Pensions World

Monitoring the employer covenant is particularly important during this fragile economic recovery reports Allison Plager

The recent recession has shown that it is not possible to be certain that the economy is always going to flourish. Politicians may rashly promise the end of “boom and bust”, but in reality, given the global nature of finance and business, this is not a promise easily kept. The UK’s economic recovery is currently fragile, but corporate transactions are on the rise and so monitoring the employer covenant is as important as ever.

Growing awareness

Trustees’ awareness of the importance of the employer covenant is growing. According to Jackal Advisory’s Simon Kew, “trustees and employers are coming round to the need to monitor employer covenant and the Pensions Regulator guidance is encouraging just that”. Similarly, Roger Cooper of Pi Consulting says that trustees generally recognise the importance of monitoring covenant strength as “they can no longer take for granted the continuing existence of their scheme sponsor”. He adds that “regular dialogue between sponsors and trustees increasingly features as part of day-to-day governance of schemes and is to be encouraged to help foster a spirit of partnership between these key stakeholders”.

The Pensions Regulator (TPR) issued guidance in November, setting out the practice that it expects trustees to follow in assessing, monitoring and taking action on employer covenant (see www.lexisurl.com/mes). This provides helpful focus and one upshot has been increased interest among trustees. As PricewaterhouseCoopers’ (PwC’s) Jonathan Land says, according to the guidance, “monitoring the covenant is as important as monitoring investment performance” and it has for some trustees “clearly been a wakeup call”. He notes that an effect of the guidance has been that, while PwC has been advising clients on covenant monitoring for years, “many more are now asking us to help them develop and implement appropriate monitoring processes”. Interestingly, and perhaps comfortingly, he adds that “employers are also increasingly engaging with us to ensure that an appropriate framework is in place”.

The upshot of the guidance has been, says Mercer’s Darren Masters, that “trustees have shown increased willingness to engage employers in determining effective monitoring and notification frameworks to protect members’ benefits”.

Regular checks

The question remains, however, whether the covenant is reviewed often enough.  A recent Mercer trustee survey showed that over one third of trustees only monitor the covenant on an annual basis. Out of the 119 schemes surveyed, 37% of respondents carried out formal covenant monitoring only annually or even less frequently. As to communicating with the sponsor, 72% of trustee boards invited sponsor representatives to attend meetings regularly, but only in 18% of cases was there a joint sponsor and trustee forum that met regularly. For many schemes, ie 68%, the relationship with the sponsor is informally managed and led by the chairman.

Mr Masters says that “trustees should ensure that they have a framework in place, with trigger points to let them know when they should check the covenant”. He mentions that the TPR guidance states that all trustees should “have a framework for assessing and reviewing employer covenant, including regular monitoring”, but feels that there is room for improvement in some trustee boards in this respect.

However, he acknowledges that some trustees monitor the covenant on a quarterly basis, saying this is “largely because of the risk that the parent company may not be able to support the scheme”. This also constitutes good governance and he adds that this tends to be why trustees of FTSE companies carry out such regular reviews.

Increasing co-operation

Employers are supportive of the need for trustees to review the covenant and have become more sensitive to the pension scheme’s liabilities. They need to manage the risk in the scheme and it makes sense to collaborate with trustees to ensure they are kept well informed. As Mr Masters says, employers are “increasingly co-operative, becoming more involved in the process of employer covenant assessment, including taking a proactive stance to provision of information”. As to the provision of data and information that may be price sensitive for publicly quoted businesses, he says “this can be overcome with appropriate confidentiality undertakings”.

The potential difficulty for trustees is how they review the covenant in a non-confrontational way. As Roger Cooper, says, just as TPR’s guidance helps trustees understand their responsibilities and how they can discharge them, it “also helps sponsors understand the trustees’ perspective”.

Zolfo Cooper’s Gary Squires also sees more awareness from employers of the pensions regulatory environment and the requirement for trustees to understand the covenant. He says that employers recognise that “meeting trustees’ information needs and engaging them in managing pensions risk can benefit the employer, for example with less onerous recovery plans and a lower Pension Protection Fund levy”.

