In recent years, few topics seem to have risen so regularly to the top of the pensions “hot topics” pile as that of the employer covenant. And rightly so, you might reasonably think. But despite Regulatory guidance, do pension scheme trustees and employers actually feel confident that they know just how often their covenant should be reviewed, by whom or to what level of detail? I’m not sure.
The clear suggestion is that, although internal reviews might be ok in certain circumstances, a decision not to commission a full external review represents a risk.
I think we must all now agree that the employer covenant is absolutely crucial when it comes to some of the decisions that go right to the heart of running a pension scheme:
- How prudent should you be when valuing liabilities?
- How hard should you push in funding discussions with the employer?
- How do you value non-cash support?
- What level of risk can you afford in your investments?
- Ultimately, should you consider scaling back future benefits to make the scheme more affordable?
In a document recently published for consultation, the Pensions Regulator stressed, on the one hand the importance of trustees knowing and understanding the employer covenant and on the other, that they should not “spend a disproportionate sum on the assessment of covenant relative to the value of liabilities in the scheme” but “should bear in mind the costs of covenant monitoring…relative to the size of the scheme and the employer and to the potential benefit of the exercise”.
Whilst useful, it isn’t explicit guidance is it? And people are already putting different spins on it. For example, one client has been told by its covenant advisers that they should commission what will be an expensive report in a form that can be sent to the Regulator with their recovery plans. But, on the basis of these statements from the Regulator alone, I imagine it will still be quite difficult for trustees to justify an expensive external review to the FD. So where does it leave them?
Well, distilling down what the Regulator says:
- A full covenant review must be carried out before every Scheme Specific Funding valuation – that much is clear from the consultation document.
- But there is no requirement that the review needs to be an external review. An “in-house” review could be sufficient.
- That said, it may be difficult to rely on an “in-house” review unless you can be certain that the individuals carrying it out:
- have the necessary skill-set to seek out the relevant information, interpret it and then test it (likely to involve a combination of accountancy, business analyst and even legal skills); and
- are not tainted by any conflict so that the conclusions reached are independent and reliable.
Extreme cases are relatively simple: for example, where there is a small scheme supported by a large employer it might be easy to conclude that relying on in-house resources to pull together a broad review is sufficient – particularly where some of the trustee board are very familiar with the business and, better still, understand the finances. Conversely, an external review might be more appropriate where there is a large scheme supported by a small employer – it is more likely that the review will need to survive scrutiny in what could be difficult discussions with the employer and, if bad turns to worse, with the Regulator.
In between those two extremes, it is difficult for employers and trustees to know exactly when an in-house review will not be acceptable. In groups where the business appears to be performing well, it is possible that employers and trustees will assume that an in-house review will be fine. In most cases, that assumption may be safe, but there are risks with that approach – big issues could easily be missed. How can you be confident that the big-ticket assumptions, on which an abbreviated review has been based, are sound? For example, I’ve seen a scenario where a full external review revealed that a major trustee assumption – that the covenant was based on the company in which the group’s major assets sit – was wrong. In fact that company was arguably not under any legal obligation to support the scheme at all. I’m not sure whether that would have been picked up unless the issue of covenant had been investigated thoroughly.
That begs the question – how can you ever be certain that you don’t need a full external review? Maybe you can’t and, in a way, I guess that explains why the Regulator is reluctant to set out precise guidelines for the level of review required.
In terms of conclusions, I think that an in-house and/or abbreviated covenant review can be sufficient, depending on the group, and the scheme. However, you do need to be confident that the people carrying out the review are in full control of all relevant facts and are capable of providing an opinion which is not only objective (although I wonder if it can ever be entirely independent) but is also robust enough to defend decisions taken now and, if possible, with the benefit of hindsight.
There you go then, it’s simple!
Gareth Soanes is an associate at Allen & Overy LLP.
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