On 13 August 2015, The Pensions Regulator (TPR) published new guidance on assessing and monitoring the employer covenant of a defined benefit (DB) pension scheme.
This guidance replaces TPR's 2010 guide to "monitoring employer support". It is the first in a series of guides for trustees of DB occupational pension schemes to help them apply the DB funding code of practice, which encourages schemes to adopt an integrated risk management strategy. This recent publication is aimed at trustees and their advisers, however sponsoring employers of DB schemes will also find it of interest. Guidance is due to be published later in the year relating to integrated risk management and investment strategy, further helping trustees to apply the DB code.
The new guidance provides practical help on how to evaluate the extent of an employer’s legal obligation and financial ability to support their DB scheme now and in the future.
- The guidance reflects TPR's statutory objective of minimising any adverse impact on the sustainable growth of an employer when exercising its scheme funding functions.
- Key is that Trustees should assess employer covenants as part of their triennial valuations and monitor employer support regularly between formal reviews and when assessing covenant in other circumstances, for example, in a change in corporate structure or before agreeing to a flexible apportionment agreement.
- Covenant assessment should be proportionate but schemes should get external advice where they lack "objectivity or expertise".
- Covenant assessment should focus on entities with a legal obligation to support the scheme.
- Trustees should clearly document the assessment process and its conclusions.
The guidance is clear that understanding covenant is vital to an integrated approach to risk management. An understanding of covenant should underpin the trustees' approach to investment and funding.
Trustees are being urged to use this new guidance to help them decide:
- who should assess the covenant;
- what a proportionate approach should look like;
- how the covenant should be assessed in the context of the scheme;
- how to monitor the covenant on an ongoing basis and prepare contingency plans to react appropriately; and
- what to consider in terms of improving the security of the scheme.
The guidance includes case studies, checklists and scenarios to make it more user-friendly and give a better understanding as to how covenant assessment and monitoring should operate in practice.
The guidance also sets out specific points for schemes in the not-for-profit sector and non-associated multi-employer schemes to consider.
The guidance states that trustees need to understand the employer’s covenant from a number of perspectives:
- Legal - the nature and enforceability of the employer’s obligations to support the scheme
- Scheme-related - the funding needs of the scheme, now and in the future
- Financial - the ability of the employer to contribute cash when required.
In the guidance, TPR acknowledges that schemes will not necessarily require regular external covenant reviews and encourages trustees to consider how much work is required depending on the strength of the covenant. Trustees should take into account all the factors relevant to their scheme when deciding on the required extent and frequency of review. To help with this, the guidance indicates a number of possible factors which influence how detailed an approach or frequent a review is needed. Trustees and employers are encouraged to work openly and collaboratively together.