What is meant by an "employer's covenant"?

The Regulator describes the covenant as an "employer's legal obligation to fund the pension scheme now and in the future" and has stated that "the strength of it depends upon the robustness of the legal agreements in place and the likelihood that the employer can meet them". The covenant includes statutory obligations as well as obligations to make payments in terms of the payment schedule and other unsecured promises to provide future support to the scheme may also be included.

As mentioned above, the Regulator has published for consultation draft guidance on monitoring employer support setting out standard practice which the Regulator expects trustees to follow in assessing, monitoring and taking action in relation to the employer's covenant. The Regulator is keen to hear from trustees and other interested parties with regard to their views on the draft guidance, including whether the guidance strikes the right balance between specifying a process for monitoring covenant and not imposing disproportionate or unnecessary costs on trustees/employers.

Whilst the new guidance is not being presented by the Regulator as a major change, in reality this new guidance represents a significant change in approach and an additional burden of responsibility for the majority of trustees– unless, of course, significant re-drafting takes place following the consultation process. The Regulator has actually stated that "monitoring the covenant can be as important as monitoring investment performance" yet at present the two issues are not given equal weighting by the majority of trustees.

What does the Regulator recommend that trustees and employers must do?

As drafted, the guidance is both lengthy and prescriptive. It is clear that the Regulator expects both trustees and employers to be proactive in ensuring that there is adequate security for the scheme.

Specific recommendations set out in the guidance include:-

  • Trustee framework for review - all trustees should have a framework for assessing and reviewing employer covenant including regular monitoring. The monitoring plans will vary from scheme to scheme, but it will be good practice to include key business performance measures and a plan of action in the event that those performance measures are not met - such plans could include calling on contingent assets or looking for increased funding;
  • Full review once every 3 years - a full review of the covenant should take place before each scheme specific funding valuation i.e. usually once every 3 years;
  • Annual monitoring - it will usually be appropriate to review the covenant annually once the financial results and annual plans of the sponsoring employer are known;
  • Meeting agendas – trustees should have a standing item on their meeting agendas to discuss the sponsoring employer's covenant. Trustees should check there have not been any company events since their previous meeting and that there are no events planned in advance of the next meeting giving cause for a more detailed review or a need for immediate mitigation. Trustees should also consider the ability of the employer to generate sufficient cash in the period to the next trustees' meeting to pay contributions due in that period;
  • Plan ahead for rapid deterioration in employer covenant – trustees should be ready to act quickly if the triggers in their monitoring plan are breached or if they become aware of corporate activity that may have a materially detrimental effect on the security of members' benefits and should engage with the sponsoring employer in the same way as other creditors;
  • Be prepared to go beyond the actions included in the monitoring plan – in the event of serious concerns over covenant following a particular event, the trustees should be prepared to consider:- bringing forward the next actuarial valuation; adjusting the valuation assumptions in view of the weak covenant; realigning the investment portfolio in line with the weaker covenant; and contacting the Regulator at an early stage if they have serious concerns;
  • Employers and trustees to work together – the Regulator expects trustees and employers to work openly together, with trustees signing confidentiality agreements if necessary;
  • Trustees to ask probing questions and consider whether professional advisers are necessary – trustees should ask probing questions to enable them to understand the employer covenant and should assess whether they have individuals (without a conflict of interest) on the trustee board with adequate expertise to assess covenant or whether they need to employ professional covenant assessors. The type of skills requried include the ability to understand the employer's group structure and legal obligations between members of the group and having the necessary experience to analyse and understand the information that predicts future change to company performance;
  • Act proportionately – trustees and employers should act proportionately in approaching covenant assessment and monitoring. The Regulator states that nothing in the guidance is intended to produce cost to the scheme that is disproportionate to the related benefit.

As mentioned above, there is still time for interested parties to respond to the Regulator's consultation. Once the guidance has been finalised, we will provide an update in a future bulletin. Whilst some trustee bodies may feel confident in their own ability to monitor the sponsoring employer's covenant and take appropriate action if necessary, there will be others who feel ill-prepared to cope with such a stark change in the extent of their responsibilities. Once the guidance has been finalised, we will be able to help with trustee training for those schemes that need additional support to implement the Regulator's recommendations.