Are trustees doing all they should when it comes to monitoring the strength of the employer covenant? Allison Plager reports

In a nutshell: 
  • trustees should review the covenant regularly, and certainly at the triennial scheme funding valuation
  • employer covenant risk is the second overall most important risk faced by defined benefit pension schemes
  • a particular problem for trustees is the cost of the covenant review in terms of cost and the time it takes.

Reviewing the employer covenant is not easy. It can involve asking the employer some potentially awkward questions about the company’s financial affairs and is likely to require the need for professional help, although that is not a legal requirement. Guidance and information can be found on The Pensions Regulator website, for example “Monitoring employer support” (www.lexisurl.com/tprmes).

Trustees should review the covenant regularly, and certainly at the triennial scheme funding valuation. The covenant is the lynch pin of a defined benefit scheme’s ability to ensure the viability of the scheme and safeguard member benefits. The Pensions Regulator describes it as the “employer’s legal obligation and its ability to fund the scheme now and in the future”.

Further injections

Over the years, trustees have become more aware of their responsibility in this area, as have the employers. Research carried out in summer last year by MetLife Assurance showed that, for the second year running, employer covenant risk is the second overall most important risk faced by defined benefit pension schemes, with sponsors becoming increasingly concerned about the issue, placing it third in importance. This was the third annual “UK Pension Risk Behaviour Index” where 89 sponsors and trustees are asked to assess 18 investment, liability and business risks that affect their schemes.

Although it is not surprising that trustees consider the covenant so important, it is more notable that employers are attaching more significance to it. The research shows the importance of selection rate (the percentage of times it was selected by respondents when presented alongside other risk factors) for sponsors increased from 41% in 2011 to 49% in 2012, while it remained steady at 56% in 2012 for trustees compared with 55% in 2011.

MetLife ascribes employer awareness to the continued widening of scheme deficits for many schemes and the resulting increase in requests from trustees for additional top up contributions. Total importance selection rating for employer covenant among trustees and sponsors was 53% for 2012 compared with 49% in 2011 and 28% in 2010. Wayne Daniel of MetLife Assurance said: “The employer covenant is a crucial element in protecting members’ benefits and the increased emphasis from both trustees and sponsors on the risk indicates that both understand how important the covenant is, especially where the scheme is in deficit on a solvency basis.”

BDO’s Richard Farr believes that trustees and sponsoring employers are beginning to give the employer covenant sufficient attention. He said: “There is still a wide range of attitudes to employer covenant assessment from trustees. Many trustees have recognised the value and importance of employer covenant assessment for a number of years. Due to pressure from the Pensions Regulator and input from well informed advisers, we are finding that an ever increasing number of schemes are seeking some form of independent covenant assessment.”

He added that “there is significant pressure on fees, often because of the lack of understanding of what a review can do”, which can limit their full effectiveness. But encouragingly, he said “sponsoring employers are becoming increasingly aware of the importance of being engaged in the employer covenant assessment process and the tangible benefits that co-operation with trustees and employer covenant advisers can yield”.
Paul Crouchman of Premier Pensions Management agrees that trustees are attending to the covenant but said, “in some situations they feel it would be difficult to commission an external covenant when the sponsor provides regular updates of their financial performance which it would regard as sufficient”. Trustees are concerned about the impact this might have on their relationship with the sponsor “particularly if the trustees are under fee pressures”.

Closer examination

Given that covenant reviews are an accepted part of a pension scheme’s governance, are trustees focusing on the right issues? Chris Atkin of Atkin & Co suggested that covenant reviews have been watered down too much, saying they should focus more on the willingness of the sponsoring employer to support the scheme financially, rather than just its ability to do so. Open discussion and stronger relationships between trustees and sponsors will help develop this.

Mr Atkin said: “Some trustees see covenant reviews as a simple box ticking exercise, but these should stretch further than checking the employer’s immediate cash position, the availability of contingent assets or examining risk levels. The employer covenant is crucial with regards to decisions that go right to the heart of running a pension scheme, but any covenant review is meaningless if the relationship between the employer and trustee board is weak. Increasingly, we are seeing the willingness of the employer to support the pension scheme and provide money evaporate. This is not a good scenario for the health of a scheme.”

He said trustees need “to communicate more effectively with the employer and delve deeper when it comes to meeting their governance requirements. The irony is that employers and members may view a covenant review as a very expensive exercise, when the sponsor may already be struggling to meet liabilities for the scheme. Greater effort must be made to think independently of the required reviews and encourage healthy and open communication channels between the pension scheme and the company.”

Specialist expertise

A particular problem for trustees is the cost of the covenant review in terms of cost and the time it takes. As mentioned earlier, it is not a statutory requirement to appoint an adviser when reviewing the covenant, but often specialist expertise is needed.

The Table provides a selection of companies which offer a covenant review service. These range from firms of accountants, such as BDO, Grant Thornton and KPMG, to consultants such as Mercer and Aon Hewitt, and specialists such as Jackal and Zolfo Cooper. Most have a dedicated team, but some, including Barnett Waddingham and Premier Pensions, include the service as part of their general service for trustees. Premier Pensions does not have a “forensic accounting service” on the basis that it can be expensive. Mr Couchman explained that it is because of trustees’ concerns about cost that his firm has devised a service “which avoids the need for expensive forensic research unless absolutely necessary”.

Essential strength

The employer covenant is likely to be critical when considering de-risking. As Ben Harris of Barnett Waddingham said “de-risking often implies additional costs and trustees need to be sure that these can be met by the employer as they arise. Every case is different and whether and when it is appropriate to review the covenant will depend on the scheme and the employer’s circumstances.”

The covenant should be considered regularly, said Mercer’s Darren Masters, “and more particularly when considering a change such as de-risking”.
Agreeing that the strength of the covenant will play an important role in a de-risking exercise, Punter Southall Transaction Services’ Lorant Porkolab said: “De-risking typically reduces the scheme’s risk profile. However, the extent of the risk reduction and the set of possible alternative solutions should also reflect the strength of the covenant support, as all of the risk the pension scheme is exposed to is underwritten by the employer covenant. The stronger the covenant, the more risk the scheme can tolerate.

“If the employer is concerned about the level of risk carried by the scheme and it also has the financial resources required to reduce that risk, then it can be beneficial for all parties involved to implement the most suitable de-risking strategy. However, for employers the cost is often too high.

“As the employer covenant is often the largest single risk for the scheme, the concept of de-risking should also be applied in this area. Contingent assets and other forms of undertakings by the employer can strengthen the support and reduce the covenant risk, allowing the scheme to potentially carry more investment risk and have more return seeking assets in its portfolio.”

BDO’s Mr Farr said that the employer’s decision to de-risk is not always taken with reference to its employer covenant: “There are circumstances, where trustees seek to de-risk their investment mix in response to a weakening employer covenant. Trustees have also asked us to consider employer covenant whether they should reduce transfer values paid on enhanced transfer value exercises.”

Look after the covenant…

And the scheme will look after itself. That is wishful thinking, but trustees and sponsoring employers should take note that a strong covenant is important for a pension to operate effectively.


Allison Plager is a financial journalist.