INDEPENDENT COVENANT ADVICE AND WHEN TO SEEK IT
In this interview, MHM’s Director, Steve Button puts crucial questions on the advantages of seeking independent covenant advice to industry insider, Catherine Dent-Leitch. Catherine is a chartered accountant and a manager in the Covenant Solutions team at Isio, one of the UK’s largest pensions advisory businesses.
Steve: Hi Catherine, thanks for joining me today. To get us started, can you briefly explain when and why trustees of defined benefit [DB] pension schemes might consider getting covenant advice?
Catherine: Thanks Steve, that sounds like a good starting point. Trustees need to understand the business or group that supports their scheme, as a scheme’s covenant support should inform decisions on investment, funding, journey planning and risk management. It’s useful to consider The Pensions Regulator’s [TPR] expectations, which is that all trustees should undertake proportionate covenant analysis, with trustees exercising their own professional judgement in deciding what that means in practice.
Steve: OK, that immediately raises the question of what is “proportionate”. Does it always meaning engaging a third-party adviser?
Catherine: For some schemes, it may be appropriate to engage external advisors to maintain regular covenant monitoring, due to the size or complexity of the sponsor’s operations. Alternatively, schemes with a stable employer in a simple group structure may wish to engage advisors only for their triennial valuations or in specific scenarios, such as a transaction or refinancing. Trustees should stand ready to justify their approach and decisions to the regulator and other stakeholders should future circumstances mean they need to.
New pensions legislation, evolving regulatory guidance and the rapidly changing economic environment make identifying and managing covenant change situations increasingly challenging.
Steve: What added value comes from involving an external adviser?
Catherine: An independent covenant advisor can help navigate the complexities of the sponsor’s business, financials, market, competition and structure and deliver a view that has the necessary level of expertise and objectivity. Where covenant is under threat or is changing, an external advisor can explain and measure the risk of regulatory intervention, particularly under TPR’s new powers enacted in the Pension Schemes Act 2021.
Steve: Apart from trustees, who else might have concerns about the employer’s financial strength and would therefore seek professional covenant advice?
Catherine: We speak to a wide range of pension scheme stakeholders seeking advice or guidance on employer covenant issues, including a sponsor’s management, directors or shareholders, potential acquirers or joint venture partners and lenders.
The Pension Schemes Act 2021 extended the reach of TPR’s moral hazard regime, to protect the scheme’s interests, so it’s important that all relevant parties understand the pensions risks they are exposed to and how best to manage them.
Steve: What typically is included in your report following a covenant assessment?
Catherine: At Isio, we can tailor an assessment to suit the requirements of our client. Generally, our assessments would primarily be delivered through a concise report and follow-up conversations between our covenant specialists and the client.
Our reports contain the conclusions of our employer covenant assessment in line with the applicable regulations and guidance, and any specific considerations. We also summarise the key considerations behind the assessment in a proportionate level of detail to meet client needs.
Steve: Does that include a rating that clients can easily understand?
Catherine: At present, our triennial assessment reports include a rating in line with TPR’s four-point scale, i.e. Strong to Weak, or CG1 to CG4. We expect we may need to adapt this approach in light of incoming regulation and guidance, as the recent draft DB funding code consultation suggested we could see a move away from ratings towards assessment of time horizons. As the new regulations and guidance are finalised, we will ensure our approach aligns with regulatory expectations.
Steve: A lot can happen in three years if trustees only consider this alongside funding valuations. What support is available to trustees so they can carry out their own monitoring in between external reviews?
Catherine: Active covenant monitoring can look very different from scheme to scheme, as can the level of advisor involvement. Fundamentally, monitoring should allow trustees to identify off-plan performance, emerging risks and one-off events so they can intervene, where needed, as early as possible.
For our team, a monitoring engagement could be risk identification and trigger-setting, designing a monitoring dashboard, advising on best practice information sharing we’ve observed in the market, educating trustees on emerging risks for the sponsor or sector or preparing monitoring reports or snapshots to be presented at trustee meetings – which is what most people typically expect.
