Updated guidance on assessing employer covenant

The Pensions Regulator has issued updated guidance for trustees of defined benefit schemes on assessing and monitoring employer covenant.

Employer covenant – three perspectives

This guidance makes clear that, when assessing employer covenant, either with advice from a covenant assessor or based on their own assessment, the trustees should consider the employer covenant from three different perspectives:

  1. Legal – which takes into account the nature and enforceability of the obligations on the employer to support the scheme.
  2. Scheme-related – which takes into account the funding needs of the scheme, both at the time that the assessment is performed and in the future.
  3. Financial – which takes into account the ability of the employer to be able to contribute cash to the scheme, as and when required.

Key points for trustees to consider

Below is a useful list of key points that trustees should bear in mind when assessing employer covenant, which are also included in the guidance:

  • Through which employers can the scheme access value?
  • What is the trustees’ assessment of the employer’s current and likely future profitability and cash flows?
  • 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 of time?
  • 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?

Should an independent review be commissioned?

In certain circumstances, trustees can assess employer covenant themselves. In such cases, it is imperative that they familiarise themselves with and follow the guidance. The guidance also provides useful comment on when trustees should consider commissioning an independent review of covenant as opposed to, or in addition to, assessing this themselves. 

The Regulator’s view is that the appropriate approach will depend on a number of scheme- and employer-specific factors, as well as the circumstances of the scheme, but the trustees should consider appointing an expert where:

  • They do not have the necessary expertise and experience to assess the covenant.
  • The trustees are not able to take an objective view (where, for example, an influential trustee holds an important role with the employer).
  • The scheme is highly reliant on the covenant (for example, under-funded or with a high risk investment strategy).
  • The covenant is complex (for example, where there is a complicated group structure or when asset-backed contributions are being used).
  • The covenant is undergoing significant change (for example, an employer restructuring).
  • The employer and trustees do not have a good relationship.

This new guidance will be a welcome support to trustees of defined benefits schemes when assessing and monitoring employer covenant but if you have any questions or would like further information, please contact one of our pensions specialists below.

Author: Vicki Thomas

This information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.

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