Covenants: Inadequacies in the covenant assessment process
How should UK pension fund trustees evaluate the credit risk they are exposed to in their main employer sponsor?
• Assessing the insolvency risk of the sponsor is crucial yet complex.
• It is hard for pension fund trustee boards to remain objective.
• TPR covenant strength assessments are not specific enough to guide trustees
Life for defined benefit (DB) pension trustees is not easy. With very low interest rates pushing deficits higher, they must consider more sophisticated investment strategies, following the advice of advisers without always understanding how the strategy might work.
They also face the death of the DB pension system. Employer sponsors are reluctant to increase contributions to a system that is considered obsolete. And as if life were not complicated enough, trustees have to come to a view on the long-term covenant strength of the sponsoring employer.
What does this mean?
Having spent 25 years predicting corporate defaults, lately as the head of Moody’s in EMEA, I have performed a number of covenant strength reports for UK pension fund trustees.
Yet this exercise has not involved answering precisely that question. Let me explain.
UK pension funds are managed as trusts, independently from the sponsor. In DB pensions, funds are set aside and invested to ensure that members receive the pension they were promised, contractually, as part of their employment terms. The amount contributed by employers is based on a number of factors, one of which is the financial health of the employing company itself.
The logic is that if the sponsoring company is in good financial health and can operate profitably, it can make contributions to the pension fund over a long period of time and increase funding if the need arises.
In such a case, the company would receive a ‘strong’ covenant grade on the Pension Regulator’s covenant grade scale.
However, if the company is struggling, unable to make additional contributions in the long term, and has a high probability of failure with insufficient assets in the pension fund, it would receive a ‘weak’ grade.
In such cases trustees ought to take action to ensure they protect the rights of pensioners. This could range from asking for higher contributions, asking for more security such as physical property, intellectual property, parental guarantees, or forcing the company to wind up and use its assets to secure pensioners’ rights. This is quite a big decision.
And to make such decisions, trustees need a reliable, independent assessment of covenant strength, and its credit profile. This should be based on forward-looking information about the financial health of the company, which will enable an assessment of its long-term credit strength.
With my background in the credit rating industry and as a financial analyst, I was curious to see what tools and what language I would use to convey this information to trustees, and also what they would do with it. After all, unlike in a ratings agency where efforts have been made to ensure that rating analysts and rated corporates do not get too close, here trustees and employers have to work together symbiotically to ensure the best outcome for all. As a result, the relationship between the sponsor and the trustees is close by design. This is sensible, but problematic because it creates a tension that is difficult to handle for trustees who are dependent on the sponsors for their livelihoods.
The first degree of complexity is to determine how big the problem is. I mean, if there is no deficit, there is no problem, right? Wrong.
A company may have a manageable deficit or even a surplus when measured as a going concern, assuming that it can make contributions for the next 20 years, say. But, if it were to cease trading tomorrow, trustees would have to consider a different way to measure the deficit, which would nearly always increase. This process is often dismissed as unrealistic – yet companies default every year, making this a reality.
Or think of the BHS pension fund trustees. On a going-concern basis the BHS deficit in 2015 was only £200m (€221m) – large, but manageable in the context of a big firm. But as soon as BHS filed for bankruptcy, the deficit ballooned to £571m. Why? One key measure, the technical provision valuation – which assumed that the company was to continue trading – was estimated at £200m, and assumed another 20 years of contributions and returns on the existing funds invested over the same period. This reduced the deficit as reported in the accounts of the pension fund.
The other figure, £571m, was the deficit when the company ceased trading, estimated without the benefit of further contributions – after all the company declared itself bankrupt. This is the solvency valuation or section 75 debt. Both measures are correct, but circumstances determine which is relevant. Interestingly, a third measure is also reported in the financial statements of the company itself, under FRS17, close to a going concern valuation, but not quite.
