Governance Spotlight: Employer Covenant


Introduction

The second instalment in our series of newsletters from the Sackers’ Governance Team distils the key principles from the mass of messages about monitoring employer covenant.

For DB schemes, the sponsor’s ability to support the scheme financially into the future is critical. It not only underpins the security of members’ benefits, but will drive the trustees’ funding and investment strategy. What essential steps should trustees be taking?

In this Alert:


What is the employer’s covenant?

  • TPR’s latest guidance defines covenant as an employer’s legal obligation and its ability to fund the scheme, both now and in the future.
  • Understanding the employer’s obligation in law to the scheme is therefore vital. As this can be hard to establish in multi-employer schemes or complex corporate group structures, turning to your lawyers will be the first port of call.
  • In a shift from recent thinking, TPR’s view is that the employer’s “willingness” to support the scheme does not define its covenant – although it will drive consequential matters such as a funding plan.
  • The other key strand is the employer’s financial position, on a forward looking basis.

Are trustees obliged to appoint professional covenant advisers?

  • There is no express legal obligation to do so.
  • But the regulatory environment is now akin to one of “comply or explain”, with intense pressure on trustees to justify why they might opt not to.
  • Trustees should consider whether they have the skills themselves to assess the employer’s financial covenant – recognising that they may be constrained by resources and the need for objectivity.
  • In our experience, an independent view can often add a new perspective even where trustees have the necessary skill set.

Proportionate approach

  • When spending scheme funds to pay for covenant advice, trustees should take a proportionate approach in the context of the scheme’s exposure to risk and volatility.
  • Cost and necessity drive the concept of proportionality, with TPR encouraging trustees to avoid standardised reports and to seek added value instead. Ask yourself: what will a detailed covenant review add?
  • There is plenty of choice, with a well developed market of covenant advisers. We can help trustees run a robust selection process and map out the type of review to be undertaken.
  • Remember, history does not determine the future. The employer’s ability in the past to fund the scheme will not necessarily be borne out in the future.

Ad hoc or a regular agenda item?

  • The valuation cycle, scheme mergers or known material changes to the employer’s business / sector can indicate the need for a comprehensive assessment of covenant.
  • But TPR also strongly encourages trustees to carry out regular covenant reviews. Regular, less detailed assessments can be an appropriate way to monitor covenant.
  • Given the central function of covenant monitoring to so many aspects of trustees’ duties, it is important to implement a framework that is fit for purpose in what are often rapidly changing conditions.
  • Many of our clients find that delegating monitoring responsibility to a suitably empowered sub-committee helps to achieve the objective of proportionality.

The bigger picture

  • Assessing and monitoring the employer’s covenant is critical to the proper discharge of trustees’ duties, but it does not have to drive a wedge between trustees and employers.
  • Trustees need to understand and respect the employer’s concerns around confidentiality so as to build and maintain an appropriate relationship of mutual trust.
  • Developing and implementing a workable protocol with the employer for the sharing of information can ease tensions, ensuring that trustees receive timely and pertinent updates about the employer’s ability to support the scheme.
  • Sometimes though trustees will need to stand firm: we can advise on the legal levers to pull where employers refuse to engage appropriately in sharing with trustees the information they need to monitor the employer’s covenant.

How we can help

As well as advising on the legal aspects of covenant, we can bring our in-depth experience to bear in:

  • working with trustees to evaluate their skills and objectivity in considering the need for professional covenant advice;
  • assisting trustees in carrying out a robust selection process when appointing covenant advisers, including negotiating appointment terms;
  • helping to map out the scope of advice to be provided;
  • drafting terms of reference when delegating to a covenant monitoring sub-committee; and
  • developing an information protocol with the employer that balances the trustees’ objectives with the employer’s concerns around commercial confidentiality and sensitivities.

Monitoring employer support, November 2010