Are you up to speed with the strength of your scheme's employer covenant? TPR has issued guidance to help

The Pensions Regulator (TPR) has published guidance for defined benefit (DB) schemes on assessing and monitoring the employer covenant. To access the guidance, please click .

We already review the employer covenant – is there really anything new in this latest large tome from TPR?

Covering 66 dense pages of information, checklists, scenarios and recommendations, this guidance reinforces what a serious business reviewing the employer covenant is. A quick round the table at a trustees’ meeting every once in a while where the employer-nominated Finance Director trustee reassures all that the employer is sound and is greeted with a series of accepting nods, allowing all to move on to the next agenda item, will absolutely not satisfy scheme needs on this front.

A proper review of the employer covenant involves an investigation into and understanding of a number of interlinked aspects of both the scheme and the employer. An easy assumption to make is that an employer covenant review essentially involves getting a good understanding of the financial strength of the scheme employer(s) – something which an external covenant assessment report can fairly simply provide. However this is to underestimate the complexity of the task.

We set out below the 3 main steps required. This summarises the main points in TPR’s guidance, which unfortunately we have to advise you is recommended reading!

1. The legals come first

Before any useful assessment of employer strength can take place, the trustees must understand the nature and enforceability of each scheme employers’ legal obligations to the scheme, and those of any other entities (such as group companies) that are involved with the scheme voluntarily or via contractual obligations.

This is likely to involve legal advice on:

• the position under the scheme’s trust deed and rules,
• the schedule of contributions,
• section 75 debts payable now or in the future to the scheme, and
• whose insolvency could result in all or part of the scheme entering the Pensions Protection Fund.

The trustees further need to understand the balance of powers in the scheme, and also the impact of any guarantees and other contractual obligations in place. Where the scheme is multi-employer the complexities also multiply, and the trustees must understand how the obligations of each employer are structured as this will affect the importance of their respective covenants.

2. Next step – funding needs and investment risk

In keeping with TPR’s general focus on trustees taking a holistic approach to scheme funding and investment, the covenant also needs to be assessed in the context of and relative to the scheme’s funding needs and investment risk to understand the nature of the employer’s obligations. This may involve some actuarial and investment input to ascertain the size of the scheme’s deficit relative to the size of the employer as well as the level of investment risk in the scheme.

TPR also highlights that the maturity of the scheme’s membership will affect the timing of the scheme’s reliance on the covenant and the trustees’ therefore need to understand this as well.

3. And finally – a constructive review of the employer’s financial ability to support the scheme can take place

With the building blocks in place, the trustees can turn their attention to what they probably thought an employer covenant review was all about in the first place – unearthing the employer’s true ability to financially support the scheme now and in the future.

TPR emphasises that this review should be forward rather than backward looking. Past performance may be an indicator of future performance, but of itself it is not an adequate measure.

The review needs to consider:

• the employer’s current financial health,
• the employer’s prospective cash flows,
• the markets in which the employer operates, the medium and long-term outlook for those markets and the employer’s competitive position in those markets,
• the estimated outcome for the scheme in the event of employer insolvency, and
• the impact of the employer’s wider group.

TPR’s guidance contains much detail for each of these factors, including numerous useful examples and case-studies. These highlight the level of financial and accounting expertise required to develop a rounded understanding of the position. An employer with a good credit rating is not necessarily one that has all the nuts and bolts in place to reassure the trustees of its medium to long term standing for the scheme. An example showing how group assets and debt can be interpreted to suggest two wildly different levels of return to the scheme on an insolvency illustrates how easily trustees without expertise can misunderstand the position.

Proportionality

TPR highlights throughout the guidance the need to take a proportionate approach to all aspects of this process. There is a useful checklist at pages 11-12 listing indicators helping trustees to understand whether their scheme’s and employer’s circumstances require a more or less in depth approach.

Does this mean an external covenant assessment is de rigeur?

No. TPR specifically considers this at page 13 of the guidance, and sets out key points for trustees to consider in determining whether to do the assessment themselves or not. A complex scheme that is facing a number of high risks, along with some conflicts of interest on the trustee board and limited trustee expertise in the areas required, will need to seriously consider instructing external experts. Where trustees do decide to go down that route, TPR includes a checklist of points to cover when drawing up a brief for a covenant adviser at Appendix A.

Where trustees do appoint an independent covenant assessor, this does not remove the need to undertake steps 1 and 2 above – the external assessor will need that information in order to undertake their job properly.

So how often are we going to have to embark on this process?

TPR recommends a full covenant review at each valuation (i.e. every 3 years) as a minimum. Trustees also need to monitor the position regularly in-between and have well-developed contingency plans so they can take prompt and effective action when required. Many of the legal building blocks in section 1 above will remain the same, and a legal review on subsequent covenant assessments may be less onerous than the first time it is carried out.

What about TPR’s new objective on the sustainable growth of the employer – any mention of that in all this?

Yes – TPR’s guidance does contain several nods to its recent objective to support scheme funding arrangements that are compatible with sustainable growth for the sponsoring employer. There is a whole section on assessing sustainable growth plans at pages 33-34. If the employer’s plans to invest in sustainable growth restrict the funding available to the scheme, the trustees should understand how the scheme will benefit by supporting this investment and whether other stakeholders are contributing appropriately. They also need to consider whether scheme security can be improved by contingent assets.

Not-for-profit organisations and non-associated multi-employer schemes

Both of these types of scheme face specific issues in relation to the employer covenant, and the guidance includes an appendix for each (B and C) setting out some of the particular issues and how to deal with them.

You’ve convinced me to read the 66 pages of guidance. Just let me know – is there any more coming?

Yes – later this year, TPR intends to produce further guidance to help trustees navigate the DB code, including guides on integrated risk management and investment strategy. We will keep you up-to-date!