Determining how perilous the situation could become is therefore tricky. They face a combination of concepts, enhanced by different valuation methods for specific purposes, shrouded in jargon and capped by a reluctance to achieve specific and clear outcomes.
Let us put ourselves in the shoes of a pension trustee. Professional advisers report with a number of estimations for the deficit. One is the going-concern estimation already discussed – a number that tends to be bad enough and keeps getting worse. Another is the estimation of the liability if the Pension Protection Fund were to take over tomorrow, after discounting it. Yet another, the largest and least optimistic, illustrates the actual deficit should the firm cease trading (the section 75 valuation). A fourth valuation, this time reported by the company in its own accounts, is thrown into the mix.
The discussions between trustees and sponsors will revolve around the level of contribution to the pension fund. The sponsor will argue that additional contributions are a missed opportunity to invest in the future and its employees. It will also argue that the section 75 deficit is unrealistic and does not represent a fair view. The company will be supported by professional advisers in this view.
Need for independence
Trustees are often either appointed by the company, are employees or former employees. Few have the technical knowledge to follow the intricacies of investment strategy and risk levels. Even fewer will grasp the long-term probability of default calculation. This is an unequal contest. If subjected to pressure from the employer, trustees would need to demonstrate clarity of thinking, a determination which may antagonise their employer, and an independence which few have, to force the issue and ask for more. Especially, when again they will receive conflicting information. For instance, the PPF uses a credit rating produced by Experian, an information services provider, to calculate its annual levy. Although, it is called a credit rating, it is a model-based point-in-time measure, driven by the net profit of the firm. It is useful but not what trustees should use to estimate the riskiness of the sponsor in the medium to long term.
Why can’t the trustees just use the service of a qualified expert who can give them an opinion, as in other areas? That is just it – even if they do, and these experts know how to perform a long-term forward-looking credit analysis, the opinion will be in the vaguest of terms.
This is because the covenant strength should be expressed, according to the Pension Regulator (TPR), on a scale of 1 to 4. Covenant grade 1 (strong) for example, is: very strong trading, cash generation and asset position relative to the size of the scheme and the scheme’s deficit. The employer has a strong market presence (or is a market leader) with good growth prospects for the employer and the market. The scheme has good access to trading and value if the employer is part of a wider group. Overall low risk of the employer not being able to support the scheme to the extent required in the short/medium term1 .
This is similar to S&P’s or Moody’s definitions of an investment grade rating. But unlike Moody’s or S&P, TPR does not provide any guidance as to what the expected default probability of such a covenant grade might be – a 1% probability of default in the next five years? A 3% probability? Neither does it provide guidance as regards financial ratios that should be consistent with such a high grade. The result? Most CFOs would argue their company fits at least part of that description. I have yet to meet a situation where this was not the case. Without context or guidance, the definition is not very useful, and trustees are ill-equipped, even with a professional covenant assessment report, to assess risk effectively.
This lack of precision becomes problematic when we look at the lower rankings. Here is the definition of a weak covenant (covenant grade 4) according to TPR: employer is weak to the degree that there are concerns over potential insolvency or where the scheme is so large that without fundamental change to the strength of the employer it is unlikely ever to be in a position to adequately support the scheme.
In credit ratings, this could be a B- or a CCC rated company. Default probabilities in the short term vary between 20 and 50% . Here the risk level is higher and prompt action is needed if the interests of the pension fund are to be protected. But the sense of urgency of such an extreme credit rating downgrade, and the indications of default probability, appears to be lacking. In the face of this, trustees lack the decisive argument needed to force the company to act swiftly since they cannot express the risk they are facing.
Covenant strength and credit ratings are two different views of credit risk, and I am not advocating that one should be replaced by the other. It would, however, be beneficial if trustees receive specific guidance of the risk they face. In that respect, regulators and protection funds should devise improvements to the system that should take inspiration from the well-established work of rating agencies in the corporate risk sector.
Olivier Beroud is founder and managing director at Beroud Consulting and formerly head of EMEA at Moody’s