The Regulator has updated its guidance on assessing and monitoring the employer covenant in order to help trustees apply the defined benefit funding code of practice (“the Code”).
The guidance is intended to identify good practice for trustees in:
- assessing the strength of the employer covenant in relation to a DB scheme "as part of an integrated approach to managing scheme risks"; and
- monitoring the covenant and taking action to improve scheme security.
Trustees’ risk taking should be governed by the ability of the employer to be able to continue to fund the scheme through a range of likely future downside scenarios. The approach to be taken in assessing the covenant should focus on whether the employer is likely to be able to support the scheme through cash contributions in order to achieve and maintain full funding over an appropriate period. In order to achieve this, a sound understanding of the covenant is a key principle.
The guidance sets out three perspectives from which trustees need to understand the employer’s covenant:
- legal – the nature and enforceability of the obligations to support the scheme;
- scheme-related – the funding needs of the scheme, now and in the future; and
- financial – the ability of the employer to contribute cash when required.
In order to be able to effectively manage risk trustees should have a sound understanding of the covenant. To assist trustees in achieving this the guidance sets out key factors to be considered and provides examples of requirements for trustees.
As a minimum, trustees should carry out a full covenant review at each valuation, as well as monitoring the covenant regularly between formal reviews, and have well developed contingency plans in place.
The frequency of assessments, as well as the level of detail required, will vary dependent on the circumstances of the scheme and employer, and trustees may take a proportionate approach in their assessment of the covenant.
Factors which may be considered in making this decision include:
- the complexity of the group structure;
- the size of the deficit; and
- the employer’s cash flow relative to the scheme’s funding needs.
Trustees should review whether they are able to assess the covenant themselves, or whether independent advice is required. The guidance provides a list of factors that may point towards external advice being appropriate, including:
- the trustees do not have the necessary expertise and experience to assess the legal and financial aspects of the covenant;
- the trustee board as a whole is not fully able to take an objective view, for instance if an influential trustee holds an important role in the employer;
- the scheme is highly reliant on the covenant, for example the scheme is large relative to the employer, is under-funded or has a higher risk investment strategy;
- the covenant is complex, for example there is a complex legal or operating group structure or an asset-backed contribution (ABC) structure is being used;
- the covenant is undergoing significant changes, for example the employer is restructuring; and
- the employer and trustees do not have a good relationship.
The assessment process and its conclusions should be clearly documented, including any decision as to whether external advice was commissioned. The guidance sets out the scope of a covenant assessment and includes a list of questions which the trustees should be able to answer, as well as providing examples of good and inadequate analysis in covenant reports.
Trustees and employers should work collaboratively. Where appropriate information is not supplied by the employer, the level of reliance to be placed on the covenant by the trustees when setting their funding and investment strategies is something that should be considered.
Employers must justify the prioritisation of investment in sustainable business growth if it is at the expense of contributions to the scheme, and in the absence of sufficiently detailed plans the trustees should not be willing to compromise the position of the scheme to support the investment.
Assessments which are carried out should be forward looking and focussed on the employer’s ability to contribute cash to the scheme in order to maintain full funding over an appropriate period.