Understanding your covenant

The Pensions Regulator recently released a handy 66 page guide on “Assessing and monitoring the employer covenant” for defined benefit schemes. As a professional trustee I have obviously read it cover to cover but, if you want to cut to the chase, you may want to start with page six, the “At a glance” summary.

The guidance is aimed at trustees and advisers but it would be sensible to make sure that sponsoring employers see it too – it never hurts for the Employer to understand the backdrop to perhaps searching questions. The Regulator has suggested that all trustees should at least read pages 6 through 8.  From a knowledge and understanding point of view, I think all trustees should at least scan all 66 pages – there are some useful pointers and examples in there – but they should completely familiarise themselves with the “At a glance” summary.

Now I started reading the guidance wondering if I was going to find something new.  Is it asking trustees to do more than most are already doing?  Is there anything there that is not already required under the DB funding code?  I don’t think there is anything new but, there is some clarifying detail in places and some of the example scenarios are very useful in understanding exactly what the Regulator expects from Trustees.

I had expected Value at Risk (VARs) to feature more than they did however; I think the Regulator has to be careful about how much they push the need for such analysis. The calculation of VAR’s is still an expensive piece of actuarial analysis for most schemes reliant on traditional actuarial systems and processes.

The key messages in the guidance feed back to the DB funding code and general principles of Trustee Knowledge and Understanding:

  • Know your scheme – know its funding position, investment strategy and the recovery plan.
  • Know your sponsor – who has a legal responsibility for funding the scheme; can they afford to fund the scheme; what are the big risks to that funding?
  • Know your strengths – does the trustee board have the knowledge and skills to subjectively assess the employer covenant? If you don’t, then what can you do to fill the gap?
  • Know how your funding position and covenant interact – what are their relative sizes?
  • Take a proportionate approach relative to the complexity of, and your scheme’s reliance on, the covenant.
  • Understand how the covenant strength impacts your decision making.

Covenant conversations can be difficult, trustees and/or their advisers sometimes have to ask some rather intrusive, emotive and indeed challenging questions for the sponsoring employer. It is also an area where real conflicts can arise. Independent subjectivity is often invaluable be that through the advisor or a completely Independent Trustee.