The Pensions Regulator (TPR) have recently issued guidance for defined benefit (DB) schemes on how to assess and monitor the employer covenant (“the guidance”). This guidance aims to provide trustees and employers of DB occupational pension schemes with detailed good practice guidance to assist with their duties in the process of employer covenant assessment. This guidance will be welcomed by DB scheme trustees as to quote my colleague Richard Smith’s June 2015 blog “What drives your Employer Covenant?“, “…assessing the strength of a company and then monitoring the way that changes is no easy task”.
In July 2014 the TPR issued its revised Code of Practice 3: Funding Defined Benefits (“COP”) which identified three key areas of risk DB schemes face and how these risks interrelate;
1. Employer Covenant Risk
2. Investment Risk
3. Funding Risk.
TPR expects that where significant changes occurs to one of these influencing strands, that appropriate adjustments are made to the others. For example, if the trustees are considering changing their investment strategy to invest a higher proportion of their assets in return seeking assets such as equities, they should consider the impact this will have on the schemes funding and on the employer covenant. Is the employer covenant strong enough to withstand investment returns which turn out to be lower than expected? This guidance is a useful tool for trustees to assist them in answering such questions.
TPR have structured their guidance in an easy to follow manner. TPR recommends a minimum read for all trustees being their ‘At a glance’ summary of key points and their Introduction which specifies how to approach covenant assessments in a proportionate way. For those trustees who carry out their employer covenant assessment themselves there is a whole section “Assessing the covenant” explaining how to go about it. This section is filled with useful examples, facts and guidance on how to deal with scheme specifics when assessing the covenant. Throughout the guidance TPR highlight recommended key points for consideration specifying exactly what it is trustees need to consider during each step of the covenant assessment process.
In particular, the guidance outlines three key areas of covenant assessment;
- Legal- the nature and enforceability of the obligations to support the scheme
- Scheme-related- the funding needs of the scheme, now and in the future
- Financial- the ability of the employer to contribute cash when required.
If trustees are unsure as to whether or not conduct the employer covenant assessment themselves the guidance also specifies key points for consideration when making the decision of whether to commission an external covenant assessment. Relevant factors include whether the trustees have the necessary experience and expertise required and whether the trustee board are able to take an objective view of the covenant or do conflicts of interest exist?
The guidance certainly succeeds in providing trustees and employers with a clearer understanding of their duties when it comes to assessing the employer covenant. Although not exactly a light read – the guidance will prove to be an important tool for DB scheme trustees as they comply with TPR’s revised Code and monitor their scheme’s exposure to risk in the future.