The Pensions Regulator (TPR) has recently issued new guidance on assessing and monitoring employer covenant in relation to defined benefit pension schemes, which is likely to provide valuable assistance to trustees grappling with this increasingly important aspect of their duties. The guidance is also highly relevant to employers, since it spells out in some detail TPR’s expectations of the employer’s role in and approach to the process of covenant assessment.
TPR’s Code of Practice on Funding Defined Benefits, issued in July 2014, makes it clear that when assessing the funding position of their scheme and settling the contributions required from the employer, trustees must have a clear understanding of the strength of the employer’s covenant – ie. the extent of the employer’s legal obligations to fund the scheme, plus the financial resources which are available to meet those obligations.
This is the theory. However, in practice, covenant assessment can be a highly complex and difficult process. The purpose of the new guidance from TPR is to give trustees a better insight into precisely what they need to do, and how they should go about doing it.
The guidance is divided into the following sections:
- A pithy, ten-point “At a glance” opening page, which sets out the key messages for trustees.
- Section 1 – Introduction - which covers the role of the employer covenant and an overview of how trustees should approach covenant assessments, including ensuring that covenant assessments are proportionate, and when trustees should look to commission an external review. This section, plus the “At a glance”, are flagged by TPR as the “must read” minimum for all trustees.
- Section 2 – Assessing the covenant – this is by far the most substantial portion of the document. This is intended primarily for those trustee boards who decide to assess covenant themselves. It explains in detail how to go about assessing both the legal obligation and financial ability of the employer to support the funding needs and investment risk of the scheme. TPR makes it clear that where trustees decide to do DIY covenant assessments, it is important that the whole of the trustee board should read, understand and apply the principles in this section. Section 2 may also be useful for trustees who commission external covenant assessments, since it should enable them to understand precisely what the assessor will be doing, to define the scope of the instructions appropriately, and to understand better the advice received.
- Section 3 – Monitoring the covenant and taking action – this is relevant to all schemes. This part deals with the establishment of a monitoring framework and contingency planning, so that the trustees are in a position to identify and respond swiftly to adverse changes in employer covenant which happen between formal covenant assessments.
- Section 4 – Improving scheme security – this is again relevant to all schemes. It provides a useful overview of key types of contingent assets, including factors for consideration by trustees when valuing the level of security actually provided to the scheme. Many of the points here will already be familiar to a scheme which has a PPF-compliant contingent asset, but as a minimum, TPR’s guidance provides a useful reminder.
- Appendices – these contain guidance on specific situations: Appendix A has information to assist trustees when commissioning an external covenant assessment; Appendix B provides further information for trustees whose sponsoring employer is a not-for-profit entity, where special considerations apply; and Appendix C relates to assessment of covenant in a multi-employer scheme for non-associated employers (where assessment of covenant on an aggregate basis – as may be appropriate for associated employers – is unlikely to be possible).
The guidance is punctuated throughout with checklists and practical examples illustrating the points TPR is seeking to get across, as well as cross-references to other key parts of TPR’s suite of relevant guidance, including the Funding Code of Practice.
Although hardly an airport novel, the new guidance is (within the limitations of the subject-matter) very accessible and readable. It is also highly practical in its focus. As such, we anticipate that trustees will find it of real assistance when tackling this thorny issue.
Employers should take particular note of TPR’s pronouncements on matters such as the sharing of information with trustees (“Trustees should be concerned where information they have reasonably requested is not provided by the employer. … If appropriate information is not provided to allow the covenant to be assessed, the trustees should consider reducing their reliance on the covenant when setting their investment and funding strategies (and effectively conclude that the covenant is weaker).”)
Similarly noteworthy are some of the factors which TPR views as pointing towards the need for an external covenant assessment, which include situations where “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” or where “the employer and trustees do not have a good relationship or the employer has been unwilling to provide requested information on a timely basis.”