An MoU can ensure effective covenant monitoring

Given that most trustees monitor their scheme’s investment returns and liabilities four times a year, it seems odd that many only review the employer’s covenant once every three years. 

The Pensions Regulator has recently raised the bar for trustees with respect to covenant assessment and monitoring responsibilities, and covenant is now the foundation stone of the regulator’s guidance on integrated risk management.

Formalise the covenant monitoring process

So, what is the best way to monitor your covenant and to avoid surprises? Trustees and employers should jointly agree a memorandum of understanding that covers both information sharing and covenant monitoring. This will help to formalise what is generally quite an informal process.

The frequency of monitoring should take into account factors such as the availability of information, the volatility of a company’s finances, the strength of the covenant and the overall risk in the scheme

We often hear trustees say that the financial director provides a five-minute update at every trustee meeting. While such updates are useful, they are not always rigorous enough and, generally, result in little discussion, follow-ups or actions points. 

Crucially, in this situation, there is no pre-agreed consensus among trustees (and with the employer) as to what constitutes a material weakening of covenant or what actions to take in such a situation.

There are some important factors that a memorandum of understanding on information sharing and covenant monitoring should cover.

Trustees should get reasonable access to forward-looking information such as the employer’s budget or forecasts for the next two to three years, as other major stakeholders do. This can be a hugely sensitive issue for some employers, but putting confidentiality agreements in place and tailoring the information can help overcome any reticence.

In return, employers can reasonably expect trustees to share liability and investment updates, Pension Protection Fund levy information and notifiable events, for example.

The covenant assessment that accompanies the triennial valuation should identify the main covenant risks and the key performance indicators to monitor, at least on an annual basis. These are usually the same key performance indicators that management and other stakeholders monitor and, therefore, should not create extra work for management.

Some are generic, such as operating profit gross, cash flow and net assets. Others are employer-specific, and can include energy reserves, drug pipeline, sales and assets under management.

Once key performance indicators are set, trustees and employers should agree clear triggers that will result in pre-specified actions (part of integrated risk management).

Setting trigger points involves judgment and negotiation with the employer if they are to become legally binding. Triggers should not be set so low that by the time they are hit, it is too late to act effectively, but rather at a level that indicates a material change in the covenant strength while allowing time for the trustees to put in place mitigation.

A well-funded scheme with a strong sponsor does not require as much monitoring as a poorly funded one with a weak sponsor.

Identify key factors

Also, monitoring too many factors can lead to confusion and inaction. Too few could potentially lead to missed covenant changes. Trustees should identify the key factors specific to the scheme and employer.

The frequency of monitoring should take into account factors such as the availability of information, the volatility of a company’s finances, the strength of the covenant and the overall risk in the scheme.

Indicators for schemes requiring more regular monitoring include: weak covenant, weak funding levels, the employer operating in a volatile industry, high funding or investment risk relative to the employer. 

The outcome of monitoring should be clear from the start, with the best monitoring frameworks including a list of actions when each trigger is hit. These can include adjusting the investment and funding strategies, putting in place contingency plans or instigating further information sharing.

Finally, trustees should review the covenant monitoring framework regularly, at least as part of each triennial valuation.

Aidan O’Mahony is a partner in Aon Hewitt’s retirement practice