EMPLOYER COVENANT Keep an eye on it

Reviewing the employer covenant is a serious undertaking. Financial journalist, Allison Plager reports

In a nutshell: 
  • the employer covenant is crucial to the effective operation of a DB pension scheme
  • trustees are very aware of the need to review the covenant on a regular basis
  • for those schemes that do decide they need external help, there are a number of experts on the market.

Knowledge is power and trustees are undoubtedly required to know a lot about their pension scheme to perform their duties effectively.

One area that has been growing in significance is the employer covenant. The Pensions Regulator website contains some useful guidance on what it expects trustees of defined benefit (DB) schemes in particular to do in respect of monitoring the covenant; see for example, the November 2010 guidance.

While trustees should carry out a review at every scheme funding valuation, they are not specifically required to obtain an independent review. Trustees may be deterred from appointing a third party because of the expense, but there can be problems with keeping the review in house, for example:

  • Do the trustees have the necessary skills to find the relevant information, interpret and test it?
  • How independent will they be, especially where the financial director is on the trustee board?
  • Where the covenant is found to be weak, would they be able to come up with and instigate a recovery plan?

For trustees that do decide they need external help, there are a number of experts on the market. The Table provides a selection of advisers, with most of the skills required to review the covenant.

Over the years, trustees have become more attuned to the need to review the covenant. As Bruce Mackay of Baker Tilly said, most trustees that his firm engages with “have self-evidently fully bought in to the importance of assessing and monitoring the employer covenant”.

He added that it “a dwindling minority of trustees who do not give the covenant due levels of attention”, and he acknowledged that some “continue to prefer not to use independent firms to carry out the assessment for their schemes”.

The trustees should obtain an independent view, said Capital Hartshead’s Sue Curley, “especially when undertaking the actuarial valuation”. Financial presentations from the company are useful, but she said “an independent assessment is needed at least every three years”. Acknowledging that independent reviews are not cheap, she said it can help in situations when “it may be difficult for a trustee to approach the employer for information –  it is the independent reviewer’s job to do that and analyse the information”.

Essentially, it removes a lot of pressure from the trustees if they appoint a third party to have the sometimes probing discussions that such a review needs.

KPMG’s Dave Clarke agreed that trustee awareness “has significantly increased in the past 18 months, and across all size schemes”. His teams are receiving more enquiries from smaller schemes and ascribed this to the “growing deficit problem and better awareness of the Pensions Regulator’s guidance”. Both of these have “hit home harder” recently, with trustees seeing the need for an independent review.

John Lander of PricewaterhouseCoopers (PwC) referred to a recent PwC survey on UK pension scheme governance, where 70% of trustee groups from a variety of large schemes said: “They had sought external employer covenant advice, which is an increase compared with previous years. In our experience, many trustees now regard their schemes as major unsecured creditors of the employer and hence have a greater focus on the strength of the employer.”

Top marks for the trustees then, but how about awareness on the part of the sponsoring employer? “Employers’ attitude towards assessment of their covenant is rather more patchy,” according to Mr Mackay. This is to some extent mirrored by Mr Lander who has found that the increased focus by trustees has resulted in employers “beginning to pay more attention to employer covenant”. However, he said “the attention given by employers is still lacking. Greater understanding and control of the covenant allows employers to drive the process and retain control of the scheme funding process just as they would any other business decision.”

MetLife Assurance Ltd’s 2011 UK pension risk behaviour index found that the employer covenant is the second most important risk, behind funding deficits, facing UK DB pension schemes. However, its results showed that trustees appear to be placing greater emphasis on covenant risk than sponsors, with trustees selecting employer covenant as important 55% of the time it was presented to them, while sponsoring employers selected it 41% of the time.

