The covenant comparison is key to pension plan buyouts, says Akash Rooprai, Mercer

In a nutshell: 
  • monitoring the covenant is essential
  • TPR has issued guidance on monitoring employer support
  • seek specialist advice.

A key consideration when buying out defined benefit pension liabilities is the strength of the chosen insurer’s financial covenant, compared to the existing overall covenant supporting the pension plan. It is not always a straightforward comparison but a robust investigation can help you make the right decision.

For a pension plan, the main covenant risk arises from the willingness and ability of the employer to contribute additional funds as and when necessary, but additional risk arises from the counterparties to the investments held by the plan. Measuring employer covenant has become commonplace since the new funding regime was introduced in 2005, and is receiving significant regulatory scrutiny following the new guidance on monitoring employer support, issued by the Pensions Regulator in November 2010. Furthermore, with the establishment of investment subcommittees, there has been increasing focus on the counterparties of the plan’s assets.

Concentration of effort

When pension plans buy out their liabilities with an insurer, there is a concentration of effort to understand the financial strength of the chosen insurer. This involves analysis of the most recent publicly available information (such as annual regulatory submissions to the FSA), along with an up-to-date investigation of the insurer’s corporate structure, latest financial position and business plans. Often this is considered without any robust
comparison to the existing covenant, though there is usually some analysis of how key financial metrics for that insurer compare with other insurers.
The analysis of an employer covenant is – for most employers – a different discipline to the analysis of the covenant of an insurer. In the former, there is likely to be no regulatory overlay (or perhaps a different regulatory regime to that under which the insurer operates). Also, most employers
have a simpler financial structure than most insurers, even if their corporate structure is complex. As a result, covenant analysis is often carried out
by different organisations, focusing on different areas. Perhaps in future, some techniques for meaningful comparisons can be developed, possibly by analysing the effect of defined external shocks on the business.

Duration of liabilities

The duration of pension liabilities is notable as it’s relevant to covenant analysis. Pension liabilities usually extend many decades into the future. Ideally one would form a view of the covenant (either existing or insurer) over the whole duration of the liabilities. However, the further into the future the analysis is taken, the more opaque the view becomes. Business projections are typically over a three to five year time horizon. It’s difficult to have reliable projections beyond this time whether looking at a sponsoring employer, an insurer, or any other counterparty. However, decisions need to be made on the information available. It is often acceptable to make a decision on whether or not to buy-out based on projections that do not extend to the full duration of the liabilities, which is often not viable.

In doing this, account should be taken as necessary of the often significant cash contribution off ered by the employer to enable the buyout to occur. This is often judged to be suffi cient to counteract any uncertainty over the longer term – that is, cash now is generally considered to be worth more than an equivalent amount due at some time in the future.

Seek advice

Whatever type of analysis is carried out, it is likely to be beneficial to ensure that appropriate advice is obtained from specialist providers with relevant experience of assessing and benchmarking insurer risks. Comparing this to the existing covenant is important and should be a focus. Mercer and our sister company Oliver Wyman frequently carry out specialist employer covenant analyses and conduct insurer financial strength reviews with this in mind. In a buyout, it’s important to bring all these considerations together in an appropriate way, against the background of very long-term liabilities, to enable a sensible and robust decision to be made.

Akash Rooprai is a principal at Mercer;

Akash Rooprai is head of pensions risk management at Capita Employee Benefits.