Trustee and Employer Covenant
When The Pensions Regulator (our friends in Brighton) introduced the concept of Integrated Risk Management with its now familiar triangle of covenant, investment and funding (see below) many trustees thought it would be a case of documenting a process that they already did.
Over time though, trustees have found this to be a tricky area for them and indeed the sponsors of the pension scheme. Why is this? We suggest that a primary reason is that trustees receive separate advice from a covenant adviser for the covenant, an actuary for the funding and an investment adviser for the investment. There is absolutely nothing wrong in this, and in many ways it’s an important check and balance on the conflicts of interest point, but what it can cause is unconnected advice. Instead of an holistic solution, trustees have to grapple with connecting three separate bits of advice and then have to figure out how to join it all together.
What should trustees do?
The template for the discussions can look like this:
- Timeline – Firstly, it’s essential the trustees know where the legal covenant lies, the UK employer or the European/Global group? Getting this bit wrong from the outset will have serious repercussions. Having identified the correct party, does the sponsors’ business have specific milestones which can affect their ability to fund the pension scheme, such as a major client contract expiring and having to be renegotiated or debt having to be repaid. Understanding the cash flow is particularly important for trustees, is there capacity for additional funding now or some point in the future or equally is there a pinch point which needs to be managed?
- There are key accounting ratios which can help the trustees to understand what the sponsor can afford (free cash flow, the size of the pension scheme deficit and the scheme investments Value at Risk). Is this in line with the covenant grading, say tending to strong? If not, the trustees will need to dig deeper.
- Whilst cash is king, can the trustees access some other contingent assets, such as a property or asset based funding arrangement or an escrow account?
- Is there a possible future event, such as the loss of a major client or expiry of corporate debt facilities which the trustees need to have a contingency plan for? Responding to a crisis is a lot easier if you have considered this in advance and have a strategy already in place. This is certainly something trustees will want to keep under regular review. What would have worked last year might not work this year, for example, there have been changes of directors and their responsibilities.
- The value of scenario planning such as a hostile takeover or the sale of a subsidiary cannot be overestimated. The possibility of moving return seeking assets to more defensive assets is always a possibility but trustees need to be mindful of the impact this will have on future funding levels. The trick here for trustees is to have open lines of communication with the sponsor so there are agreed information sharing protocols in place.
- If the company is paying dividends or there is covenant leakage, say the sale of a UK operating site, the trustees need to have a Plan B. This could mean moving the target date for full funding, reducing the level of investment risk along with other factors.
What trustees need to do is seek clear advice which joins the dots across the three areas of covenant, investment and funding. And then, having received, challenged and fully understood the advice, develop, plan and continually monitor all this.
Only then can trustees be confident they are on the right track.