Covenant assessments: regulator lays down some guidelines

United Kingdom

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

It is clear from the Pension Regulator's (TPR) code of practice on scheme funding that the employer covenant is one of the three key elements trustees must balance when managing a defined benefit pension scheme (along with investment and funding strategies). If one element changes then trustees should consider the impact on the other two. 

Last month, TPR issued guidance for trustees on assessing and monitoring the employer covenant. The Regulator expects as a minimum that trustees should undertake a full covenant review at least at the time of each triennial valuation but the new guidance is relevant at any time when the trustees are assessing covenant (for example before a scheme merger or where some form of apportionment of the deficit is being proposed).  

Trustees should consider the covenant from three perspectives:

  • Legal – the nature and enforceability of the obligations to support the scheme.
  • Scheme-related – current and future funding needs of the scheme.
  • Financial – ability of the employer to contribute cash when required.

TPR expects trustees to take a proportionate approach. A less detailed review would be required where the scheme funding position is strong in the context of the employer’s profitability and cash flow and where the employer structure is straightforward. A more detailed approach would be required where the scheme is large in relation to the employer’s resources, the structure is complex or deficit repair contributions are material.

Many trustees commission external covenant advisers to undertake assessments and reviews. The guidance includes points that TPR expects trustees to consider when deciding whether or not to commission an external assessment:

  • Whether the trustees have the appropriate expertise and experience to do it themselves.
  • The importance of any conflicts.
  • The degree to which the scheme relies on the covenant.
  • The complexity of the covenant.
  • Whether the covenant is undergoing significant changes (e.g. employer restructuring).
  • The relationship between trustees and employer – can the trustees easily obtain the information they need?

Trustees should have in place arrangements to monitor the covenant, including identifying triggers or thresholds that could have a material impact on the covenant (and therefore on their funding and investment strategies). Key factors might include the following:

  • Material change in affordability of contributions.
  • Changes to group structure.
  • Employer plans to refinance or make dividend payments.
  • Significant industry changes.
  • Key personnel changes.

Trustees should familiarise themselves with the guidance and make sure they have arrangements in place for monitoring events which may affect the covenant.