UK Pensions Briefing | Pensions Regulator publishes updated employer covenant guidance: Key messages

Key messages: Overview

• The employer covenant is the extent to which an employer has a legal obligation and financial ability to support a scheme now and in the future, as well as any support from contingent assets.
• At a minimum, trustees should assess the employer covenant at each valuation.
• This should focus on the employer’s ability to make cash contributions to the scheme, and the scheme’s access to contingent asset support, to eliminate any existing funding deficit and to address any further deficit that could arise from a scheme-related stress event.
• Trustees should ensure that the aggregated level of risk taken by the scheme is supported by the employer covenant.
• As well as supporting trustees through the valuation process, covenant assessments are also used to respond to other scheme-related events such as scheme mergers, transfers to a superfund, as well as employer-related events such as mergers and acquisitions, restructuring or periods of corporate distress. Considering how the employer covenant changes before and after these events will be a factor in determining if mitigation is required.
• The required depth, and frequency thereafter, of an assessment should be proportionate to the circumstances of the scheme and employer. The approach taken should be documented and trustees should be able to justify why it is reasonable and appropriate.

Key elements of the updated guidance

The updated guidance is divided into eight modules covering two elements of employer covenant:

1. Financial ability of the employer to support the scheme in relation to its legal obligations
   
   This element will include the following:
   1. Identifying employers and assessing their legal obligations.
   2. Assessing the employer’s current and future cash flow.
   3. Assessing the employer’s prospects.
   4. Assessing the reliability period and covenant longevity period.
2. Expected support from contingent assets, if legally enforceable and financially sufficient
   
   This element will include the following:
   5. Contingent assets.
   6. Recovery plans.
   7. Determine covenant information need to assess supportable risks.
   8. Monitoring the covenant and taking action.

In assessing the covenant, trustees will need to exercise judgment, having taken professional advice.

Proportionality: Factors that affect the level of assessment and frequency reviews

As mentioned above, assessments should be proportionate to the circumstances of the scheme and employer. Relevant factors include, but are not limited to, the following interrelated matters:

• Size of the scheme both in absolute terms and relative to the size and level of covenant support provided by the employer e.g. a light touch assessment may be more proportionate where the employer is very large relative to the size of the scheme and it has ample cash flow.
• Funding level of the scheme e.g. a light touch assessment may be more proportionate where the scheme is already well funded on a low dependency funding basis, solvency basis or both.
• Level of funding and investment risk within the scheme journey plan e.g. a light touch assessment may be more proportionate where the scheme’s journey plan relies on only a small amount of risk being taken before the relevant date.
• Maturity and expected cash flows of the scheme e.g. maturity should not be considered in isolation, but in the context of the scheme’s funding level and level of risk-taking. A more detailed covenant assessment is usually likely to be required where a scheme is reaching significant maturity and is underfunded or running moderate to high levels of risk in its journey plan.

Once an approach has been decided, trustees should document this and be able to demonstrate why it is reasonable and appropriate. 

When to commission a professional covenant assessment

The guidance states that deciding when to commission a professional covenant assessment, in full or in part, will depend on a range of specific scheme and employer risk factors (as listed in the guidance). The decision should include considering the overall impact of these risk factors taken together and weighted appropriately based on the scheme’s circumstances. 

Trustees should periodically assess whether to commission professional covenant advice, as changing circumstances for the scheme or the employer may lead to situations where it can add greater value. 

If trustees decide not to obtain professional advice and to perform their own assessment, they should be comfortable that they can adequately perform all the relevant steps set out in the guidance, and fully document and be prepared to explain their analysis and conclusions.

Conclusions

The Regulator expects trustees to use the guidance to assess whether their existing covenant analysis is focused in the right areas and remains proportionate, particularly if the scheme has experienced a "significant change" its funding position.

The guidance emphasizes the Regulator’s commitment to protecting member benefits and ensuring employer support aligns with the scheme’s risk profile. The Regulator expects trustees to assess the “reliability period” during which the employer can be reasonably depended upon to support the scheme (which the Regulator considers will be three to six years for most employers). Trustees should also consider the “longevity period” for which the employer’s support will last (which the Regulator considers this will not exceed 10 years for most employers). Trustees are urged to read applicable sections of the guidance in full and to ensure their scheme members are protected.

The guidance also details how trustees should approach ascribing an appropriate value to contingent assets and contains a number of worked examples. For example, where trustees benefit from a “look through” guarantee (i.e. where the guarantee provides an ability to for the trustees to claim all monies owed by the employer to the scheme directly from the guarantor without any restrictions or qualifications once a trigger event has taken place), the guidance states that the trustees should assess the guarantor’s financial ability to support the scheme as if it was a statutory employer. This is a significant change from current practice, and it will be interesting to see how covenant advisers’ approach this in practice, as most guarantees we have seen do not operate on a “pass through” basis.

A high bar has also been set for trustees, who need to have “reasonable certainty” when, for example, setting the reliability period and the longevity period, but with no definition of this term in the guidance.

While for some schemes, the updated guidance will represent ‘business as usual’, others will need to adapt their approach, with sponsors likely needing to provide more information to trustees to support their assessments. However, for most employers, this will be an opportunity to take a more pro-active role, so that information shared is better and covenant focussed, as a failure to do this may result in a weaker covenant assessment by the trustees and, ultimately this could lead to higher contributions.