Reassessing the covenant

In the darkest days of the recession, with the economy tanking, the FTSE struggling and defined benefit (DB) pension scheme deficits weighing down many companies’ already depressed balance sheets, the employer covenant may have started to feel like a terrible curse to some financial directors. It’s not supposed to be this way: the covenant should be a layer of protection for the scheme, but not a financial trauma for the employer.

Sustainable growth

In December 2013 The Pensions Regulator (TPR) published a consultation on regulation of DB schemes, including a draft code of practice to help trustees meet legislative requirements around scheme funding, a draft regulatory strategy setting out a risk-based approach; and a draft funding policy. The consultation ran until 7 February and the regulator hopes to have the new code in place by July 2014.

The guiding principle behind these changes was an intention to balance the employer’s funding obligations to the scheme against its ability to invest in ‘sustainable business growth’. “The best support for a DB pension is a strong employer and effective trustees working together to manage and balance the risks to their business and scheme,” said TPR interim chief executive Stephen Soper in December.

There is a noticeable difference here to the approach taken by TPR in the past – a shift in emphasis visible even in comparison with guidance issued on the covenant in 2010, which altered the wording of the covenant definition to “... an employer’s legal obligation and its ability to fund the scheme now and in the future”, rather than its “willingness and ability” to do so, as in the previous wording. The focus then was on the employer’s legal obligations.

“What you have [in the new draft code] is a greater recognition of the needs of the employer,” observes Baker Tilly associate director in the restructuring and recovery department John Gilmore. “Trustees still have to do as much as they can to protect members’ interests; and the best way to do that is to deal with a deficit. But trustees also have to bear in mind that the best outcome is to have the deficit dealt with in a reasonable timeframe supported by a strong employer.”

Employer support

As many DB schemes and their sponsoring employers have drifted further apart – numbers of active scheme members actually working for sponsoring employers have fallen, while more schemes have closed to new members or future accrual – fewer scheme trustees now have inside knowledge about the financial health and strategic aims of the employer. This makes the covenant and the trustees’ periodic assessments of its strength – of the employer’s ability to meet its financial obligations towards the scheme – more important.

In spring 2013 almost nine out of ten trustees (88 per cent) said their sponsoring employer offered ‘good’ (46 per cent) or ‘very good’ (42 per cent) support to their scheme, according to Baker Tilly’s 2013 Pension Scheme Trustees Confidence Survey. More than six out of ten trustees (63 per cent) thought the covenant had been strengthened over the previous year, compared to 30 per cent who felt it had weakened.

But only 54 per cent said they thought the employer was contributing as much as it could, down from 71 per cent in 2012; and 34 per cent thought the employer was not contributing as much as it could, up from 26 per cent the previous year.

“Many schemes have now been through a couple of triennial valuations now, so a lot of boards of trustees probably know their covenant-related issues pretty well,” says Gazelle Corporate Finance managing director, pensions advisory, Donald Fleming. “There is a focus on funding levels in part because a lot of big schemes are on a journey towards de-risking and self-sufficiency. They’re working out what their risk profile will be over the next few years and how it will affect their funding.”

TPR wants to encourage a more collaborative approach between trustees and employers, to establish long term funding plans. It expects trustees to understand and manage funding, investment and covenant-related risks in an integrated way.

The aim is certainly not to let the sponsoring employer off the hook, says pensions law specialist Sackers partner Zoe Lynch. “The code says trustees should be looking at whether the company can afford the recovery plan and whether it’s reasonable for them not to spend the money on the pension scheme but to use it in other ways that may improve the covenant,” she explains.

PwC pensions credit and advisory team head, Jonathon Land, says trustees should acknowledge that sometimes an employer investing in the business at the expense of the scheme is acting in the best long term interests of the scheme. “But that will be allowed on the basis that, when times are good again, the company will make amends,” he says. “We should now expect trustees to be more sophisticated in the way they set out the contributions they will expect in future.” This could lead to more innovation in scheme funding; to more employers and trustees agreeing to use contingent assets owned by the employer to help fund the scheme, for example.

External reviews

“The regulator says you must understand the covenant, so will that drive more trustees to get formal [external] reviews?” asks Jackal Advisory director of pensions Simon Kew. “If you look at the employer and the covenant is clearly either very strong or very weak, then there’s no point getting a review. But it may be worth looking at where the money is, how trustees can get hold of it and protect the scheme.”

There has been some scepticism about the value of external covenant reviews in the past, particularly as they can be very expensive. Spence & Partners director Marian Elliott says trustees must establish exactly what they want the review to achieve. “It needs to be specific to the sponsor’s business, the industry they’re in and the risks they’re exposed to, looking at key customers, suppliers, profits and cash, as well as plans for investment and growth,” she says. “Trustees need to explain what they’re trying to understand and the type of information that will be useful to them.”

Whatever the means used to examine the covenant, the emphasis TPR has placed on risk is to be welcomed, says Fleming. However, says Elliott, even if trustees use sophisticated tools to further their understanding of the covenant and the risks affecting it, they still face a major challenge in bringing all this information together.

“Trustees are getting this information from different sources: the covenant report, actuary’s report, investment advice – and perhaps at different times,” she says. “Understanding how to use that information to drive decisions can be very difficult.” This is where building a true partnership with the employer will be crucial.

While it is clear that TPR’s guidance on funding and the covenant is only one of the factors that will influence most trustees’ and employers’ actions, it is possible that schemes in real trouble, where funding is poor and the covenant weak, may find themselves facing a more proactive regulator.

“The regulator might look at those cases in more depth and maybe talk about investment strategy,” suggests Barnett Waddingham partner Steve Hitchiner. “But that’s purely speculative on my part at this stage and those cases are unusual.”

“I don’t think that the regulator is intending to be more interventionist,” counters Elliott. “But advisers will have to raise their game, to help create more dynamic funding plans that react to changes in circumstances. I don’t think that means the plan should change every month, or even every six months, necessarily, but trustees should be looking at whether the plan remains appropriate more often than once every three years. That can be done inexpensively with good technology. But advisers need to make their advice really accessible, so those sorts of decisions can be made.”

David Adams is a freelance journalist

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