“The best thing a pension scheme can have is a strong employer covenant….”
A strong employer covenant is generally a scheme’s most valuable ‘asset’ and understanding it is at the core of Integrated Risk Management. Trustees are quite rightly under regulatory pressure to have a clear view of the risks and opportunities around their employer underpin, and to be responsive as things change for better and for worse.
A scheme’s employer covenant, where it’s strong enough, is its anchor. It’s the covenant that gets called on when liabilities rise because interest rates fall, or inflation increases. It’s the covenant that has to come good if scheme assets are devalued by a fall in the markets. The covenant has a lot of work to do for many of the schemes in the Defined Benefit (DB) Universe, beyond simply generating the cash for a recovery plan.
Well governed schemes will carefully consider employer covenant and are increasingly taking specialist external covenant advice in support of their triennial valuations.
An employer health check every three years is clearly a good thing, but is it enough? Things can change rapidly in a business, no matter how stable it may appear at a point in time. Disruptive technologies, new business models, political changes, social trends, transactions, shift of strategy by a major supplier or customer, key personnel movements, general economic conditions – all of these things can present business opportunities, but will also present risks that can unsettle your scheme’s employer covenant.
I can’t see that there would be many situations where checking in annually on employer performance would do any harm…
Where the scheme’s a significant creditor, is running material Value at Risk (VaR), and/or where the business is facing challenges, it will be appropriate to monitor far more regularly – say quarterly, or even monthly depending on the specifics of the situation. The management team will be producing information for stakeholders, the common mistake trustees make is simply not asking for it. Information sharing is relatively simple to set up and removes the element of surprise from triennial valuations which is a fundamental of Integrated Risk Management (IRM). It’s not the role of pension scheme trustees to be involved in the running of an employer’s business, but it is clearly their role to protect members’ benefits. When there are problems for the employer and the possibility of business failure, the trustees will have their hands full considering and enacting contingency measures if they’re doing their job properly.
Trustees should take guidance from their covenant advisor as to what sort of monitoring would be proportionate, necessary and valuable to them. This doesn’t mean you dig the drains up every quarter, it should be measured and costs proportionate. Something I learned early in my career as an accountant was to ask management teams what’s important to them and their business – how do they get comfort that trade is heading in the right direction and under what conditions do they start to have concern or take action? It’s then critical to consider the scheme’s position and sense check and adjust the management’s thresholds accordingly. The trustees’ position is very different from management’s, generally representing an unsecured creditor which never intended to ‘lend money’ to the employer in the first place.
Ultimately, trustees doing their best for members will have a good understanding of the employer covenant and its direction of travel, and will continue to turn more towards professional covenant advisors for support in this given the specialist nature of the work. Depending on the specifics of the employer and scheme they will be checking in at agreed intervals, and receiving appropriate information that allows them to understand business performance and challenges alongside management. This will allow them to determine and take the right action to protect members’ benefits if things start to go wrong, and to do this in as timely a fashion, potentially improving outcomes for all concerned.