Putting employer covenant at the centre of your DB scheme’s plans

The Pensions Regulator puts employer covenant at the heart of DB pension scheme journey planning.
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Assessing a DB scheme’s employer covenant

When undertaking a triennial valuation for a defined benefit (DB) scheme, trustees’ first considerations should be how strong is our employer covenant? And how much risk can it underpin? 

Assessing a DB scheme’s employer covenant alongside funding and investment risks is not a new concept for DB schemes – TPR has guided trustees to adopt robust integrated risk management (IRM) processes to ensure that these risks are appropriately balanced. However, TPR is now introducing the requirement for DB schemes to go beyond IRM and have a long term journey plan that is explicitly linked to employer covenant strength and its longevity. 

Assessing a DB scheme’s employer covenant: what should I consider?

TPR’s new funding requirements means an employer covenant will require far greater levels of consideration for many DB schemes

To set a long-term objective, as required by TPR, trustees must question and understand the sponsor’s ability to support the scheme. Here are some questions to consider when thinking about assessing employer covenant:

Visibility (1-3 years)

On a forward looking basis, do you know how much free cash your sponsor(s) will generate, and how much of this is “reasonable” for the DB scheme to receive?

Reliability (c.6 years)

How many years are you comfortable that your sponsor can generate these levels of free cash flow? How does this compare to the level of funding and investment risk the DB scheme is running?

Longevity

How long can you rely on the ongoing performance of your sponsor(s)? How sensitive is ongoing performance to changes in demand and other risks such as climate change?

Long term journey planning

Answering the above questions will be key to forming a DB scheme’s long term journey plan, establishing an appropriate funding target and investment de-risking strategy, and the ability of the sponsor to underwrite scheme risks. If you are unable to form a view on visibility, reliability and longevity, it could undermine your valuation.

Nearly all schemes need to assess their employer covenant on an ongoing basis, particularly with respect to future prospects. Going forward, many schemes will need to take independent employer covenant advice, some of which will be for the first time, to be able to demonstrate to all stakeholders that these risks have been given due consideration. 

Along a scheme’s journey plan there will be “bumps in the road” to navigate, and that is where integrated covenant, funding and investment monitoring plays its role.  Constant monitoring and responding to events as necessary is required to achieve the end goal. 

TPR’s new funding requirements mean trustees will need to question and understand a sponsor’s ability to support their scheme in far more detail than they have perhaps done in the past
Thomas Austin

Director, Employer Covenant

Mercer has the breadth and scale to guide you on the covenant

At Mercer we have always made employer covenant the starting point of our funding assessments, adopting a “covenant first” approach. We have a team of covenant specialists who work closely with our funding and investment experts across the breadth of the UK. Strength in all three of these areas is a distinctive feature of what Mercer can offer, although we also provide independent covenant advice alongside third party advisors and have a great deal of experience doing so in a seamless and integrated manner.

There are many scenarios where we provide employer covenant support, including:

We provide a range of reviews, from high-level desk top analysis for smaller, non-complex clients, all the way through to in-depth reviews for schemes sponsored by multi-national listed entities with complicated legal and operating structures. 

Our advice includes a focus on the “so what” of the covenant rating, linking the covenant strength reported to funding and investment considerations and to realistic and available options for covenant enhancement.

To ensure trustees keep abreast of how a scheme’s employer covenant develops over time, we provide monitoring reviews that can be provided on a monthly, quarterly, biannual or annual basis depending on scheme / employer risks. We advocate the use of a key performance indicator (KPI) dashboard that are RAG rated (red, amber, green) – this visual representation of employer covenant is intuitive and easy to understand regardless of a trustee’s financial background.

In addition, we help to establish notification protocols where employers are committed to inform trustees of activity that could impact the covenant (e.g. restructuring, refinancing, return of capital, M&A, etc.), which works alongside the requirements of the notifiable events regime. Having adequate covenant monitoring frameworks in place is high on TPR’s agenda for trustees and covenant should be a standing agenda item at all trustee meetings.

Where trustees are particularly focused on the level of cash contributions available to fund a scheme, it may be appropriate to conduct an affordability review. This exercise concentrates purely on the level of cash generation and/or liquidity a sponsoring employer has access to, and how much of that cash it is fair and reasonable for a pension scheme to receive.

Following changes to the Moral Hazard code introduced under the Pension Schemes Act 2021, scheme sponsors will need to undertake pre-emptive analysis of the impact of corporate actions and scheme related events on employer covenant. For trustees, the new objective Moral Hazard tests provide clearer benchmarks for assessing material detriment and the leverage they may have to seek appropriate mitigation.

Sponsoring employers often undertake corporate activity, such as an entity reorganisation, refinance, dividend payment or other return of capital, sale or acquisition of business, etc., that can reduce the strength of the employer covenant, consequently having a negative impact for a DB scheme. 

In these scenarios, TPR has set out its “Type A event” framework, within its Clearance guidance, that directs schemes and employers to assess the impact of corporate activity on employer covenant. Where the corporate activity is deemed to be “materially detrimental”, both parties need to agree upon “appropriate mitigation”. As neither of these terms are defined by TPR, we provide “Type A” reviews that assess the impact of corporate activity and advise upon appropriate forms of mitigation, which can include negotiation support where required. 

In certain circumstances, sponsoring employers may seek to reduce / suspend deficit payments, or indeed seek to permanently separate the DB scheme from the employer (via assisted entry into the Pension Protection Fund (PPF)) in extremis. Whilst employers need to meet a very prescriptive set of circumstances for such actions to be deemed acceptable to trustees and their stakeholders, we have significant experience helping schemes consider these issues and negotiate mutely beneficial outcomes.

These are emerging risks that can have a material impact on employer covenant over the medium to longer term, and are considerations that TPR now expects trustees to make for all aspects of their schemes (i.e. investment, funding and covenant). Indeed, it is now compulsory for larger schemes. We help schemes understand the climate related risks that may impact their employer over the short, medium and longer term, both on a physical and transitional basis, aligning this with how similar scenarios may impact DB scheme assets and liabilities. 

For multi-employer schemes, in certain scenarios, an employer may want to “exit” from the DB scheme without having to settle its scheme liabilities, which may be done by “apportioning” the liabilities to another employer. The most common method is by using a Flexible Apportionment Arrangement (FAA), although there are others. Trustees must consent to an FAA, being content that the statutory Funding Test is met, and that it is in the scheme members’ best interests. We provide reports concluding on the Funding and Best Interest Tests, and advising on what mitigation may be required to allow a FAA to proceed.

Schemes with a strong guarantor, asset backed funding arrangement, charges over assets or bank guarantees, may qualify for a reduced annual levy to the PPF if they are PPF compliant. To qualify for this reduction the trustees need to provide annual certifications. We undertake work to assess the certification that can be made, including providing full Guarantor strength Reports for large and complex guarantees, with a duty of care to both the scheme and the PPF provided.

We are here to help you put employer covenant at the centre of your strategy

Our large covenant team draws on Mercer’s funding and investment expertise to provide you with a full range of advice. Because we advise trustees and corporate sponsors we understand the issues and challenges from both sides of the table. This enables us to take a pragmatic approach that gets the job done with the minimum of stress and cost — while providing the assurance you and your members require.

We can also provide training sessions, explaining the importance and interplay of covenant and the changes TPR has and is introducing, which might be a useful way to introduce our team to your trustees, especially in the run up to a triennial valuation.

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Get in touch to discuss your employer covenant with a member of our team.