Four steps to a targeted, practical covenant review

But a common complaint from some trustees is that the covenant review is simply a regurgitation of figures they already have access to and it is not clear how this adds to the decision-making process.

This should not be the case. A comprehensive understanding of the covenant can considerably improve a scheme’s position when it comes to funding and risk. Equally, it can flag any areas for real concern in time for corrective measures to be put in place.

How then do trustees go about getting the information they need from their covenant advisers in a form that they can use to drive strategy decisions for their scheme? And how do they determine that they are getting value from the covenant review spend?

Be clear on objectives

The most important thing trustees can do is properly frame the questions they want answered. In order to clearly communicate the brief to any potential advisers, it is important that trustees understand what they know, what they do not know and the key points that need investigation.

Trustees also need to be clear on the scope of the project. There are many different forms a covenant review can take, from a simple report, to active participation in trustees’ negotiations with the company, to providing input into the stochastic analysis on funding and investment risk being carried out by the actuary.

The greatest sense of dissatisfaction seems to stem from a mismatch between the output and trustees' requirements – an initial briefing meeting to discuss and challenge the nature of covenant advice needed is essential to overcoming this problem.

Gather information in advance

Another problem that tends to hamper a satisfactory covenant review process is lack of time or availability of the relevant personnel at the sponsor. If time is tight, trustees can assist this process by gathering information from the sponsor in advance. All covenant assessments will require some common documentation, such as:

• the current and previous years’ accounts;
• the pension scheme valuation, including any recent updates;
• management accounts and forecasts; and
• information relating to M&A activity or the structure of the group.

Run an efficient procurement process and control fees

If going to tender for a covenant assessor, keep the beauty parade to around three or four target assessors. The tender or interview questions should be aligned to the requirements of the scheme and focus on assessing the potential providers’ ability to deliver against those requirements.

For example, a firm that deals primarily with insolvencies might be particularly well placed to assess the potential loss to the scheme and recoverability in a range of scenarios, but may be less suited to a review of future business plans.

As far as fees are concerned, advisers should have a clear idea of the amount of work required to deliver against a clear brief. It is not unreasonable for trustees to seek a capped or fixed fee, which should help the covenant assessor target their work accordingly.

If an assessor is unwilling to fix or cap, they should be able to easily explain why that is the case, providing clear reasoning. In these circumstances, it might be possible to agree a cap or budget, following the provision of certain items of information.

Require collaboration

Trustees are required to take an integrated approach to risk management. Both funding and investment plans should be set with explicit regard to the sponsor’s ability to support these strategies, both now and in the future. 

It is therefore essential that any covenant adviser is aware of the funding and investment strategies being considered and that their advice ties in with this. Wherever possible, advisers should be asked to collaborate and talk to each other, to present the trustees with useful, big picture advice.

Marian Elliott is head of trustee advisory at Spence & Partners