UK: TPR Issues New Guidance For Assessing And Monitoring The Employer Covenant

Last Updated: 10 September 2015
Article by Justin McGilloway

The Pensions Regulator's new guidance for trustees of defined benefit occupational pension schemes is objective, collaborative, and to be welcomed.

On 13 August the Pensions Regulator ("TPR") published the first in a series of guides for trustees of defined benefit occupational pension schemes to help them apply the 'Funding Defined Benefits' Code of Practice, which was published in July 2014.

Replacing TPR's original 2010 guide to "monitoring employer support", the new guidance is designed to provide practical assistance on how to assess and monitor the employer covenant – an employer's legal obligation and financial ability to support its scheme. In particular, the guidance now addresses TPR's newest statutory objective of minimising any adverse impact on the sustainable growth of an employer when exercising its scheme funding functions. 

Although primarily aimed at trustees and their advisers, the guidance will also be of interest to employers as sponsors of defined benefit occupational pension schemes. 

In summary

The guidance has been welcomed by the pensions industry and is designed to help trustees decide:

  • who should assess the covenant – an independent covenant review is sensible where trustees believe they lack objectivity or the expertise required to perform an appropriate assessment;
  • on a 'proportionate' approach to covenant assessment depending on the circumstances of the scheme and its employer(s) pragmatism should prevail in determining the level of detail and frequency of the assessment;
  • on which corporate entities to focus – those with a legal obligation to support the scheme should be the focus of any assessment;
  • how to monitor the covenant on an ongoing basis and prepare contingency plans to react appropriately trustees are advised to undertake a full covenant assessment at each valuation but as covenant can change quickly, they should also have measures in place to monitor it between formal reviews; and
  • how to improve scheme security – various tools for improving security can be beneficial for both trustees and employers alike.

Sound understanding

At is most basic level, the message is that trustees should have a sound understanding of the employer covenant. TPR does not expect trustees to eliminate all risks to their schemes but it is vital that they understand and actively manage the risks they are taking. A key principle of 2014's 'Funding Defined Benefits' Code of Practice is that trustees' risk-taking should be informed by the ability of the employer to address a range of likely future downside scenarios over a reasonable period. The employer covenant underwrites the risks to the scheme and an understanding of the covenant should underpin the trustees' integrated approach to investment and funding.

Building on the integrated approach

The guidance explains that there is a need for trustees to understand the employer covenant from a number of perspectives:

  • Legal – the nature and enforceability of employers' 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.

The covenant should be assessed and monitored with a level of detail and frequency proportionate to the circumstances of the scheme and the employer, including a degree of reliance on the employer now and in the future and the complexity of the employer's operations.

In addition, any assessment of covenant should also provide answers to some pertinent questions, which include the following:

  • Through which employers can the scheme access value?
  • What is the trustees' assessment of the employer's current and likely future profitability and cashflows?
  • Is the scheme being treated equitably with other stakeholders?
  • How much value could the scheme recover in an insolvency of the employer?
  • What are the potential implications of all this for the scheme's investment and funding strategies?

The guidance also sets out a non-exhaustive list of factors which affect whether a more or less detailed approach, or a more frequent review, is needed. For example, if the employer is large relative to the size of the scheme and generates significant cashflows relative to the funding needs of the scheme, this would suggest a less detailed approach and/or a less frequent review. However, if there are material calls on the employer's cashflows, for example it has significant debt repayment obligations which restrict the affordability of contributions to the scheme, a more detailed approach may be suitable.

Trustees should take into account all of the factors relevant to their scheme when deciding on the nature of and frequency of the review. Importantly the guidance also states that covenant assessments should also add value to the trustees' overall decision making process.

Comment

TPR's general approach to employer covenant is not new but the content has been revamped to reflect the fact that market practice has moved on considerably over the last few years. In this respect, the guidance is to be welcomed and no doubt trustee boards up and down the country will be breathing a sigh of relief as they now have more clarity on what is expected of them. Hopefully, covenant assessment should be less arduous for trustees but it remains to be seen whether it results in an upsurge in trustee boards seeking external advice on covenant assessment. If this is the case, it will no doubt push up the running costs of maintaining a defined benefit scheme.

Objectivity is at the heart of the TPR's guidance. This will provide trustees with a timely opportunity to reflect on current policies for managing conflicts of interest – especially where there is a failure to agree with the employer on the strength of the covenant.

Case studies, checklists and examples of both inadequate and good analysis help explain how covenant assessment and monitoring should work in practice – vital for those trustees who do not employ external covenant assessors.

TPR also reiterates previous comments that trustees and employers should work openly and collaboratively together. This supports WB's own experience that the best run schemes are those where information sharing and transparency prevail.

The guidance also outlines specific considerations for schemes in the not-for-profit sector and non-associated multi-employer schemes.

We are expecting further guidance from TPR later in 2015 on matters such as investment strategy and integrated risk management. Whilst we cannot be sure what these hotly anticipated documents will say, one thing is certain: TPR expects trustees to be on top of their schemes and the employers who fund them!

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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