Why should trustees look forward?
A trustee’s fundamental aim is to try to ensure that every pound of the pension promise goes to every member when due. To manage the future delivery of that promise, a forward-looking approach is imperative to effectively identify, monitor and manage key risks over the whole journey plan.
A forward-looking covenant assessment plays a crucial role. Such an assessment should take the strength of the sponsoring employer, and other covenant support, today, as the starting point, and then consider the various factors in the future that may impact the sponsor and potentially derail the sponsor and thus the scheme from its desired journey plan.
It is future, not past cash flows of the sponsor, that will fund the scheme.
The importance of a forward-looking approach is endorsed by the Pensions Regulator, who guides that trustees should ensure “that the covenant assessment looks at both the present and future”.
What factors matter for a forward-looking assessment?
While the historical financial performance of the employer covenant helps form a view as to its strength, the adage “past performance is not indicative of future performance” highlights that solely focusing on historic strength and performance and merely extrapolating into future expectations could miss obvious developments and exceptional events which may materially influence capacity to support the scheme.
The trustees will want to consider the impact on operating performance, cash generation, balance sheet and capital structure and ability to raise capital based on key areas including:
- The sponsor’s market and industry
- What is the sponsor’s competitive position within the market and how is that changing?
- What could reduce or increase market growth?
- The sponsor’s strategy and management resource
- Has the sponsor a well-developed strategy to compete and grow within its chosen markets?
- Has the management the resource and operational ability to deliver effectively on the above strategy?
- Regulation and legislation
- How much of the sponsor’s business is exposed to / protected by a regulatory environment?
- How likely is the regulatory environment to change?
- Environmental, Social and Governance (“ESG”) factors
- What steps is the sponsor taking to mitigate key ESG risks?
- How do these factors impact the market, industry, regulation and legislation?
How can trustees predict the unknown?
While the future development of the covenant is uncertain, trustees can undertake scenario analysis, which may include forecasting the employer’s financial performance and then flexing the underlying assumptions for various risks to produce a range of likely outcomes.
Although trustees will not be able to accurately predict the timing and scale of downturns, they will be able to better understand how certain scenarios could impact the covenant and, therefore, be better prepared to mitigate them if and when they occur.
How can the approach feed into a future monitoring framework?
A forward-looking model can form the basis of an Integrated Risk Management framework to help trustees identify, prioritise and, where proportionate, quantify the material risks that affect the prospects of meeting the scheme’s objective and especially the interrelationship of covenant, investment and funding risks affecting the scheme.
Such a model might include the generation of financial forecasts for the employer covenant to form a base for benchmarking the employer’s actual financial performance over time against original expectations at the time of the previous valuation and provide a basis for fine tuning where needed as time progresses.
What does this mean for trustees?
A forward-looking approach to covenant assessment is a vital tool in identifying, monitoring and managing the risks of the sponsor falling short of the capacity to support its pension scheme to the end of its journey plan.
Given that all trustees share the common goal of securing members’ benefits and ensuring that their respective scheme reaches its endgame with limited disruption along the way, a forward-looking approach to covenant evaluation is an essential part of most scheme’s toolkits.
Joel Anders, Analyst – 020 7337 4128 (email@example.com)