The employer's legal obligation and its ability and willingness to fund the scheme now and in the future is known as the employer covenant. The employer covenant effectively underwrites the risks to which the scheme is exposed such as underfunding, longevity and investment.
The Pensions Regulator expects trustees to assess and regularly monitor the employer covenant. It has published a statement setting out what it expects of trustees. It has also published guidance for trustees on monitoring employer support as well as a short guide for employers.
Trustees should begin by identifying which companies are legally obliged to fund the scheme and to what extent. The wider employer group may also be important if, for example, a parent company has given a guarantee.
Employers should be encouraged to share information with the trustees at an early stage. Bear in mind that the information the employer provides could be confidential, and the employer might want the trustees to sign a confidentiality agreement. Trustees should also look at publically available information such as statutory accounts, credit ratings and comments in the financial and trade press.
In most cases, trustees should carry out a full review of the employer covenant at each valuation. This will help them decide what level of risk is acceptable for the funding and investment strategies. Covenant assessment is a complex process and trustees are likely to require independent professional advice to assist them in making their assessment.
It is good practice for trustees to treat covenant review, however informal, as a standing trustee agenda item.
The Pensions Regulator expects trustees to monitor the covenant on a regular basis. They need to consider how often to do so. Working within the employer's existing financial reporting obligations will save cost and time, but additional reporting may be required on certain events, such as a business sale. It is good practice for trustees to treat covenant review, however informal, as a standing trustee agenda item.
The regulatory 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 and trustees should avoid placing too much reliance on verbal assurances of support from management or on historical performance.
Trustees should keen the scheme's investments in mind when assessing and monitoring the employer covenant. A weaker covenant may encourage trustees to invest in lower risk investments.
Trustees should be proactive and have in place processes so that they can act quickly on triggers or warnings, such as the employer breaching one of its banking covenants or if there is a change in employer ownership.
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. Additional funding could be sought from the employer; or another form of security, such as a guarantee. However, trustees must also balance the employer's needs. A solution that threatens the viability of the employer is unlikely to be in the interests of the scheme or its members.
A regular covenant review can ensure that trustees are better prepared if the employer's covenant significantly deteriorates such that it can no longer support the scheme. If this happens, The Pensions Regulator has powers to require other companies within the group to provide support. Understanding what the regulator would look for, and using the 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.