Covenant remains a key focus as trustees are encouraged to focus on current challenges and longer-term risks

This morning The Pensions Regulator (TPR) published its Annual Funding Statement (AFS) setting its expectations of trustees and sponsors for the year ahead. Covenant remains a key focus as trustees are encouraged to focus on current challenges and longer-term risks. Emily Goodridge and Nigel Sillis summarise the key points below.

1. Covenant challenges at the forefront

The AFS leads with covenant challenges, underlining the new challenges arising from the Ukraine/Russia conflict as well as the “lingering effects of COVID-19 and Brexit”. Some sectors and sponsors are directly impacted by the Ukraine/Russia conflict, whilst others may suffer indirectly through supply chain disruption; engagement with the sponsor is key.  

The AFS expresses TPR’s concerns about an uptick in shareholder distributions following a hiatus during the pandemic, urging trustees to consider whether the scheme is being fairly treated compared to other stakeholders. We recommend trustees continue to engage with their sponsors to better understand the impact of the current economic challenges, such as rising energy prices and supply chain disruption.

2. Trustees need to be mindful of long-term reliance on covenant

Some sponsors are trading well through the recent challenges, whilst others have and continue to struggle. Similarly, different hedging strategies mean some schemes have fared better than others through these recent integrated risk management (IRM) shocks. This has a polarising effect, creating an expanding gap between well-funded schemes with a healthy covenant, and those in a weaker position.     

The AFS recognises that many schemes are now fully funded on a Technical Provisions basis; notably the average recovery plan is now less than six years across all valuation tranches.

Whilst many schemes now no longer need cash funding, TPR continues to emphasise the importance of covenant. The AFS reminds trustees of the ongoing reliance on covenant up to the Long-Term Funding Target and beyond, to the point at which the scheme ultimately winds-up.   Trustees should focus on longer-term covenant risks and look to reduce reliance on covenant. This is a shift of focus for many trustees, who still think of covenant only as a rating.

3. Integrated risk management remains a key focus

The Ukraine/Russia conflict, COVID-19 and Brexit all represent IRM shocks, impacting both covenant and funding. The AFS stresses the importance of IRM, noting material risks can be correlated, and things can change quickly.

Scenario planning is highlighted as a useful tool for risk management, allowing trustees to consider covenant and funding impacts of plausible downside scenarios and undertake contingency planning. We encourage trustees to refresh their covenant monitoring so that it is forward-looking, and focused on longer-term covenant risks and plausible downside scenarios, not just near term financial metrics.  

4. Scenario thinking is important for investment strategy too

The AFS notes the importance of stress testing and scenario analysis to covenant assessment. These techniques are also valuable when setting investment strategy. Trustees should ensure that their chosen strategy is appropriately balanced.  An effective investment strategy will need to be resilient to an increasingly uncertain macroeconomic landscape. Investment managers will need the right tools and techniques, and be alive to the need to consider alternative scenarios, in order to navigate expectations of the higher market volatility that the AFS correctly identifies.