High profile collapses mean that a strong employer covenant and the role of the trustee are more crucial than ever, warns editor Stephanie Hawthorne

In a nutshell: 
  • high profile business failures such as that of BHS Stores emphasise the fact that protection members' pensions must remain trustees' overarching concern
  • 1,000 schemes are at serious risk of falling into the PPF, which representone sixth of the total number of schemes in the UK listed in the Purple Book
  • covenant monitoring is of vital importance and should be under at least the same scrutiny as investment performance.

With high street failures such as BHS Stores and Woolworths fresh in the memory and Brexit worries ahead, protecting members’ pensions must remain trustees’ overarching concern.

The Pension Protection Fund (PPF) is there as the ultimate lifeboat and while PPF benefits are better than nothing, there is a substantial risk that for many the gold plated final salary pension scheme is mere base metal.

Indeed, a staggering 600 defined benefit (DB) schemes may never pay off their pension debt. This was the stark conclusion of a recent report The greatest good for the greatest number by the Pensions Institute, with 1,000 schemes at serious risk of falling into the PPF. That is an astonishing one sixth of the total number in the UK listed in the Purple Book, although in the 2017 Green Paper on the security and sustainability of DB schemes, Richard Harrington, the pensions minister said: “We don’t believe there is a systemic crisis in the sector.”

In the spotlight

The employer covenant assumes ever greater importance, as the Pensions Regulator emphasises: “The employer plays a vital role as scheme sponsor and effectively underwrites the risks that the scheme is exposed to, including underfunding, longevity, investment and inflation. The employer covenant – the employer’s legal obligations to a DB scheme, and its ability to meet them – remains a crucial element in protecting members’ benefits.” The strength of the employer covenant can change materially over a short period of time, which could have significant implications for the scheme’s investment and funding strategy. The Regulator says: “Trustees should monitor the covenant regularly between formal assessments so they can act quickly if needed. The frequency and depth of monitoring should be proportionate to the circumstances of the scheme and employer.”

Reviewing the covenant is far from easy and so hard pressed trustees may benefit from using a specialist. Most leading consultants offer covenant services and a selection are listed in the Table.

Since the BHS collapse, Aidan O’Mahony, partner at Aon Hewitt, says: “Trustees are more concerned about covenant strength, covenant monitoring and Regulator scrutiny of their decision making.” Similarly, Jon Wolff of Lane Clark & Peacock, says: “It has sharpened the focus of a number of trustee boards on the importance of the covenant to their overriding objective of ensuring that member benefits are paid in full. There is also an element of not wanting to be exposed in the extreme event that they are hauled in front of a parliamentary select committee if a disaster scenario occurred.” Darren Masters, partner at Mercer and head of its covenant consulting group, concurs: “The high profile nature of the BHS Select Committee interviews has certainly made trustees aware of the need to justify their decisions.”

Adrian Bourne, senior consultant at Willis Towers Watson, points out that Brexit and the typically adverse impact on schemes has thrust scheme risks to the fore, with material increases in deficits placing much greater reliance on the sponsors.

But not everyone has seen the light. Chris Ramsey of Barnett Waddingham counsels that “the documentation of employer covenant discussion could be better in a lot of cases”, while O’Mahony points out that: “Many trustees still monitor funding and investments quarterly, but covenant only every three years!” Masters has a similar experience: “Covenant is an increasingly important consideration for trustees, but our experience remains that less than 50% of clients take an active engagement in the assessment and monitoring of covenant on a regular basis, while investment returns and management performance issues are considered at every trustee meeting.”

What to monitor

According to the Regulator, key covenant factors to monitor will vary by employer, but could include the following:

  • material changes in current and forecast affordability of contributions to the scheme
  • changes to the group structure directly affecting the employers or other entities, which have a material impact on the covenant (such as a subsidiary of an employer)
  • any plans to refinance or to raise external financing in the group
  • dividend payments (or analogous extractions of value such as changes in intragroup debt) above a specified level
  • adverse movement in the employer’s key performance indicators
  • reputational damage to the employer’s brand
  • significant changes in the employer’s industry, such as the merger of two of the employer’s competitors, regulatory changes or material technological innovation
  • governance or key personnel changes to the employer.

The Regulator gives an example of a monitoring framework, illustrating possible triggers for action. “The trustees of a scheme are concerned about the risk of a future weakening in the covenant as a result of changes in its industry. In such an event, they believe that the level of investment and funding risk would need to be reviewed and that higher contributions from the employer may be required. The employer’s dividend policy is to distribute 50% of post-tax profits to its parent company. The trustees could set up a monitoring framework, which would include trigger points that they have identified would indicate or lead to a material weakening of the covenant and would result in the trustees taking action.”

The role of the Regulator

In this world of massive deficits, the role of the Regulator itself has also come under scrutiny. Howard Ringrose of BHP Chartered Accountants says: “Regulation needs strengthening in scenarios as happened at BHS, but the Regulator should not be heavy handed with well-run schemes.” O’Mahony says: “Better and quicker screening of large high risk schemes would help the Regulator focus its limited resources. More powers are not necessarily a panacea.”

The Regulator does not need more power, agrees Lorant Porkolab, principal at Punter Southall Transaction Services, who adds: “It is easy to criticise the Regulator and make quick judgments based on a few high profile cases where something went wrong, in particular with the benefit of hindsight. Overall – when considered in a balanced way, the Regulator has done a reasonably good job, given that it has been given potentially conflicting objectives (eg protecting members’ benefits and protecting the PPF) and they also had to ‘learn on the job’ regarding the new challenges presented by employer covenant issues.”