On the other hand, Mr Clarke is finding employers to be supportive, definitely more so than in the past. He said it is important to try to take a “collaborative approach” when reviewing the covenant, and sponsors have recognised the benefits of engaging with trustees and their advisers. This is where taking independent advice can be helpful. A balanced and collaborative approach from advisers can often help to strengthen the relationship between the trustees and the sponsors, which is a “component of any covenant”.

However, it is also worth taking a sensitive approach with company directors, as they have the task of running the company, as well as supplying advice about the covenant.

Regular reviews

For many, if not all, companies with DB schemes, the ultimate goal is to offload the burden. Here also the employer covenant plays an important role. As Mr Land said: “The employer covenant and derisking strategies are inextricably linked. The requirement to derisk is greatest when the covenant is weakest, but funds may not be available to achieve it.” The alternative is partial derisking, which he explained focuses on “interest rate risk, inflation risk and longevity risk as scheme circumstances require”.

MetLife Assurance’s Emma Watkins said: “At its most basic, the sponsor covenant is the employer’s ability to pay contributions in to a pension scheme both today, tomorrow and in the future. Consequently, regular reviews help trustees ensure that they can pay members’ benefits as they fall due.

“Given the sponsor covenant effectively underpins the viability of any pension scheme, logically it should be a factor in all ongoing funding and investment decisions, including derisking.”

Referring to derisking, she said: “Initially when a scheme is looking to derisk, a review of the sponsor covenant will influence the end goal, will help drive realistic time-scales and will drive the various actions needed to be taken along the ‘flight path’.

“Regular reviews thereafter will help trustees determine if they remain ‘on course’ or indeed whether there is need for intervention. For example, they may help identify opportunities to advance the plan – perhaps because of favourable employer financials or cash being made available through a sale of company assets/property.”

Reviewing the covenant can also help create mutual understanding between the employer and the trustees. As Ms Watkins said: “The importance of regular reviews in encouraging regular communication between the employer and trustees should also not be underestimated. By aligning their priorities and actions in terms of pension scheme de-risking to achieve both the trustees’ and employer’s objectives, a joint derisking plan is much more likely to be successful, efficient and cost-effective.”

Smith & Williamson’s Finbarr O’Connell agreed that “the employer covenant is one of the critical risks to be considered when looking at derisking the pension scheme to achieve the aim of buying out the members’ benefits in full”. He also mentioned “establishing regular discussions between trustees and sponsor where the investment management risks of the scheme, taking any changes in employer covenant into consideration, are imperative”. With markets in a state of fluctuation, he added that these discussions “also assist the trustees to appreciate the important of the employer as guarantor, if its covenant is strong, in derisking models”.


Fairly obviously, if the same adviser is acting for the trustee and employer, this could lead to a conflict of interests. Some advisers do not act for both sides; these include Gazelle and Lincoln. Simon Kew of Jackal said he usually “only acts for one or the other at one time, although our service can be tailored to benefit both”. Others believe there should be no problem acting for employer and trustee. Darren Masters of Mercer said “if approached properly in a collaborative manner, the assessment of covenant and the consideration of the findings of the covenant review with the trustees and the employer rarely present issues in relation to conflicts of interest”. However, were conflicts to surface, Mr Masters said the firm’s “role as covenant adviser to the trustees is our primary concern”.

In this together

Clearly the employer covenant is crucial to the effective operation of a DB pension scheme. It is not a new phenomenon and trustees are very aware of the need to review the covenant on a regular basis. As Aidan O’Mahoney of Aon Hewitt said: “second time round valuations, ie post the scheme specific funding regime, trustees are learning quickly about the benefits of monitoring, even if many struggle to identify the key performance indicators appropriate to their specific sponsor”.

Ideally, it is beneficial on both sides if an agreement can be reached so that information is shared. Mr O’Mahoney said “the more sophisticated sponsors and trustees tend to agree an information protocol such that information specifically relevant to the sponsor covenant is shared and discussed on a regular basis”.

Perhaps this is the holy grail to which other trustees and employers should aspire.

Allison Plager is a financial journalist.