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OPDU Report 26 October 2009 Advisory Service Forum The employer that stands behind a defined benefit scheme underwrites the risks that the scheme is exposed to. This includes longevity, investment and inflation risk. The employer effectively acts as the scheme’s insurer, guaranteeing members’ benefits if the scheme proves to be under resourced. This ‘insurance’ is the scheme covenant. A covenant assessment is therefore an assessment of the strength and reliability of that ‘insurance’. It provides the trustees with an independent and objective view of the financial strength of the employer and the likelihood of it being able to meet any call in respect of unfunded liabilities. When setting technical provisions during a scheme specific valuation, the reliance that can be placed on the employer to underwrite the risk that experience may vary adversely from the assumptions made, is a fundamental part of assessing what assumptions are appropriate for valuing scheme liabilities. Covenant assessment and valuation are therefore inherently linked and the assess-ment process is integral to valuations. The impact of the economic downturn on covenant assessment The economic downturn and the restriction of credit have affected many employers and have had a consequential impact on covenant strength. In June 2009 the Pension Regulator published a statement reiterating guidance on its flexible approach to scheme valuation and stressed the need for trustees and advisors to continue to focus on ‘the proper consideration of the employer’s covenant in setting prudent targets and appropriate recovery plans’. The Regulator’s guidance was specifically aimed at addressing uncertainty in the minds of employers and trustees on how to deal with the valuation process in light of the recession. It recognised that many sponsoring employers face cash constraints and greater uncertainty regarding future prospects, but was clear that in setting technical provisions the trustees must take into account the extent to which the employer can support them. The Regulator specifically stated that: ‘Where the employer covenant is so weak as to be negligible, the assumptions should be chosen so that the scheme is self sufficient, this means that technical provisions should be set at the level at which they can be expected to meet the full accrued liabilities and expenses in the future on the basis that the scheme had been closed and all risks minimised’ ‘If the employer covenant is considered to be strong relative to the scheme, the technical provisions could be set using assumptions which reflect the strong ability of the employer to underwrite any risk that actual experience in the future might vary from the assumption made’ ‘However, even in circumstances of a strong employer covenant, the assumptions made will still have to be prudent in the context of the scheme’ It is clear therefore in these economic times, that trustees are expected to make the assessment of the employer covenant an integral part of the valuation process. Assessing covenant strength In assessing the strength of the employer covenant trustees need to gain an understanding of a number of different aspects of the employer that underwrites the scheme liabilities. These may include the matters below. The employer’s legal obligations to fund the scheme Trustees need to understand which companies are legally liable to make contributions. This is usually only companies who are participating employers. Where the employer is part of a group of companies this may not include companies to which scheme members provide services, (for example where members are employed by a service company), or companies that hold the assets of the group. In group situations group companies outside the formal legal structure often provide support to the scheme. In these circumstances it is important to understand the relative importance of the employer to the group as a whole. To assess how integral the employer is to the achievement of the group’s strategy and whether it is appropriate to place reliance on ongoing group support if the risks of group insolvency are considered remote. The employer’s corporate group structure In group situations trustees need to understand how the group structure may affect the covenant strength. For example, cash may be held centrally, outside the covenant, due to a centralised treasury facility. Often, where the parent company is registered overseas cash may be held offshore. This type of structure may put the scheme in a worse position in the event of group insolvency, as witnessed in the much disputed transfer of funds from London to New York prior to the Lehmann’s collapse in 2008. It is therefore a risk factor that needs to taken into account in covenant assessment. Corporate debt may also have been guaranteed by the employer, which may put the scheme in a subordinated position in the event of group insolvency. The financial strength of the employer relative to the scheme deficit The trustees need to understand the financial strength of the employer in terms of its capital base, availability of cash and its current and future profitability, relative to the size of any ongoing and buy-out scheme deficits. An employer whose adjusted net assets are less than or equal to 50% of the buy-out debt is considered to be insufficiently resourced in pension legislation. This can be used as a guide to financial strength but is only one aspect of the wider consideration. The industry risks associated with the employer Trustees should ensure that they have a good understanding of the risks associated with the sector that the business is in. For example, is the business cyclical? Where does the industry sit in the business life cycle? What are the competition threats? What legal or regulatory issues may affect the business? The employer’s debt structure The trustees should gain a good understanding of the debt structure supporting the business and the risk associated with this debt. For example, is the level of debt commensurate with the size of the business? What is the timetable for repayment? Will new sources of funding need to be negotiated and when? Can the interest burden be supported? What security has been granted? What rights attach to shareholders? Overall view and assessment of options to strengthen covenant Having performed an analysis of the matters relevant to the specific employer, an assessment of the covenant can be made and an assessment made of the options that may be available to improve the covenant. Options for strengthening the covenant Options may include the formalisation of group support arrangements through the provision of guarantees, the provision of contingent assets, or an agreement to certain triggering criteria such as maintenance of agreed levels of capital in participating employers or agreement of group undertakings regarding dividend payments. Contingent assets Thinking around the provision of contingent assets has advanced in recent months with many employers considering the possible use of securitised income flows to generate a contingent asset that can be made available to the scheme. This is an interesting development and an option that should be considered as part of the overall review. Monitoring changes in covenant on an ongoing basis The Regulator has also released recent guidance on scheme abandonment and clearance applications. The guidance stresses the importance of assessing the value of the employer covenant in those circumstances. Outside of the triennial valuation many circumstances can arise where the trustees need to be able to react and respond to employer notification of transactions that may impact on the covenant. In order to be able to respond knowledgably and quickly trustees should ensure that they have a system in place to monitor any changes affecting their assessment of the employer covenant so that they are in a position to deal appropriately with any proposed activity. Monitoring keeps the covenant assessment current and imbeds the knowledge gained from an assessment into the general administration of the scheme. Engaging covenant advisors Due to the complexities often involved in covenant assessment situations, many trustees engage covenant advisors to help them. In engaging such advisors the following may be of assistance: Consider appointing a sub-committee Scope of work
. Advisors should also provide guidance on appropriate procedures for ongoing monitoring and be prepared to work with existing actuarial and legal advisors to ensure that the trustees receive advice which is consistent and robust. Sarah Ellis |
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