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:
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.
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.
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.
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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