The Regulator provides substantial detail on what trustees should consider when assessing the covenant, and focuses on three main angles: ‘legal, scheme–related and financial’.
The Regulator expects analysis of various sources in order to establish legal obligations in respect of the scheme. Firstly, employer duties under the Trust Deed and Rules and any statutory schedule of contributions must be considered. Employers potentially liable for section 75 debt and whose insolvency would cause entry into the Pension Protection Fund must also be investigated. If third party support is provided, it is key that trustees understand the nature of that support and the Regulator urges caution in distinguishing between promises given to employers by their parent companies from those which are directly enforceable by the trustees. The Regulator acknowledges that in certain circumstances it may be appropriate for trustees to take account of informal support provided by an employer’s group company. However, it is clear that trustees should consider this only in the short term unless a substantial legal commitment is provided. Additional issues will need to be considered in multi-employer schemes, particularly those relating to partial wind-up, the extent of orphan liabilities and the focus of the trustees’ attention if the scheme is a ‘last-man-standing’ arrangement.
Scheme related (funding needs and investment risk)
The Regulator believes that the covenant review should be carried out (as a minimum) every three years preceding agreement of the tri-ennial valuation. However, more frequent reviews may be necessary if scheme circumstances dictate, such as a major restructuring of the employer or a transfer exercise. The trustees will need to understand a variety of scheme-specific factors about the funding and investment needs of the scheme to properly evaluate the covenant. These will include an analysis of the size of any deficit versus the size of the employer, the level of risk within the scheme’s investment portfolio, the maturity of the scheme membership and accordingly, its cash-flow requirements. Understanding these aspects will inform the trustees’ decisions on setting their funding targets at an appropriate level.
Financial (assessing employer support)
The most detailed section of the guidance is that describing the trustees’ evaluation of the employer’s support and how affordable that is likely to be when the scheme most needs it. This will involve:
- a detailed analysis of the employer’s current financial resources and its prospective financial performance;
- the medium and long-term outlook for the relevant scheme employers and the wider industry within which they operate; and
- the impact of the insolvency of any employer, or that of any wider group.
Trustees should place more emphasis on cash-flows and future projections than on surplus or profits declared in previous years’ accounts, They should also be live to any vulnerabilities and sensitivities in projections made by the scheme’s employers and consider whether any assumptions match those adopted for the purposes of the scheme’s funding requirements. Business valuations and credit ratings should be considered, but with caution, as they are often an outdated measure. Trustees should focus on the more tangible areas of support which employers can provide, focussing particularly on discretionary cash-flows after taking account of the costs and expenses of running and maintaining the business.