Masters takes a different approach: “There has not been enough evidence of the Regulator stepping out of its role as referee and into the shoes of a player.” He adds: “The Regulator has an existing strong set of powers, many of which it has underused; these include its moral hazard powers and its powers to intervene in scheme funding negotiations.”

He concludes: “New powers may be needed to intervene in scenarios where transactions put pension benefits at risk, and current powers cannot prevent the transaction from taking place. However, the challenge here is not to interfere in legitimate business activity, so the criteria for ability to intervene may be difficult to define.”

In a similar vein, Wolff believes that: “Pension schemes are often a forgotten stakeholder in corporate transactions and restructurings, and it would be useful if the Regulator’s powers could give trustees greater leverage in order to strike fairer deals. However, the concept of pension schemes being able to seriously disrupt or even block deals which could create value for UK plc is not likely to gain much political traction, particularly given the current uncertain environment.”

But Simon Willes, executive chairman at Gazelle, says: “The Regulator has already become much more active and intrusive in relation to corporate transactions.”

Bourne makes the very valid point: “There needs to be a more transparent and accepted means by which sponsors can manage their scheme risks, including being able to disconnect/sever the scheme when the size and scale of that scheme is such that it is ‘killing’ the sponsor, but insolvency doesn’t necessarily have to be inevitable over the next 12 months.”

The new buzz phrase

Following the Regulator’s guidance on the subject in December 2015, integrated risk management is an important new area. It is a risk management approach that can help trustees to identify, manage and monitor the factors that affect the prospects of meeting their scheme’s funding objectives. Bourne says: “In general, most parties have ‘upped their game’ and embraced it, but without looking to over-engineer what can be a complex means of linking covenant, funding and investment.”

But Willes points out: “Trustees are often poorly equipped and time limited in terms of adding interpretative expertise and are unwilling to extend budgets; sponsors are interested if it helps reduce pension costs, but otherwise less interested. At present, only the largest schemes with strong governance and good levels of expertise within the trustee board are taking action. The Regulator’s guidance last year was lengthy and difficult to digest and has resulted in a confusing number of different tests and approaches.”

Interestingly, Hymans Robertson’s second annual independent trustee survey in 2016 showed that a quarter of independent trustees believe sponsor failure, or “covenant risk”, is one of the biggest risks to DB schemes. Yet 43% of independent trustees say long-term covenant risk is not integrated into schemes’ strategic investment and funding decisions.

Calum Cooper, partner and head of trustee consulting at Hymans Robertson, emphasises: “Covenant should be properly accounted for in guiding strategic investment and funding decisions of DB schemes. Currently, the cost of covenant risk is a £450bn reduction in the value of benefits. It needn’t be this high.”

Vital importance

Covenant monitoring is of vital importance and should be under at least the same scrutiny as investment performance. Employees and pensioners are depending on your diligence – but there is plenty of help at hand if you find it too onerous. Neglect this area at your peril for, in the end, the only risk that really counts is covenant. If there is no scheme sponsor, members may lose much of their biggest asset – their pension.


The significance of PPF drift

At Rothesay Life, a large proportion of the schemes we see have reached the end of their natural life cycle. Some are fortunate enough to secure full benefits and buyout, while others are trying to escape the clutches of the Pension Protection Fund (PPF).

Whichever end of the spectrum schemes find themselves at, they will all have been deeply impacted by the covenant afforded to them by their sponsoring employer. Nearly every month we see an article which states the size of the combined deficit of UK defined benefit pension schemes. This deficit often ignores, or only partially takes into account, the sponsor covenant, whether through committed funding or an estimate of the recovery that schemes would make on the insolvency of the sponsoring employer. But why does this matter?

It matters because of the concept of PPF drift. A scheme’s PPF liabilities grow each year as more members reach normal retirement age (NRA), when those members are no longer subject to the PPF compensation cap, and because each time a pension increase date is reached, the members bank this increase. While on the face of it, this is good news for the members of the pension scheme, it is only true for all the members when the scheme is underfunded in comparison to the PPF funding requirement.

Where the scheme has assets in excess of the cost of purchasing benefits equal to or greater than those provided by the PPF, PPF drift actually only sees the reallocation of existing assets from one cohort of members to another (those under normal retirement age (NRA) to those over NRA). And while a scheme may on the face of it be underfunded compared with the PPF basis, this may not be true when taking into account any recovery made from the sponsor in the event of insolvency. It is for this reason that understanding the covenant also allows trustees to understand who is most effected by the insolvency of the scheme.

Over the years, we have insured tens of thousands of scheme members who have been impacted by the insolvency of their employer and the loss suffered by the members ranges from a few per cent to losing over half the value of their pension.

Understanding a scheme’s unique position allows trustees to negotiate funding in a way that protects all members of the scheme and may in some instances mean that compromising benefits is in the best interest of the greatest number of scheme members and may allow a company to continue to employ its staff and generate value for the wider economy.

Sammy Cooper-Smith is co-head of business development at Rothesay Life


Stephanie Hawthorne has been editor of Pensions World since 1989. An honours law graduate of King's College, London and winner of 10 first and second prizes for pensions, property and insurance journalism, Stephanie has been a journalist for 25 years. Starting her financial career as a researcher/marketing specialist for a national independent financial adviser and subsequently a leading life office, she then moved on to Insurance Age, Planned Savings and Financial Times' Money Management (deputy editor). Stephanie has contributed articles to the Financial Times, Mail on Sunday, The Times, The Sunday Times, The Sunday Telegraph and The Observer, as well as numerous magazines. Among her other editorships are Counsel: The Journal of the Bar of England and Wales (from 1997 to 2007) and Charity World (managing editor, 1993 to 1997).