10th Dec 2021

The covenant advisor of the future

As the end of 2021 draws ever closer, I believe now is the perfect time to start looking ahead to 2022 and all it holds.

Employer covenant advisors continue to play a crucial role in helping trustees manage substantial risks to members’ benefits. Covenant is truly an existential risk for a DB pension scheme, as most schemes would not be able to secure members’ accrued benefits in full if the employer became insolvent.

A key part of my role at 20-20 Trustees is to help shape and match the role of the covenant advisor to the schemes that I work with – both directly and supporting colleagues across the wider 20-20 Trustees portfolio. This has led me to reflect on how covenant advisors might need to adapt to the challenges facing trustees, as well as what differentiates the best players in the market.

As market developments and increasing regulatory requirements continue, the questions trustees will need to address will move further away from looking at financial metrics. I see the three areas below as the most significant changes to “traditional” covenant advice, with market leaders already developing their thinking and approach to these particular issues:

  • Covenant horizona longer term view of covenant will be increasingly important when trustees are required to adopt a long-term funding target (as expected under the forthcoming Funding Code). Trustees will not expect advisors to have a crystal ball, but the ability to think through covenant risks and potential future covenant scenarios in a structured way will be extremely valuable. Covenant advisors will need a good understanding of wider macroeconomic and market trends and, most importantly, be able to assess the relevance and potential impact of these on the sponsor.

  • ESG – ESG considerations have been on the agenda for many trustees and sponsors for years, but with new reporting requirements (and more on the horizon) the level of engagement with ESG has increased markedly in the last 12-24 months. It remains to be seen whether trustees will be formally required to take account of ESG in their assessment of covenant strength, but assessment of ESG risks will be best practice, at the very least. It is likely that advisors to large schemes will lead the way, but covenant advisors will need to develop ways to incorporate ESG thinking into their advice (in situations where fee budgets are more constrained).

  • End game solutions – recent years have seen a number of alternatives (or alternative paths) to a traditional insurer buy-out. After a long process, Clara Pensions has now received authorisation as the first superfund, with the Pension SuperFund also waiting in the wings. We have also seen the first capital-backed journey plan entered into by one of 20-20 Trustees’ schemes, as well as other products such as Insured Self-Sufficiency and Assured Payment Policy come to market. Innovative end game solutions, particularly where private capital is involved, pose interesting and potentially complex covenant questions.

It is often the case that there is no single “right answer” to a given covenant question – businesses and pensions schemes operate in a complex environment. The most effective covenant advisors are those who provide commercial advice and make practical recommendations to trustees, recognising that innovative solutions delivered for other clients may not be appropriate for all schemes.

To conclude

In my view, the core skills of a covenant advisor are commercial acumen, financial analysis and the ability to communicate effectively with trustees. I do not expect these core skills to change but the most effective covenant advisors will be those who develop and adapt their offerings to meet the challenges ahead.

I am really looking forward to working with the talented advisors in the industry to address the challenges we will face in 2022… and beyond.