Employer covenant – first set of guidance issued

In this Alert:

• Key points
• What is the employer covenant?
• Whose covenant should the trustees assess?
• Assessing the employer covenant?
• Monitoring
• Contingent Assets

Key points

• TPR has produced draft guidance1 for trustees on how to monitor employer support.2
• This includes information on how to assess the sponsor’s (and other employers’) covenant.
• The guidance also covers contingent assets.
• There is also a short guide for employers and a bite-sized learning moduleon employer covenant review.

What is the employer covenant?

The concept of employer covenant has been developed by TPR over the past few years. The draft guidance explains:

“The covenant is the employer’s legal obligation to fund the pension scheme now and in the future. The strength of it depends upon the robustness of the legal agreements in place and the likelihood that the employer can meet them.”3

The strength of the employer covenant has therefore become a crucial factor in relation to scheme funding (including the recovery plan). In assessing the covenant, the draft guidance advises trustees to focus on the financial position of those employers with legal obligations to the scheme – both now and in the future.

Whose covenant should the trustees assess?

To assess which companies to monitor, the trustees must identify which employers are liable to pay scheme contributions as well as identifying whether any other employers, such as former employers, may be responsible for providing support. For example, which employers may be required to pay an employer debt if the scheme went into wind up?

Assessing the employer covenant

TPR’s draft guidance says trustees “should consider appointing external experts to advise on covenant”, unless they have the requisite skills themselves.

Items on the TPR’s covenant hit list include:

• the employer’s financial position;
• the scale of pension obligations relative to cash flow;
• the strength of the industry sector;
• an analysis of the wider economy; and
• the relative priority placed on pension obligations by the sponsor’s board of directors.

Some of these items should be relatively straightforward for some trustee boards to assess, with appropriate information from the employer.4 But an estimate of the potential for cash recovery by the scheme on insolvency of the employer may require professional assistance, as might a detailed assessment of the group structure and any cross-group guarantees.

Monitoring

Regular monitoring is, of course, an important element of covenant review. An employer covenant can change swiftly as a result of economic circumstances or particular events. For this reason, TPR warns trustees to be wary of relying on historical information on covenant.

TPR advises that covenant should be a standing item on trustee meeting agendas, and that a full review should be conducted before each triennial actuarial valuation. Such a review may need to be updated on an annual basis and trustees may also need to react to one-off events, such as disposal of a business.

Contingent Assets

The draft guidance serves as a reminder that contingent assets can have a life beyond PPF levy reduction.

The guidance recognises that trustees and employers may wish to put contingent assets in place to increase the strength of the covenant or the security of the scheme. But, before doing so, trustees should focus on what they are foregoing, such as the potential for higher contributions which may be beneficial for cash flow.

1 The Consultation closes on 7 September 2010 – Sackers will be responding
2 Following an announcement last week – see our Alert dated 10 June 2010
3 Draft Guidance, paragraph 1
4 TPR specifically recognises employer concerns about passing on confidential information and indicates that trustees may be required to sign up to confidentiality agreements