Liability-Driven Investment please step aside! Time to make room for Covenant-Driven Investment

Last week, I was fortunate enough to be invited to speak at a conference about asset strategies and risk management. In an attempt to wake the audience up (mine being the last presentation of the day), I boldly announced at the beginning of the presentation that I have invented something no one in the industry has yet come up with - Covenant-Driven Investment (CDI). Well, at least the terminology, based on information from my research assistance Google. To be honest, I was somewhat surprised that Google did not return any searches on Covenant-Driven Investment given how we all acknowledge that the sponsor covenant is the ultimate underwriter of all risks taken by the pension scheme. (Much to my disappointment, I later discovered Raj Mody beat me to it a few years back and is the real creator of Covenant-Driven Investment.)

I was delighted and proud when, following my session, the panel of speakers started picking up the term Covenant-Driven Investment during their discussion. I must say, it's quite contagious. And before you know it, speakers and guests were all using the term and discussing how they are already practising Covenant-Driven Investment in some shape or form.

However, the idea of starting a formal valuation with Covenant-Driven Investment as the starting point and letting the funding assumptions 'just fall out at the bottom' doesn't really fit with the current regulatory regime. Can we really single-handedly change the regulatory regime? I was somewhat encouraged by the fact that someone from the Pensions Regulator whispered in my ear to say that she thought my approach was 'actually quite sensible' even if it was unofficial of course. With the recent Regulator's Statement talking about the need for an integrated risk management strategy and how 'investment strategy should be compatible with the employer's ability to address investment underperformance', perhaps we are closer to getting there than we realise? 

So what is Covenant-Driven Investment? Well, every risk management strategy starts will some sort of risk cycle, so here it is.

The traditional approach in reviewing investment strategy merely looks at risk appetite with the scheme's views only (the pink box in the middle). Once the trustees have decided on a strategy (often without the company's involvement until the end), the sponsor will then be asked to rubber stamp on a piece of paper called the Statement of Investment Principles, commonly known as 'consulting the employer'. Whether the sponsor can stomach the risks, well nobody knows.

Covenant-Driven Investment extends this by looking at the scheme's exposure within the context of the business risk appetite, business outlook to withstand any increase in contributions in the event of investment underperformance, synergies between the scheme and the business's exposure to markets. Likewise, when designing triggers, pre-defined covenant as well as financial and funding triggers are built into the process. 

Of the clients who have adopted this approach, both trustees and sponsors have come out of the process saying how 'it all makes sense' to them. And to me, that is Result. A good risk-based regulatory regime can only be a success if it makes sense to the stakeholders that are required to follow the rules. Fingers-crossed for the integrated risk management statement which is to follow later in the year from the Pensions Regulator.....

Celene Lee is a senior manager in our Pensions Risk Management team. You can contact her on 020 7213 1660 or by email at celene.lee @uk.pwc.com