PENSIONS PROGRESS New covenant guidance

Helen-Mary Finney, Aon Hewitt, explains the new regulatory guidance on assessing and monitoring the employer covenant

In a nutshell: 
  • the covenant is considered essential to an integrated risk management approach
  • assessment and monitoring should be proportionate to the circumstances
  • the Regulator includes a number of practical examples.

The Pensions Regulator has released new guidance on assessing and monitoring the employer covenant – defined as the extent of the employer’s legal obligation and financial ability to support the scheme now and in the future. Trustees of defined benefit schemes are expected to understand and manage risks proportionately, and the covenant should shape the trustees’ approach to investment and funding.

This is the first in a series of guides intended to help trustees apply the code of practice on funding defined benefits, which came into effect in July 2014. Later in the year, the Regulator intends to publish further related guidance, including guides on integrated risk management and investment strategy.

What is new?

There is little in the guidance that is completely new and the principles will be familiar to users of the previous covenant guidance published in 2010. In general, it consolidates and updates much of the formal and informal guidance issued by the Regulator in recent years. In particular, it takes account of the Regulator’s revised code of practice on funding defined benefits. There are new appendices that address covenant assessments for multi-employer and not-for-profit schemes (eg, charities and universities), including “last man standing” and formally segregated schemes.

The guidance re-emphasises that covenant assessments should focus on:

  1. the legal obligation requiring an employer to support the scheme
  2. scheme related issues – the funding needs and investment risk of the scheme now and in the future
  3. financial strength – the ability of the employer to contribute cash when needed.

Approach to assessments

It is expected that any investment and funding risks should be based on the ability of the employer to support the scheme. A sound understanding of the covenant is therefore an essential part of an integrated approach to managing scheme risks. Trustees are not expected to eliminate all risks to their scheme, but they should understand and actively manage the risks they are taking.

The new guidance gives much more detail on the process of assessing the covenant, which is intended to guide trustees through the process. The Regulator has taken a practical approach, providing checklists and a number of examples and scenarios to illustrate key points.

The guidance covers when to commission an external covenant assessment and how to manage the costs and tailor the scope of such an approach. Where trustees do not commission an external covenant assessment, they are expected to have the appropriate objectivity and expertise and to be comfortable that they are able to perform adequately the steps set out in the guidance. Whether or not they do commission independent advice, they should clearly document the assessment process and its conclusions.

As well as assessing the strength of the current covenant, assessments should be forward looking and focus on the ability of the employer to contribute cash to the scheme over an appropriate period.

Covenant assessment and monitoring should be proportionate to the circumstances of the scheme and employer, including the degree of reliance of the scheme on the employer now and in the future and the complexity of the employer’s operations. Trustees and employers are expected to work openly and collaboratively.

The Regulator points out that covenant can change quickly, so regular monitoring and well developed contingency plans are important.

Sustainable growth

Since July 2014, the Regulator has had a strategic objective with respect to minimising any adverse impact on the sustainable growth of an employer. Trustees are required to consider the employer’s plans to invest in the sustainable growth of the business, where this might restrict the funding available to the scheme. If an employer’s investment plans restrict funding, trustees need to understand these plans and the (long term) benefit to the scheme of such an investment.

The guidance makes it clear that all stakeholders (not just the pension creditor) must contribute appropriately to such investment and that the trustees should also look for downside protection, for example, through the provision of a contingent asset.

Helen-Mary Finney is a senior consultant at Aon Hewitt.