What do funds need to think about when it comes to employer covenant and their overall employer risk management framework in a changing landscape of increased funding levels, challenging economic conditions, and mounting pressure for contribution reductions.
Management of employer risk
A clear and transparent integrated risk management approach is the foundation on which to build policies for funding, investment, and management of employer risk – “covenant.”
Employer covenant is an employer’s legal obligation and financial ability to support its pension obligations now, and in the long term. This underwrites the risks inherent in the investment and funding strategy: member benefits are ultimately paid for via a combination of investment returns and contributions.
Crucially, if more risk is being taken in the investment and funding strategy (e.g. riskier investments and/or less prudence in the assumptions), this increases the fund’s reliance on the employer as it increases the risk of a funding gap i.e. shortfall, arising in future.
Whilst much of the focus for the 2025 Local Government Pension Scheme (LGPS) actuarial valuations will be on funding and investment strategies, it has never been so important for funds to also consider employer risk.
We comment in this briefing note on the key areas funds should be thinking about and how we can support you. In particular, how our recent acquisition of Cardano, a specialist covenant advisor, will help funds “Discover” a new way to approach covenant analyses and monitoring.
What should funds be thinking about?
Some of the key areas funds should be thinking about are set out below:
Historically, where employer covenant is concerned, funds have focussed on those employers without any form of guarantee, when looking to set contributions that are fair and affordable, whilst prudently managing risk to the fund in the long-term. Typically, given the historic funding levels, discussions have centred around the level of deficit contributions.
However, given recent improvements in funding for many LGPS employers, as part of their funding policies, many funds will soon need to decide on the extent to which funding surpluses will be utilised for contribution reductions - in many cases for employers facing severe budget challenges.
Establishing an effective employer risk framework therefore becomes vital for funds.
The new FSS guidance published by the Scheme Advisory Board gives increased focus on how employer risk is managed, integration of employer risk into the funding strategy and the funds communication of its approach, stating:
“The FSS should also set out how the fund assesses covenant risk.”
“The FSS should clearly set out the risk assessment methodology and criteria by which the fund will assess the long-term financial health of employers, and how this will be monitored.”
“A key activity when reviewing and developing the FSS is the communication and engagement activities.”
What assurances can you provide that such reductions will help improve your covenant in the long-term should funding positions deteriorate and contribution increases are required in the future?
So, what constitutes an Effective Employer Risk Framework?
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Assessment
Needs to be proportionate so the fund can focus resources on where risk is greatest, backed up by expertise where a deeper analysis is necessary. -
Monitoring
Tailored to the risks presented by individual employers and utilising resource efficiently. -
Communication
Two way – proactive, clear, and robust communication on funding and policies to employers and notification from employers on material events that will impact employer risk. -
Integration
Clear and transparent links between employer risk and decisions around contributions and investment strategy.
How we can help you manage employer risk efficiently
Led by experts in corporate finance and restructuring, Mercer’s specialist covenant team has provided support to LGPS funds for over 20 years.
In 2024, we acquired Cardano, a leading specialist covenant adviser, which further enhances our covenant offering to LGPS funds in terms of specialist advice and tools to support all elements of your employer risk framework.
Recognising that complexity and cost can pose challenges for funds, this includes development of a market leading approach to monitoring of employer covenant utilising AI.
Cardano’s Discover tool can provide proportionate and effective covenant analyses and monitoring for LGPS funds and provides a cost-effective solution for funds juggling a myriad of challenges.
Discover can be accessed through an easy-to-use online portal. This enables funds to monitor and rate covenants across multiple and diverse employers in real-time. It includes an option for funds to require employers to upload data directly to the tool, minimising the administrative burden, allowing funds to focus resources elsewhere. The tool is able to:
- Provide an overview of all employers in the fund selected to be monitored with the ability to drill down and interrogate each.
- Give employer covenant ratings complete with rating drivers.
- Monitor news flow and public peers in between financial information.
- Automatically alert funds to covenant developments.
- Benchmark covenant metrics.
- Explore what-if scenarios for funding and corporate activities.
- Streamline information collection, going directly to employers.
At a time when there is pressure on funds in all areas, Discover does the heavy lifting, so you don’t have to, with the cutting-edge use of AI to accelerate the automation journey. Underpinned by our team’s extensive knowledge and expertise in assessing the covenant of LGPS employers, specifically when funds need it in more complex situations, the combined approach brings the best of both worlds: robust risk management packaged in a cost-efficient monitoring framework.
Discover AI Powered Covenant
- Senior LGPS Covenant Consultant
- Senior Director, Cardano