What’s in a name? The misnomer of a look-through guarantee

In its updated covenant guidance published in December, the Pensions Regulator set out what it means by its new concept of a “look-through guarantee”.  However, when you dig into the detail, it isn’t a variation on a guarantee at all. It’s a separate concession to the trustees regarding the affordability assessment of covenant. In deciding whether to amend an existing guarantee so that it qualifies as a “look-through guarantee”, guarantors and sponsors will need to take legal, covenant and actuarial advice and consider the potential impact of the counter-factual on its scheme funding obligations very carefully indeed.   

What is a look-through guarantee?

The concept was first introduced in the Defined Benefit Funding Code of Practice, which sets out the Regulator’s expectations as to how much value trustees should ascribe to contingent asset support, and specifically guarantees, when assessing covenant under the new funding and investment regime. Paragraphs 42 and 43 of the employer covenant section of the Code say:

"Some guarantees are structured in such a way that they largely replicate the obligations placed on a statutory employer. This includes providing a formal look through to the guarantor for affordability purposes. These guarantees provide an ability for trustees to claim against the guarantor in respect of all monies owed by the employer to the scheme without restrictions or qualifications once a trigger event has taken place. They cannot be revoked without trustee agreement. These are referred to as 'look through' guarantees.

Where trustees benefit from a look through guarantee, when assessing the employer covenant, they should assess the guarantor’s financial ability to support the scheme as if it was a statutory employer."

The guidance builds on this and draws a distinction between “look-through” and other guarantees. If the conditions for a look-through guarantee are not satisfied, the trustees will need to assess the level of risk that the guarantee can support. The guidance says:

“To meet the requirements of a 'look through' guarantee, you must be comfortable that the framework of agreements allows for the following:

• An underpin for the full section 75 deficit.
• Missed DRCs [deficit repair contributions] under the terms of the schedule of contributions.
• A legal mechanism enabling you to look through to the guarantor's cashflows when setting contributions. If this is absent, yours and our powers are restricted to looking at the affordability of the statutory employer(s) on a standalone basis.
• No time limitations (referred to as evergreen).
• No onerous conditions attached that could compromise yours or our powers.
• Legally enforceability both in the UK and any relevant overseas jurisdictions. This should be supported by appropriate legal advice.
• An information sharing protocol, which ensures you can monitor the strength of the guarantor”.

Will my existing guarantee qualify?

In my experience, existing guarantees will not meet the two conditions highlighted in bold. Whilst many trustees have information sharing protocols in place, these may not cover information on the guarantor’s financial position, just that of the scheme’s statutory employers. Even if they exist, such protocols are also unlikely to be contained in the guarantee itself but are typically documented in a separate agreement. This is perhaps why the guidance acknowledges that whilst the Code purely refers to a guarantee, in practice it may be easier to document the requirements of a ‘look-through’ guarantee across more than one legal agreement.

As for introducing a legal mechanism to allow the trustees to look to the guarantor’s cashflows when determining the length of a recovery plan and affordability of DRCs, this is also not something that would naturally be documented in a guarantee. It seems more logical for it to be in a side agreement as between the guarantor and the trustees in relation to scheme funding. 

As such, the term “look-through guarantee” seems to me to be a misnomer. It isn’t a variation on a guarantee at all. It’s a separate concession to the trustee regarding the affordability assessment. A guarantee which is valid and enforceable is already “look-through” to the guarantor.  That’s literally what a guarantee does.

Agreeing a look-through guarantee

Agreeing a look-through guarantee that meets the Regulator’s criteria clearly benefits trustees and will inevitably give both trustees and the Regulator additional leverage in valuation negotiations. But the advantages for the employer and the guarantor are less obvious. It is worth noting that a guarantee which doesn’t meet the requirements of a look-through guarantee still has value. The Regulator says it can still be used to support additional risk-taking within the scheme’s journey plan as long as its value can be factored into the trustees’ assessment of supportable risk. 

Example 3 in the valuing guarantees section of the contingent asset chapter of the guidance illustrates the impact of different types of guarantees where there is limited covenant support from the scheme’s statutory employer. In the examples used:

• A full look-through guarantee from a guarantor with higher cash flows and a stronger covenant allows the trustees to support more risk, resulting in a lower technical provisions deficit and a reduction in recovery plan length given the scheme’s greater access to the available cash of the guarantor.
• A PPF-compliant guarantee with a s.75 underpin on insolvency requires trustees to assess the value that would flow to the scheme when triggered. Where employer insolvency would likely lead to group-wide insolvency, trustees may decide not to rely on the guarantee to support additional risk during the scheme’s journey plan. In the absence of a formal look-through to the guarantor’s available cash, the guarantee also won’t help with setting a longer recovery plan.  
• A guarantee of a scheme’s technical provisions deficit and any deficit repair contributions with no look-through to the guarantor’s cashflows will not allow trustees to support additional risk-taking or a longer recovery plan.
• A 6-year time limited s.75 guarantee with a look-through to affordability will not allow trustees to support additional risk-taking where the employer is unlikely to enter insolvency within the next 6 years. Despite having some access to the guarantor’s cashflows, the trustees could decide not to take more risk in the journey plan, as this may result in the scheme being less well funded at the expiry of the guarantee compared to a situation where the guarantee had not been relied upon. 

As these examples show, the challenge for all parties will be assessing the counter-factual. With the support of their advisers, sponsors and trustees will need to determine what impact a particular variant of guarantee will have on supportable risk, the scheme’s technical provisions deficit and recovery plan length. Or, indeed, whether a guarantee will have any impact at all. How all of this will play out in practice remains to be seen.