Steve: Are there any issues related to conflict of interests between scheme advisors?
Catherine: In most situations, getting covenant advice from a firm that advises the trustees on other matters such as actuarial or investments, wouldn’t represent a conflict of interest. In fact, at Isio, we have seen real benefits to working alongside our colleagues across the Isio group as it allows us to provide integrated, strategic advice to trustees as well as a reduction in the time spent by trustees keeping lots of advisory teams up to speed.
We appreciate that, in some circumstances, trustees may wish to safeguard independence between advisory teams, so we establish ethical walls to make sure information isn’t shared internally. For our team of dedicated specialists this is even easier, as the sole focus of our advice to trustees is on covenant matters.
Steve: Presumably, that would be different if the same firm also works with the employer in some capacity?
Catherine: Yes, there is a heightened risk of a conflict arising where one firm advises both the trustees and the sponsor, and this would need to be managed on a case-by-case basis.
Ultimately, we have a professional duty to manage conflicts and any potential threats to our integrity. Clients can expect us to raise concerns around conflicts of interest, should they begin to affect, or could be perceived to affect, our engagement or advice.
Steve: Thinking about the employer, how might you handle a situation with a challenging sponsor, for example one that is reluctant to share information directly with the trustees?
Catherine: Much of our time is spent helping trustees to navigate negotiations and working with other scheme advisors to build a strategy that ensures fair treatment for the scheme.
There are tools we can use to help manage concerns specifically around information sharing, for example the use of non-disclosure agreements. We’ve also found the appointment of an independent trustee can be a route to alleviating company concerns in this area, particularly where there is a sponsor-side event driving covenant change.
Steve: And, what if the employer challenges your conclusions on a covenant issue?
Catherine: Where there is disagreement on a covenant issue, whether it be on affordability or on the impact of a covenant change situation, effective negotiation is key, as is the ability to understand both sides’ competing priorities. At Isio, our team has experience of negotiating some of the most complex covenant change situations in the UK. We also have first-hand dealings with the regulator, often around some quite difficult and challenging matters.
In such situations there is often a need to educate pension scheme stakeholders on the implications of their actions on the scheme and its employer covenant.
Steve: Obviously, it is in the interests of all parties to maintain good relations between the employer and trustees, avoiding direct confrontation.
Catherine: Particularly given TPR’s powers, it’s important to communicate to management that positive engagement with trustees is in their best interests, both as individuals and as representatives of the company.
Ultimately, it is important that the sponsor recognises the scheme as a key stakeholder to the business. We can support trustees in building the necessary relationship and cohesion with sponsoring employers, and vice versa.
Steve: Thank you, Catherine. That sounds like a good note on which to conclude our discussion. We appreciate you taking the time to share these insights.
Interested in finding out more? Contact Steve or Catherine using the details below:
To contact Steve Button, call 07952035538, or email steve.button@mhmtrustees.co.uk
To contact Catherine Dent-Leitch, call 07795911480, or email catherine.dent-leitch@isio.com
About Isio Covenant Solutions
Catherine is a Manager in the Isio Covenant Solutions Team. Catherine is a qualified accountant with extensive experience in assessing the covenant strength of sponsors who vary in size, sector and degrees of complexity. Catherine and her team advise a range of trustee and corporate clients, to help them fully understand covenant, the risks to that covenant strength and to navigate the complex regulations and guidance.
The team was founded at Deloitte and transferred to Isio as part of its acquisition of Deloitte’s pensions advisory practice in May 2023.The team includes qualified accountants and specialist pension advisors, who have a wealth of experience across restructuring, insolvency, transactions and pensions regulation. Isio Covenant Solutions support trustees and scheme sponsors with a range of covenant advisory services, from routine covenant assessments and monitoring through to complex strategic support and regulatory engagement.
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