Employers urged to actively manage covenant

Recent analysis carried out by the Pensions Regulator showed that 50 per cent of schemes carrying out valuations between September 2016 and September 2017 are either in surplus or have a covenant adequate to support the scheme.

Covenant monitoring is more of an art than a science

Alan Pickering, Bestrustees

They also have sufficient funding and investment strategies in place. In contrast, 37 per cent of schemes have affordable deficits but insufficient funding, while 8 per cent have the potential to benefit from wider group support and 5 per cent are “potentially stressed schemes”.

Understand the covenant

The regulator said that “changes in the strength of the employer covenant are a key consideration for trustees and employers when setting their funding plans”. It added that the majority of defined benefit schemes remain affordable, but that many need to do more to tackle increased deficits.

Speaking at an event this week, organised by consultancy Barnett Waddingham, Lincoln Pensions director Luke Hartley highlighted the importance of understanding the employer covenant.

When it comes to discretionary investment, the money is split between various stakeholders, and money has to go towards dividends, debt service, investment in business and pension contributions. But “most businesses don’t have a bottomless pot of cash”, he said.

This is why “employer covenant is critical” when it comes to a company getting as close as possible to its ideal strategy, for which taking a hands-on approach can help, Hartley explained.

“If you can manage the covenant in an active way, you can manage the demands on business in an active way,” he said. And “by actively understanding covenant and by actively putting in place covenant management tools… an employer can take control”.

Hartley noted the advantages of contingent assets liability management exercises, such as pension increase exchange offers, to improve covenant strength.

Source: The Pensions Regulator

He said that having an intrinsic understanding of the covenant can also enable an employer to react quickly in times of change, and to be prepared for any shocks.

Beware of a false sense of security

Richard Farr, managing director at Lincoln, pointed out that trustees can have “a lot of emotional attachment to the overall group covenant”.

Many schemes and employers also think they are safe and in the “comfort zone” when they are actually in more of a “concern zone”, where the buyout deficit is more than the company is actually worth, he added.

There is then a “crisis zone” where the company can never fund its scheme properly “but can get above Pension Protection Fund levels”, explained Farr. If nothing is done to address this, there is then a “catastrophe zone” involving PPF compromises, insolvency planning and regulatory intervention.

Farr said this is why understanding the covenant strength and taking action as early as possible is important. “It’s like catching a falling knife. It hurts to catch it, but if you don’t catch it, it will kill you,” he said.

Trustee and employer collaboration

On the analysis of covenant strength published by the regulator, Richard Butcher, managing director at professional trustee company PTL, said that “a large number of employers don’t properly manage their pension liabilities”, but added that this mostly relates to the smaller schemes.

Smaller employers may be less sophisticated and “don’t have access to the resources that the employers at the top end of the range do”, he said.

He also said that trustees and employers can be in denial about their covenant strength. This may be the case if the employer is trading well, for example.

But “while you can see with some degree of certainty what’s going to happen to the employer covenant in the next 12 months… after you get 10 years or even five years out, all bets are off — you really have no idea what’s going to happen”, he added.

Alan Pickering, who chairs professional trustee company Bestrustees, said that “both trustees and employers should work collaboratively in devising investment strategies and exploring ways in which liabilities might be reshaped in a way that makes them more predictable, and therefore more deliverable”. 

Pickering added: “Covenant monitoring is more of an art than a science.” As a trustee, “I am more than happy to take a steer from a plan sponsor as to their preferred asset mix... obviously, one needs to make sure that the covenant is reflected in the investment strategy.”