Working together

When the covenant is poor, trustees have various options open to them, depending on the circumstances of the scheme. Mr Masters says in the past couple of years there has been “increased use of non-cash funding solutions to meet scheme funding needs, including the use of contingent assets and special purpose vehicles into which pools of assets are transferred to provide returns in lieu of regular recovery plan contributions by scheme sponsors”. Where such assets are not available, “trustees have been exploring other options such as extended or back-end loaded recovery plans, deficit contributions being linked to future profitability, dividends and cash-flow”.

Where the sponsoring employer is part of a group, other companies can help support the scheme and TPR has powers to impose liabilities if necessary. It is preferable though, says Mr Squires, to “agree a support package”, although the threat of TPR intervening may “encourage the trustees and the sponsoring employer to reach such an agreement”.

Punter Southall Transaction Services’ Lorant Porkolab says that, in the case of a transaction, the advice might be to ask for “up front lump deficit contributions, security provisions, or formal, legally binding guarantees”. When it is an actuarial valuation that has thrown up a weak covenant, advice would include discussion of the “various trade offs between short term contributions and long term security”.

More specifically, and as an example of the employer and trustees working together to improve the covenant, PKF’s Brian Hamblin says that contributions had been suspended for the period when the employer in question was in a turnaround position. It was agreed that “if the profits of the company exceeded 10% above budget, further contributions would be made”. He adds that the company has “successfully turned around and is now making significant contributions to the fund”.

Keeping the promise

Inevitably, the management of the liability to the scheme and any deficit is a major issue in corporate transactions and buyers are unlikely to want to take on full liability for legacy schemes.

Alternatives might be, says Mr Masters, for the buyer to accept “liability for active scheme members or otherwise seek significant price adjustments to reflect the risk in transferring defined benefit scheme liabilities”.

He says that where a transaction is under consideration, trustees are “keen to establish the extent of any covenant detriment, with consequential impacts on technical provisions, recovery plans and negotiating mitigation”.

Trustees need to understand the nature of enforceability of the sponsors’ promise, says Roger Cooper, and “in particular where the sponsor sits within the corporate structure both before and after the transaction”. They must be alert to events which may be detrimental and, thus, may impact the sponsor’s covenant strength, which demonstrates further why trustees need to have an effective framework in place.

Help is available

As trustees are increasingly aware of their obligations for assessing the employer covenant, particularly in light of TPR’s guidance, the sponsoring employer must also shoulder some responsibility. Commenting on recent research carried out by PwC covering 93 recent pension scheme evaluations, Jeremy May of PwC says, “it is more important than ever that companies take the lead in helping trustees to understand the strength and ability of the employer to meet its pension financing commitments”. He says it is crucial to ensure that trustees have a clear understanding of both the business and the market in which the business operates and if “employers are insufficiently assertive in the process, trustees may be forced to make their own assumptions and may assume the worst”.

The point of the covenant assessment is to help trustees and sponsors establish what they do not already know about covenant. In this respect, says Mr Masters, “undertaking a detailed review of what is agreed to be a weak covenant is counterproductive, when the focus should be on the affordability of recovery plans and investigating ways of improving the employer covenant”.

Potential awkwardness between trustees and the employer is often a problem, particularly where both have worked well over the years. As Mr Hamblin says, “some trustees consider that questioning the company over its financial position shows a lack of trust on their part. The last thing that the trustees wish is to stop the willingness of the employer to sponsor the scheme.” This need not be the case, though, if a discussion of the issues takes place.

TPR requires trustees to monitor the employer covenant and, ultimately, the more information trustees have about the covenant, the easier it is for all concerned to make assumptions about the future of the pension scheme and potential payouts to members. Trustees have no choice in this matter, but neither are they alone. Advisers, in various guises, as shown in the Table, are available to help them and sponsoring employers are also realising that it is in the business’s interests to support them.ab