C11 - Covenant Flashcards
Sponsor covenant
Combination of the ability and willingness of the sponsor to pay, or the ability of the Trustees to require the sponsor to pay, sufficient contributions to ensure that the scheme benefits can be paid as they fall due
Two scenarios under which the sponsor may be viewed as having obligations to back the scheme
- Ongoing basis, to support accruing benefits
- Discontinuance, in relation to any deficit
Conventional credit quality assessment techniques that can be adopted for assessing strength of a sponsor covenant
- Business outlook
- Financial metrics
- Implied market default risk
- Credit ratings
- Merton-type credit risk models
- Quantitatively derived credit risk
- Independent business review
Business outlook
- Assessment of the business outlook in general and of sponsors specific sector
- Cheap to obtain
- Results are subjective and difficult to quantify
Financial metrics
Financial metrics are financial statistics and accounting ratios that indicate the ability of the sponsor to service it’s obligations
Eg interest cover, gearing
- Can be compared with similar companies and previous years to spot trends
- Simple and cheap as from published accounts
- Doesn’t give indication of absolute level of risk
- Accounts may be out of date
- Management accounts not publicly available
Implied market default risk
- Market prices of company’s equities and bonds indicates markets view of credit risks and how they change over time
- Up to date info as securities are regularly traded
- For bonds, risk is measured as excess above gilts (though also includes liquidity risk)
- For equities, model relationship between equity and debt to derive cost of default
- Gives a quantifiable measure of credit risk
- Limited as sponsor needs to have traded securities
Credit ratings
- Specialist agency provide credit rating applying to company or specific debt
- Agency has access to private info
- Analysis based on financial circumstances of company, so no difficulties associated with market forces affecting prices
- Guide to the probability of a company defaulting on its financial obligation and insolvency
- Grades can be translated to quantifiable measures
- Only larger companies have full credit ratings
Who carries out an Independent Business Review
- Accounting firms
- Insolvency practitioners
- Other niche operators
Quantitatively derived credit risk
Model deriving a credit rating or probability of default from standard corporate accounting data, augmented by confidential credit info from Credit bureaux or commercial banks
Quantifiable output but relies on accounting info which is updated annually in arrears so likely to be out of date
Advantages and disadvantages of Independent Business Reviews
+ Takes account of interdependence of funding and sponsor covenant
+ Can help trustees to determine how much sponsor can afford
- More expensive
- Required sponsor co-operation to provide confidential info
Situations where it is not necessary to take into account sponsor covenant
- Scheme is very well funded and no reliance is placed on sponsor
- Sponsor covenant is strong enough to be deemed certain
- Sponsor covenant is so weak as deemed to be nil
- Sponsor has no further liability ie benefits are all paid/transferred
Ways trustees can monitor sponsor covenant
- Review publically available Financial metrics eg accounts
- Take into account any risk based measures eg levies paid
- Meet regularly with the FD or board to discuss plans and future
- Require notification of any circumstances that could materially affect security of member benefits
- Get qualifies professionals to undertake regular reviews of the strength of the covenant
Categories of sponsor covenant
Strong
Tending to strong
Tending to weak
Weak
Define strong and weak covenant
Strong - deficit is financially manageable ie reasonable likelihood of it being paid off over an appropriate period
Weak - deficit is financially unmanageable given the sponsor resources and no realistic likelihood of removing deficit within an appropriate timescale
No specific measurement to distinguish between which category they fall into
Actions the trustees may take if the sponsor has weak covenant
- Lower risk investment strategy
- Invest in assets paying out on a sponsor default eg credit risk default swaps
- Consider alternatives to cash backing eg charge on sponsor fixed assets
- Include step ups in contributions so if sponsors financed improve, the improvement is shared with the scheme
- Set up contingent contribution agreement so deficit has to be cleared quicker if financial positions deteriorated
