Assessing and monitoring the employer covenant: TPR’s new guidance

Introduction

TPR has published new guidance on assessing and monitoring the employer covenant of a DB pension scheme.

Replacing TPR’s original 2010 guide to “monitoring employer support”, the new guidance is designed to provide practical assistance on evaluating the “extent of an employer’s legal obligation and financial ability to support its DB scheme now and in the future” (known as the “employer covenant”).

Although primarily aimed at trustees and their advisers, the guidance will also be of interest to employer sponsors of DB schemes.

Key points

The general approach outlined in the guidance is not new, but the content has been revamped in the light of the new DB funding code of practice which came into force on 14 July 2014 (see our Alert for details). In particular, it now addresses TPR’s newest statutory objective of minimising any adverse impact on the sustainable growth of an employer when exercising its scheme funding functions.
Trustees are advised to perform a full covenant review at each valuation and, as the covenant can change quickly and have implications for a scheme’s funding and investment strategies, regularly monitor it between formal reviews.
The assessment should focus on entities with a legal obligation to support the scheme.
According to the guidance, “trustees should consider obtaining independent external covenant advice where they lack the objectivity or expertise required to perform an appropriate assessment”.

The guidance

The key message in the new guidance is that a sound understanding of covenant is an essential part of an integrated approach to risk management.

While TPR does not require trustees to eliminate all risks to their scheme, it considers it vital that they understand and actively manage the risks they are taking. A core principle of the DB funding code is that trustees’ risk-taking should be informed by the ability of the employer to address a range of likely future downside scenarios over a reasonable period. The employer covenant underwrites the risks to the scheme and, according to TPR, an understanding of the covenant should underpin the trustees’ approach to:

investment, such as the appropriate level of investment risk that can be taken
funding, for example, the overall level of prudence in the actuarial assumptions and recovery plan.

In this context, the guidance aims to help trustees decide:

who should assess the covenant
what a proportionate approach should look like
how the covenant should be assessed in the context of the scheme (ie whether an external assessment should be commissioned)
how to monitor the covenant on an ongoing basis and prepare contingency plans to enable them react appropriately on identifying material changes in the covenant
what to consider with a view to improving the security of the scheme.

The guidance also outlines specific considerations for schemes in the not-for-profit sector and non-associated multi-employer schemes.

Case studies, checklists and examples of both inadequate and good analysis help to explain how covenant assessment and monitoring should work in practice

Approach

The guidance explains that trustees need to understand the employer’s covenant from a number of perspectives:

legal: the nature and enforceability of the employer’s obligations to support the scheme
scheme-related: the funding needs of the scheme, both now and in the future
financial: the ability of the employer to contribute cash when required.

The covenant should be assessed and monitored with a level of detail and frequency proportionate to the circumstances of the scheme and the 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.

The guidance sets out a non-exhaustive list of factors which affect whether a more or less detailed approach or a more frequent review is needed. For example, if the employer’s structure is straightforward and the scheme has a low deficit on a prudent basis in the context of the employer’s profitability and cash flow, this would suggest a less detailed approach and / or a less frequent review. However, an underfunded scheme which will require material deficit reduction contributions and investment returns to reach full funding, and whose sponsoring employer is small relative to the scheme and generates limited cash flows, would suggest the opposite.

Trustees should take into account all the factors relevant to their scheme when deciding on the required depth and frequency of review.

In carrying out the assessment, trustees and employers are advised to “work openly and collaboratively together”. Trustees should document the process clearly, and their conclusions.

Next steps

Later in 2015, TPR intends to produce further guidance to help trustees navigate the DB code, including guides on integrated risk management and investment strategy.