The Pensions Regulator has updated its guidance for trustees on assessing the employer covenant. This is not a short document – running to 66 pages; however, the last 13 pages are relevant only to not-for-profit organisations and multi-employer schemes for non-associated employers.
The Regulator recommends that, as a minimum, all trustees read:
- “At a glance” on page 6 – a summary of the key points of the guidance – and
- Section 1: “Introduction” (pages 7 to 15) which covers the role of the covenant and the principles that should underpin trustees’ decisions about how to assess the covenant and when to commission an external review.
Section 1 sets out the key points for consideration when assessing the employer covenant and includes examples of “good” and “inadequate” assessments. The Regulator stipulates that a full assessment should be carried out at least once every three years, at the time of the actuarial valuation. It then lists issues for the trustees to consider in deciding:
- whether more frequent assessment is necessary and
- when to commission an external review.
Internal assessment
Trustees who assess their employer covenant themselves are expected to read the whole of Section 2: “Assessing the covenant”, on pages 16 to 46. This section explains how the trustees should assess the legal obligation and financial ability of the employer to support the funding needs and investment risk of the scheme. The Regulator expects the whole trustee board to understand and put into practice the principles outlined in this section.
In this section the Regulator suggests that covenant assessments should focus on three key areas:
a) the employer’s legal obligations to the scheme,
b) the funding needs and investment risk of the scheme and
c) the financial support from the employer and any other entities.
a) In terms of an employer’s legal obligations the guidance helps trustees to identify those employers with a legal obligation to the scheme, including those acting as guarantors. It notes further that they should also be familiar with the balance of powers set out in the scheme’s trust deed and rules.
This sub-section contains some useful examples of companies providing support to schemes in different ways, suggesting how trustees should approach each type of arrangement when assessing the relevant covenant.
b) This sub-section suggests that, in the context of funding needs and investment risk, trustees should consider the size of the scheme’s deficit relative to the size of the employer, the level of investment risk and the maturity of the scheme. Examples are included to illustrate the relevant issues.
c) The covenant assessment should look forward and cover the financial support that the employer can provide in the short-term (within two years), medium term (two to five years), long-term (beyond five years) and in the event of employer insolvency. To help trustees assess this, there is detailed guidance on considering:
- the employer’s current financial resources,
- the employer’s prospective financial performance (ie cash flows)
- the markets in which the employer operates, the medium and long-term outlook for those markets and the employer’s competitive position in those markets,
- the estimated outcome for the scheme in the event of employer insolvency and
- (if relevant) the impact of the employer’s wider group.
Again, the sub-section includes examples to illustrate the principles and there is guidance on the assessment of employers’ sustainable growth plans.