By Jacqui Woodward, Senior Consultant, Xafinity Punter Southall
This clarity is a big step forward as the issue of the employer covenant has too often been perceived as a tick box exercise or a cosy chat about the business.
TPR recognises in its existing Code of Practice on Funding Defined Benefits that a strong, ongoing employer alongside an appropriate funding plan is the best support for a defined benefit pension scheme. However, previously the majority of focus has been on the valuation of a scheme’s liabilities and investments with the employer covenant being a secondary consideration. This latest statement by TPR shifts the balance and aims to address the key issue that our 2017 Risk of Ruin research revealed, namely that a third of defined benefit schemes in the UK may fail to deliver the benefits promised to members in full, and therefore understanding the employer covenant is a core part of long-term planning. The covenant is a critical factor in securing members’ benefits and making decisions regarding a scheme’s approach to funding and investment. The financial strength of the employer determines the degree of prudence trustees should use in the valuation of the scheme’s liabilities and the level of risk that can be supported in the scheme’s investment strategy by the covenant.
TPR has made it clear that whatever combination of employer and scheme you have, from strong and well-funded through to weak and stressed, there are covenant risks that TPR expects trustees to be actively considering and managing. These range from examining any potential covenant leakage, exploring alternative forms of security, establishing monitoring frameworks with clear and legally binding contingency plans and acting to avoid covenant weakening. It’s not all about managing poor outcomes though and TPR encourages trustees to also consider the opportunities that might improve the security position of their scheme in the future.
Covenant leakage can occur through a range of activities and not just dividend payments. For smaller employers, TPR notes that senior management pay can be as high as shareholder distributions and so this area should be considered in the context of the supporting employer covenant. Other corporate actions that may cause covenant leakage and may be overlooked include the transfer of business assets at less than fair value and loans to intra-group companies. However, the focus has truly swung onto dividend payments and TPR makes it clear that trustees are expected to assess the impact of dividends on the employer’s covenant. Trustees should consider whether the scheme is being treated fairly, by comparing expected deficit reduction contributions and dividend payments in the sponsoring employer’s budgets and cash flow forecasts. Employers will find it beneficial to proactively engage with trustees in this area to ensure that sufficient information is made available and that the reasoning and rationale for any significant corporate action is well understood. TPR expects employers to give due consideration to their pension scheme when determining payments to shareholders, particularly if the scheme is underfunded. Trustees should challenge and seek justification for any such payments that appear to favour shareholders over the funding needs of their scheme.
Trustees will be asked for documented evidence of the advice they have received on their employer covenant and TPR is working proactively with a number of smaller schemes to explain how TPR rates their employer covenant. It is clear from the Annual Funding Statement that TPR expects action on the employer covenant from all schemes and will be looking at this area closely – a collaborative but robust relationship between the trustees and the employer will help satisfy these requirements.
Although it is tempting to focus on the existing employer covenant strength it is important to remember that defined benefit pension schemes have a long time horizon and there are a wide range of circumstances that can arise over the lifetime of the scheme.
Trustees should be aware of the different outcomes that can occur, and consider these as part of their contingency planning, so that they are well informed and prepared for the worst possible outcome, should it occur.
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