees and well for all really, trustees, sponsors, advisors, in adopting the new regime?

Chris Flood

Yeah so, I suppose one is information.

Chris Brown

Right, yeah OK.

Chris Flood

You know the regulator is pretty clear on their expectations around what sponsors need to provide and quite a lot of information is going to be required. Also particularly if you’re bespoke and you have a recovery plan to fill in the statement of strategy fully. So you know, and it’s going to be quite challenging to do that without information being sourced from the sponsor. So for instance, the statement strategy looks to in some situations you’ll need to put in forecast cash flows for year 1, year 2, year 3, etc. and those are things that you’re going to need to get from the sponsor. So in many situations I don’t think that’s an issue, information provision has, and information visibility, is much better than it was a few years back. But there are some situations still where sponsors are more reticent to provide information, or the information that is available doesn’t align with the covenant structure, because of divisional reporting or whatever.

So, and those situations are definitely going to present some challenges and trustees and sponsors and the advisor going to need to work together to so solve those issues and I’ve actually got a few cases where that’s the case and I’m in discussions with the clients now. Even in some well ahead of the valuation date where the code is going to apply, just to start working through how are we going to actually solve that how are we going to find a solution and some of that is sponsor education. It’s sponsors understanding the regs and understanding –

Chris Brown

• the regime yeah.

Chris Flood

Absolutely. There’s confidentiality issues and it’s also, you know, can be just accounting and financial reporting and then that mismatch between covenant structure and what’s actually reported, but yeah we’re definitely picking some of those up now. I think the other challenge-

Chris Brown

Yeah.

Chris Flood

-that I’d call out, and maybe it’s not necessarily a challenge, is just getting the right balance between what the code and the guidance suggests you need to do, and proportionality, which is mentioned plenty of times-

Chris Brown

-plenty of times.

Chris Flood

In both documents, but that is going to need some careful thought and it’s worth noting that the code the guidance provides, lots of examples of things that trustees should consider but they are examples rather than absolute requirements.

And so for instance, if you do everything in the prospect section of the guidance most covenant review budgets are going to go through the roof. But that’s not what the regulator is saying, you just need to give some careful thought as to where you focus your attention to deliver the assessment that is focused on the things that actually matter to your scheme and while still being, sort of, proportionate to the needs of the scheme.

Chris Brown

And that auditing, why an approach has been taken and why, you know, a decision to say follow a proportionate approach is going to be a big part of it.

Chris Flood

Yeah and you’re going to need to justify, again.

Chris Brown

Yeah, that justification, the audit trail.

Chris Flood

Why you’ve done what you’ve done, why you looked at it the way you looked at it.

Chris Brown

And so, sort of, with employers, interesting what you’re saying that you’re seeing, and it’s not a particularly new idea, but you can get your ducks in a row and agree with the employer, or try to, you know, have an information sharing protocol well before any information actually needs to be shared as part of the valuation. Employers and the regulator, you know, expects there to be ways through to manage conflicts of interest, so you can have confidentiality agreements and NDAs with your trustees. So all of those are issues to think through but there should be ways through it.

I wonder whether, do you think because the new regime requires trustees to provide evidence is that a bit more leverage for them to be able to say to employers, look come on you need to give us the information in the format we need?

Chris Flood

Yeah, absolutely, and that is definitely- it goes to that education point. The ones where I’m dealing with it at the moment quite a few is just simply explaining, look these are the regulations, this is what the regulator is requiring and so we need to find a way through it and definitely explaining that is part of the solution and so far those employers where we’ve explained it they’ve listened, they’ve gone okay let’s see how we work around that.

Chris Brown

Yeah, good. Okay, so I wanted to ask you now then, you were talking about proportionality a bit there, what does a sort of light touch approach look like? Say if a scheme is in, you know, has got a large surplus on all bases or, you know, if a scheme is approaching a risk transfer project. Yeah. What are your thoughts there?

Chris Flood

Yeah, so it very much depends on the scheme and the circumstances and also what you mean by surplus. So is it surplus on TP, surplus on low dependency, surplus on a buyout basis, and what’s the size of that surplus? Is actually quite important as well, for instance does the surplus cover the VAR? Because if it does that makes a difference.

The important thing is that you’re proportionate to the needs of the scheme and you focus your attention on what’s going to make a difference. So if you’re funded above low dependency with VAR coverage on top.

Chris Brown

Yeah yeah.

Chris Flood

The prospects of needing cash funding from the sponsor is probably very limited.

Chris Brown

Yeah.

Chris Flood

And so it’s probably more relevant to focus your attention on longevity, the potential bumps in the road, over your journey plan and do that rather than spend lots of time considering reasonable affordability and covenant reliability because they’re unlikely to make a difference to your situation and I think actually on the statement of strategy you’re unlikely to be asked for reasonable affordability and covenant reliability, if you are well funded in with that sort of VAR coverage.

