Covenant-lite market expands as small schemes digest DB code

The code urged trustees and employers to consider the impact of scheme funding on sustainable business growth for the employer. It said trustees should consider the risks associated with employer covenants, investment and funding, and define acceptable parameters for each. Schemes are expected to have this in place by their 2014 valuations. 

I think it is fair to say that the starting point of the code is that a review in most instances will be the norm

Lesley Browning, Norton Rose Fulbright

Darren Masters, head of covenant consulting at Mercer, said not enough trustees have been taking covenant seriously enough up to now, but added they should approach any reviews on a “proportionate basis”.

Schemes can do a lot of this themselves on a self-assessment basis with peer review, Masters said, as many trustee boards are made up of senior people who are financially astute or are very familiar with the overall make-up of the business.

“We provide them with a suite of materials that gives them all the details of questions they should ask, materials they should gather and we’ll give things like a pro forma report that they can generate. The bit that requires judgment is often pulling that all together into an exec summary,” he said.

Lesley Browning, partner at law firm Norton Rose Fulbright, said while the code gives greater prominence to covenant, it contains some mixed messages on “balanced outcomes and proportionality”, which could inform how SME schemes approach covenant reviews.

“[The regulator] is quite clear in its response that trustees need not commission independent covenant advice if they can perform the assessment appropriately themselves,” Browning said. “And, moreover, a full review may not be necessary for a relatively small scheme or if the covenant is unchanged from the previous valuation.”

However, she added: “I think it is fair to say that the starting point of the code is that a review in most instances will be the norm.”

Controlling costs

Masters said Mercer’s self-assessment service starts from “around the £4,000 mark”, adding: “If it’s particularly complex it might end up as double that.”

However, Masters also pointed out that while self-assessment might be attractive from a cost perspective, time constraints on trustees might render it a “false economy” for some.

Simon Kew, director of pensions at covenant specialist Jackal Advisory, said self-assessment would be relatively simple process in cases where an employer covenant was either very weak or very strong.

But he warned: “The tricky part of the assessment is looking at the more technical aspects.

“If trustees are comfortable in assuming accountability for addressing each of these, via a suite of tools or not, then they can of course do so.”

Jackal last week launched an SME-specific service offering schemes and employers covenant assessments for a fixed rate of £5,000. Kew said covenant advice has previously been out of the reach of smaller schemes, due to “disproportionately high” costs.

Gary Squires, partner at pensions advisory company and covenant review provider Zolfo Cooper, said an effective way for schemes to control costs would be through “scoping” the work.

“The trick is to ensure that in paring down scope valuable information is not missed,” he said. “One way of doing this is to divide it into phases so that a high level approach is adopted initially and further phases of work can drill down into more detail if necessary.”

Zolfo Cooper’s covenant assessments can start from as low as £5,000 for straightforward cases, but are carried out in the context of a wider programme rather than being an off-the-peg service.

According to the regulator’s Defined Benefit Scheme Running Cost research paper, published in April this year, the average annual covenant cost for medium-sized schemes (those with 100-999 members) was £6,161, amounting to an average yearly cost of £28 per member, compared with £6 for large schemes (see table). 

Typical yearly covenant cost for the scheme and per member

Source: Pensions Regulator (p32, Defined Benefit Scheme Running Cost Research – April 2014)