As part of the funding approach for your defined benefit pension scheme, you should understand the current strength of the employer covenant and how it could change in the future.
The covenant is the employer’s legal obligation and financial ability to support their defined benefit (DB) scheme now and in the future.
Assessing and regularly monitoring the covenant will help you to decide the appropriate level of risk when setting your investment strategy, funding target and, where necessary, recovery plan.
Key points
- A sound understanding of the employer’s ability to support the scheme should inform your investment and funding decisions. Understanding the extent of the support available when it is needed enables you to take appropriate investment and funding risks.
- As a minimum, assess the covenant at each scheme valuation from a legal and financial perspective in the context of the scheme’s funding needs.
- Decide how to assess the covenant, eg whether to use an external adviser, how to take a proportionate approach and how to work effectively with the employer.
- Monitor the covenant regularly between valuations and have well-developed contingency plans so that you can take decisive action if you need to.
Assess the employer covenant
There are a number of points you should consider when assessing the covenant:
- take a proportionate approach to the depth and breadth of your assessment based on the circumstances of your scheme and employer, such as the level of risk in the scheme or the complexity of the employer’s operations
- decide whether to use an independent covenant adviser, eg if the trustees don’t have the required expertise or objectivity, and agree what areas you want the adviser to focus on
- make sure you work effectively and collaboratively with the employer, eg by sharing information, but make sure that you have appropriate confidentiality safeguards in place
- focus on the employers with a legal obligation to support the scheme – it may be appropriate to rely on the informal support of employers in the short term but not in the medium or long term as it isn’t certain whether this will continue
- make sure the covenant assessment looks at both the present and future, focusing on the ability of the employer to contribute cash to the scheme over an appropriate period to achieve and maintain full funding
- if the employer’s plans to invest in sustainable growth restrict the funding available to the scheme, you should understand how the scheme will benefit by supporting this investment and whether other stakeholders are contributing appropriately
For more information, go to decide how to assess employer covenant.
Ongoing monitoring of the employer covenant
The employer covenant can change quickly so you should monitor it regularly between formal covenant reviews.
You should have well-developed contingency plans. These should allow you to take action if you need to mitigate against adverse events, such as the risk of employer insolvency, or to improve the security of the scheme. Contingency plans don’t necessarily need to cover and mitigate all eventualities.
For more information, go to monitor employer covenant and improve scheme security.
Trustee toolkit online learning
The 'How a DB scheme works' module contains information on the employer covenant. You must log in or sign up to use the Trustee toolkit.