Covenants under stress in 2012

 But the climate for UK companies has only worsened since Uniq, and more schemes are now looking with trepidation at the strength of their sponsor.

“I could see a lot more employers approaching the regulator and saying, ‘let us off our liabilities and we will give you more equity’,” says Richard Butcher, managing director at Pitmans Trustees.

But PW believes the regulator wants to avoid Uniq becoming a template for struggling companies looking to dump their pension promises. For trustees, the dilemma on covenant is between what security they need from the sponsoring employer, and what the employer can realistically give them.

A weakening domestic and regional economy, and the difficulty of securing bank credit, is testing small companies in particular. Simon Kew, senior manager at Jackal Advisory, says he expects “more of the same” in 2012, particularly if the eurozone issues are not resolved. And regulatory pressure on schemes to contract an independent evaluation of their employer covenant is matched by trustees’ own concerns, given the brutal market.

Kew adds: “They are becoming acutely aware, through recent, high-profile insolvencies, of the potential for a seemingly wealthy employer to suffer significant and sudden swings in covenant.”

Pitman Trustees’ approach with some scheme clients is to agree a set of principles, akin to a banking covenant, with the sponsor. If certain changes to the business breach the pre-agreed parameters, the company is duty-bound to inform the scheme. “We can’t increase the rate of interest, but we can bring forward a valuation,” Butcher explains.

Marian Elliott, head of actuarial services at Atkin and Co, believes the focus for schemes is on understanding the challenges facing their sponsors’ businesses, and what that means for the security of the benefits they oversee. A stress-test of the employer covenant is one important part of this evaluation.

She says: “The likelihood is that there will be further shocks to the system over the next 12 months, all of which will affect companies to a greater or lesser extent. Trustees therefore need to understand the position their scheme would be in, should the fortunes of the company change.”

But stress-testing provides an indicator, not a fix. More schemes are turning to their employer to provide security in uncertain times. This can be a difficult conversation, if the employer is reluctant to give trustees extra security, insisting on the financial strength of the company. This forces the question: if the company is financially strong, why can it not provide security to the scheme?

Richard Blamey, trustee and former pensions manager at the Air Products pension plan, told PW’s sister title schemeXpert.com in October there was no need to “pussyfoot around” the subject of covenant. “[The way to approach this] is really to have a good dialogue with the employer,” he said. “No one’s going to give you money for free.”

If there is a limit to the cash employers can provide, there is a growing variety of contingent assets being agreed between scheme and sponsor. Travel group TUI used its Thomson and First Choice brands as collateral in a pension funding partnership arrangement. The group is paying the scheme £16.5m in loyalty payments to use the brands for 15 years, when it will pay £265m to reclaim the brands.

Jackal’s Kew says this type of arrangement could prove to be more popular as it is unlikely that a bank would have a charge on a brand. This security is vital for creditors, and schemes face a battle with banks over whatever assets are up for grabs. Pitmans’ Butcher warns: “The answer might well be, ‘The bank has already got it.’ I could see that becoming more difficult.”

Other difficulties lie in understanding the value of non-cash assets such as intellectual property. Schemes must ensure any arrangements are legally binding, enforceable and not overly expensive to set up. And they face the ongoing challenge of making the regulator comfortable with the assets being offered. The regulator has called for schemes to take legal advice on the authority of the employer to hand over the assets, and to watch out for the claims of other parties. But, as the Uniq deal demonstrates, even the acutely uncomfortable is not out of the question.

Ian Smith is senior reporter at schemeXpert.com