If you’re looking to buy in or buy out in the near term you’re likely to focus on the shorter term, there’s no point considering, for instance, climate change issues if those issues only materialize, you know, in a decade or so. It’s just not going to make a difference if you’re looking to buy out within 5 years I’m going to be focusing on whether there are any issues that may disrupt that 5-year horizon. Hopefully we’ll be able to conclude that longevity is at least 5 years, rather than spend lots of time and money working out justifying a longer longevity period, it’s just not needed to do that. So, it’s very much about understanding the circumstances and just focusing your attention on the right thing.

And just finally on this one, I suppose it’s important to highlight that, you know, the regulator has said that if you’re well funded the reporting requirements in the statement of strategy will be lower, we’ll have to see for the final version of the statement strategy to actually see what that looks like. But, you know, as I said earlier, if you are funded above low dependency plus VAR I don’t think they’ll be asking for reasonable affordability or reliability periods necessarily because it’s just not going to be relevant to their, sort of, supervision and work they’ll do off the statement strategy.

Chris Brown

Yeah, that’s helpful and I think will be of comfort to listeners with schemes in very well funded positions.

Okay, I just want to touch on one last thing because our time for this pod is coming to an end. I want to touch on one last thing before we then ask you for three key takeaways, and that thing is how the approach to covenant under the funding regime interacts with- well how it might interact with how you might look at covenant if a transaction is happening, if a business transaction is happening. So I know there have been some discussions around the approach to covenant under the funding regime, focusing on cash flows. Cash flows is a central part of it, and when you’re looking at, say, a business transaction concerning the employer and you’re doing a review to see is there anti-avoidance and you might be, you know, auditing the regulators moral hazard powers as part of the transaction. You look at the different tests for contribution notice. The employer resources test, my understanding is that focuses more on profits as opposed to cash flows under the funding regime, so how do those-

I suppose what I’m reflecting is, don’t know if you agree, on a business transaction there’s actually quite a bit of covenant detail to think through from different perspectives.

Chris Flood

Yeah absolutely. Standard pension schemes at 21 test the clearance guidance, that remains the same.

Chris Brown

Yeah.

Chris Flood

And trustees continually need to think about that. But on top of that you need to think, and you’ve always needed to think about this, but you need to think about how the transaction might impact the journey plan.

Chris Brown

Yeah.

Chris Flood

And using new terminology, supportable risk, how does it impact your supportable risk? So it’s definitely right that, you know, if you’re facing into a transaction now not only do you need to look at the employer resources tests, the cash flow tests, etc. but you do also need to think about those covenant metrics that we’re going to be reporting. How does the transaction impact those covenant metrics?

So for instance, if the transaction impacts the reliability of cash flows, or the longevity of the sponsor, you need to then go back and look at your journey plan and go do I actually need to update my journey plan as a result? So definitely plays into transactions.

Chris Brown

Yeah, I can see it being quite nuanced and, you know, that just underpins the benefit that professional covenant advice can can bring to, you know, thinking about all of these things.

Okay Chris, well look I feel we could continue this discussion but you know podcast format, we’ve got to draw it to a close there so I wonder if you could leave our listeners with three key takeaways about the last piece of the jigsaw, the Covenant Guidance please?

Chris Flood

Yeah absolutely, so I suppose the first is that I’d recommend that all trustees and sponsors engage with the new requirements early, don’t wait your next valuation date to pass to start thinking about what changes might be needed, start discussing it now. It’ll be a lot easier if trustees and sponsors are on the same page as they go into the valuation process. If information has been a problem in the past start discussing with the sponsor now how you might work through that. So I think that’s one.

Two, in the same vein if you’re planning for evaluation now include covenant within that planning process. The code is designed to drive IRM and get your advisors talking and working together, don’t leave covenant to the end because it could impact your plans.

And third, you know, the guidance is extensive but the regulator is not expecting you to do everything in the guidance, they recognize the need to be proportionate, to be pragmatic, so give some thought to what you need to focus on for your situation, what’s really going to matter for you and make sure that your scope of covenant review covers all those points.

Chris Brown

Yeah, thank you. I think that’s really helpful and the regulator says that as well, it emphasizes that focus on proportionality in the right level of detail, but based on the covenant support that you have in your situation and your scheme’s position. So the points you make around understanding where you are, reading the guidance, engaging the employer early and knowing what you need on covenant and using thinking about covenant early in the valuation process all makes sense to me.

[Music] Thanks ever so much Chris for coming on the podcast, I found that a really interesting discussion and I’m looking forward to how valuations will play out under the new regime. And to our listeners, thanks everyone for listening to the Burges Salmon Pensions Pod. If you’d like to know more about our pensions and lifetime savings team and how our experts can work with you, then you can contact myself, Chris Brown via our website. And all of our previous episodes are available on Apple, Spotify, or wherever you listen to your podcasts. Don’t forget to subscribe and thanks for listening. [Music]