While many DB schemes would have likely seen improved funding positions, and on the face of it they should now be less reliant on the sponsor covenant, other aspects of this crisis have highlighted areas of increased reliance on the sponsor. For example, when faced with unprecedented collateral calls, for many DB schemes the only solution was to turn to their sponsors for additional liquidity.

Viewing covenant in a different light

Many schemes have been faced with the stark choice between reducing hedges and maintaining  returns or maintaining hedge levels and reducing returns. Either option impacts a scheme’s journey plan and the potential level of covenant reliance (e.g. greater exposure to market volatility or longer time periods to reach a desired “end state”). With the dust beginning to settle, trustees are now starting to reassess their journey plans and investment strategies. Of course, that will require an up to date view on covenant and what risks it can sufficiently underpin (and over what time period), with many schemes now potentially relying on covenant in different ways. 

We are also seeing trustees discussing how sponsors or third-party providers could potentially provide emergency liquidity if the scheme is faced with a liquidity strain again in the future.

The continued importance of covenant

Unexpected developments since the crisis have reinforced the fact that covenant remains the ultimate underpin for all scheme risks. Journey plan resets will need to fit with the latest covenant characteristics and should be a timely reminder to trustees that covenant is so much more than a simple rating – it should be a dynamic view of the evolving ability of the sponsor to support scheme risk over time. Furthermore, the recent crisis should act as a helpful reminder that there really is no such thing as “self-sufficiency” and that “low reliance” is certainly not the same as “no reliance”.

While funding levels will have generally improved and many schemes perhaps don’t need to turn to sponsors for cash contributions (for deficit repair), this shouldn’t be a reason for trustees to be complacent when it comes to employer covenant. General macroeconomic conditions are clearly pointing to choppy waters for many corporates and we see material strain on many sponsor covenants as highly likely in the coming months, noting the Bank of England is now predicting a 2-year recession. This is particularly the case in certain sectors, such as where sponsors are reliant on discretionary spend or those heavily reliant on the domestic UK market. 

With many businesses having to battle hard against ongoing cost inflation and exposure to rising interest rates, we see an increasing likelihood of certain corporate events which could have material implications for covenant: Examples include:

1. Internal restructurings as management teams seek to explore every avenue available to help protect margins
2. Non-core asset disposals to enhance the sponsor’s liquidity, including preparatory steps to execute these such as the hiving up of sponsoring employer assets
3. More challenging refinancing of debt.

Such events could also create the need to re-assess a scheme’s journey plan, even if starting from a low-risk position, remains appropriate as covenant risk dynamics are potentially materially altered.

Alongside these scenarios, the combination of devalued sterling and improved scheme funding may make certain UK sponsors attractive assets for potential foreign investors – this could mean trustees are faced with takeover scenarios despite the general expectation of a downturn in M&A activity.

How can we help?

Our covenant experts are already working with many of their clients to provide an updated view of covenant, including fully understanding near term challenges, to inform any reassessment of the scheme’s journey plan and investment strategy in light of recent events. 

What’s key is that decisions trustees take on investment fit with the latest covenant dynamics, even if it’s a revalidation of the existing strategy. While a corporate event might provide trustees with the platform to do this, we would encourage even those facing a “steady state” covenant not to wait until the next triennial actuarial valuation to really get a handle on these.

As always, our client teams are also ready to help you understand the impact of specific corporate events on the employer covenant, including linking this to the scheme’s journey plan.

Please get in touch with us to discuss how we can help you.