Guidance needed?

One of the most important things for trustees to be concerned with in their role is the financial well-being and capacity of the sponsoring employer to fulfil its financial commitments to the scheme.  Hence, monitoring the covenant is a fundamental need.  It goes further than that of course, in that the covenant strength feeds into other areas such as investment strategy and evaluation of the technical provisions which go to establish the funding level and any requisite recovery plan.

The Regulator (tPR) has been promoting the importance of the employer covenant over the last 18 months and is now consulting on guidance that it is proposing to issue on ‘Employer support: covenant, contingent assets and other security’.

The consultation is wider than the employer covenant and it does provide some sensible direction on the important topic of contingent assets.  This article will, however, focus on the covenant aspects of the proposed guidance.

The draft guidance runs to over 20 pages including appendices and it explains the key issues and the deliberations required by trustees.  It also makes the important point that the assessment of the covenant should be proportionate, relevant to the scheme and cost effective -  a sentiment that we support.

In general terms, therefore, the draft guidance is useful as it creates a framework that helps trustees to ensure that they appreciate and obtain value from a review of the employer’s covenant.

Getting it right from the beginning

We support tPR’s view on the approach to covenant assessment.  The key features are:

• There should be open dialogue with the employer
• Information should be primarily forward looking
• The right skills are required to perform the work
• Trustees must be pro-active in monitoring on-going developments

The above are all based on a proper understanding of the employer.  tPR emphasises that this is more than just ‘knowing the employer’s business’.  The legal obligation of the employer and other group companies needs to be understood as well as the relationships between group companies.

It is therefore essential that trustees establish at the outset the information that is required to perform a focused and efficient review and the expected form of the output on which decisions will be made.  There is no one size fits all and there must be due regard to the complexity of the employer’s business and the knowledge of the trustees.

Keeping on track

On-going monitoring is also more than periodic updates from the employer.  The covenant review should identify the flows of information required by the trustees and the financial indicators that are critical to understanding the on-going performance of the employer.  Important in this respect is that trustees do not take everything they are told or shown at face value.  Invariably it will be safe to assume that the employer is honest in what it divulges, but we have experienced plenty of instances where employers have been ‘economic with the whole truth’.

tPR’s proposed guidance raises some interesting points in relation to monitoring:

• It must be timely to enable decisions to be made at the right time
• There should be a plan in place to enable any required actions to take place quickly. 

Actions could include the realisation of contingent assets or a re-alignment of the investment portfolio.

The role of professionals

tPR identifies areas where trustees may want to obtain ‘expert advice’.  This includes understanding the legal structure of the group the employer is a member of and the identification of key financial and other indicators for on-going monitoring.

tPR also recognises the need to consider cost.

We recognise the importance of establishing the most effective approach to covenant review.  Our work with trustees may require us to either undertake an in-depth review of the employer or simply to provide support to fill the gaps in areas where the trustees do not have the required skills.  This should also be identified and agreed at the outset.

As tPR indicates, a flexible and proportionate approach is essential. tPR’s consultation can be found on its website www.thepensionsregulator.gov.uk.

The consultation period ends on 7 September 2010.