The Pensions Regulator (the “Regulator”) has begun publishing its series of guides for trustees of defined benefit occupational pension schemes. The series of guides is designed to assist trustees’ understanding and interpretation of the new DB Code of Practice, which was published in 2014. This article considers the main issues raised in the Regulator’s ‘Guidance on Assessing and Monitoring the Employer Covenant’ (the “Guidance”). The Regulator hopes that the Guidance will shed light on the importance of proper employer covenant assessments and monitoring as part of an on-going integrated approach to managing scheme risks. The Regulator recommends that trustees undertake a full covenant review at each triennial valuation as well as focussing on interim monitoring, as the strength of an employer covenant can change significantly over a three year period. Background - Covenant Assessments The employer covenant, as defined in the DB funding code, is the extent of the employer’s legal obligation and financial ability to support the scheme, both now and in the future. The strength of the employer’s covenant underpins trustees’ decision-making on investment and funding risks. The Regulator is not seeking to increase the burden on trustees or employers but wants to ensure that covenant assessments and monitoring adds value to the trustees’ decision making. The Guidance outlines a number of important factors for the trustees to take into account during this task, as well as emphasising the importance of clearly documenting the covenant assessment process. What should trustees consider when assessing covenant? The Regulator has set out three key areas which trustees should take into account when assessing the covenant: The employer’s legal obligations to the scheme. The strength of a covenant is only as good as the enforceability of the legal agreements tying the employer to the scheme; The funding needs and investment risk of the scheme. The scheme’s size, funding position, level of investment risk and maturity of members should all be reviewed against the strength of the employer and its ability to meet its obligations in relation to the scheme; The financial support from the employer and any other entities. Does the employer’s corporate or covenant structures materially affect the strength of the covenant and their ability to meet current and future obligations? This assessment should cover the financial support in the short, medium and long term. Annexed to the back of this article are 10 key questions which the Regulator believes trustees should consider when rating the employer covenant. Taking a Proportionate Approach Covenant reviews and on-going monitoring can be expensive, in terms of both cost and manpower for both trustees and employers. The Regulator seeks to give trustees guidance on what is a proportionate approach to covenant assessments, but this will depend on the circumstances and nature of the scheme in question. Where an employer covenant is based on a simple structure, operates in a stable market with high cash flow, low deficit and without significant other material calls on its cash flow (i.e. debt repayment) the Regulator indicates there is scope for the trustees to adopt a less detailed or frequent approach. If however the employer operates within a complex corporate structure, in a volatile market where there are substantial calls on cash flow (i.e. debt repayment, acquisitions and refinancing) and the scheme requires additional funding to support a deficit, the Regulator supports a more comprehensive, regular approach. In addition, the Regulator has indicated that trustees of multi-employer schemes may require legal or actuarial advice due to the complex structures that can be in place. In a last man standing scheme for example, trustees will need to consider which entities should form the basis of the review and only the information specific to employers who have a direct obligation to support the scheme should be considered. Where a scheme is formally segregated, trustees need to be aware of which employer is legally obliged to support each section. Significant to the above is the trustees’ relationship with the employer and the integrated approach championed by the Regulator. A strong and open relationship will allow trustees to take a proportionate stance where appropriate and avoid unnecessary costs. In addressing proportionality the Regulator has also provided helpful guidance on whether or not there is a requirement to commission an external covenant assessment, and emphasises that trustees should consider the costs of commissioning this as against any potential benefits for the scheme. When deciding whether to commission an external review, trustees should consider their expertise and experience, whether as a whole they can take an objective view, how reliant the scheme is on the covenant, if there are any complex legal or operating group structures, whether the covenant structure has significantly changed and the relationship between the employer and trustee. Monitoring The Regulator knows that there can be significant changes between full reviews and is promoting continuous assessment by trustees. By keeping track of key performance indicators trustees will be able to identify any material causes for concern and act quickly to work with employers to protect the scheme’s funding and investments. Trustees should be aware of any changes to an employers’ ability to fund the scheme, changes in corporate structure and changes to the employers’ industry. The Guidance sets out a useful list of ‘triggers’ which trustees should be mindful of, but trustees should also decide on appropriate triggers in the context of their Scheme. Improving Scheme Security Trustees should be consistently reviewing the scheme’s security and working with the employer to improve the current position. Taking a flexible approach and working with employers can help secure a better future for both trustees and employers. The Regulator identifies some examples of ways to improve scheme security. These consist of commitments to increase funding on certain events, the provision of asset security, guarantees from other entities, negative pledges to obtain trustee consent and improving the scheme’s insolvency priority. The Regulator has advised that trustees need to carefully consider the value placed on contingent assets or security. When considering contingent assets the trustees need to think about what support the scheme requires, whether the asset is appropriate and whether they are foregoing any other support. Furthermore, consideration should be given to likely value upon the employer’s insolvency. The Regulators guidance makes use of worked examples throughout and there is also further specific information contained in supporting appendices regarding drawing up a brief for a covenant advisor, considerations for not-for-profit organisations and further considerations for non-associated multi employer schemes. Employer Trustee Relationship A key relationship for trustees is with the employer – see our questionnaire for initial considerations when considering this at www.irwinmitchell.com/about-us/newsletters/pensions-update/scheme-governance. 10 Key Questions The Regulator has summarised 10 key questions which the trustees should be able to answer in order to understand the extent to which the employer can afford to support the scheme now and in the future, including the risks to this support being available when it is needed: Through which employers can the scheme access value? What is the trustees’ assessment of the employer’s current and likely future profitability and cash flow? How do these compare with the likely funding needs of the scheme both now and in a downside scenario? Over what period of time can the employer afford to repay the scheme’s funding deficit? Is the scheme being treated equitably with other stakeholders? Could the employer afford to increase deficit repair contributions (“DRCs”) in the event of adverse scheme experience, and over what period? Do the employer’s plans to invest for sustainable growth restrict support for the scheme? If so, how will the scheme benefit and to what extent are other stakeholders also supporting the investment? How much value could the scheme recover in an insolvency of the employer? What are the risks to the covenant and how may it change over time? What options are there to improve security to the scheme? What are the potential implications of all this for the scheme’s investment and funding strategies? For general enquiries 0370 1500 100 Or we can call you back at a time of your choice Request a call back Phone lines open 24/7, 365 days a year Contact us today For a free initial consultation Freephone 0370 1500 100 Prefer not to call? 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