Trustees of defined benefit pension schemes, such as final salary schemes, need to know if the employer will stand behind its promise to fund the pension scheme and whether it is able to do so. The employer's legal obligation, and its ability and willingness, to fund the scheme now and in the future is known as its covenant. The Pensions Regulator, the body which oversees work-based pension schemes in the UK, expects trustees to regularly assess and monitor the employer covenant.
Determine legal obligations
Trustees must first identify which companies are legally obliged to fund the scheme and to what extent. This may also include the wider employer group if, for example, a parent company has given a financial guarantee.
Information flow
It is important to agree on a good flow of information, and to encourage the employer to share information at an early stage. Bear in mind that the information the employer provides may very well be confidential, and the employer could ask the trustees to sign a confidentiality agreement. Trustees should also look at publicly available information such as statutory accounts, credit ratings and comments in the financial and trade press.
Reviews and warning signs
In most cases, trustees should carry out a full review of the employer covenant at each actuarial valuation, which usually takes place every three years. This will help them decide what level of risk is acceptable for the scheme's funding and investment strategies. The employer covenant effectively underwrites the risks to which the scheme is exposed such as underfunding, longevity and investment.
Covenant assessment is a complex process, and trustees may want to seek independent professional advice to assist them in making their assessment. Trustees can rely on their own expertise, but must ensure that they do not have any conflicts of interest if, for example, they are also employees of a scheme employer.
The Pensions Regulator expects trustees to monitor the covenant on a regular basis and it is up to them to consider when and how often to do so. Working within the employer's existing financial reporting obligations will save costs and time, but the trustees may need to adopt additional reporting during certain key events such as a business sale. It is good practice for covenant review, however informal, to be a standing trustee agenda item.
Employer needs and investment risks
Trustees should be proactive and have in place processes so that they can act quickly if there are key triggers or warnings - such as the employer breaching one of its banking covenants or if the employer company changes owner.
Trustees can also use a regular covenant review to ensure that they are better prepared if the employer's covenant significantly deteriorates to the point that it can no longer support the pension scheme. If this happens, the Pensions Regulator has the power to require other companies in the group to provide support. Understanding what the Regulator would look for, and using their regular covenant review to gather helpful information about the group structure and the employer's function within the group, is a simple but effective way of allowing the trustees to move quickly should the worst happen.
The Pensions Regulator's guidance requires trustees to focus primarily on the employer's legal obligation and ability to fund the scheme – rather than the employer's willingness to do so. The employer's management and circumstances can change, so trustees should avoid placing too much reliance on verbal assurances of support from management or on whether the employer has been supportive in the past.
Summary
Trustees need to bear in mind that if any report suggests that the employer covenant is weak, they will have to act on this information quickly. Additional funding or another form of security, such as a guarantee, could be sought from the employer. However, trustees must also balance the employer's needs as a solution that threatens the viability of the employer is unlikely to be in the best interests of the scheme or of its members.
When assessing and monitoring the employer covenant, trustees should bear in mind the level of risk attached to the scheme's investments. If the covenant is weaker, then it may be better to stick to lower risk investments.