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.
Detailed guidance
Ensure your approach to assessing the strength of the employer covenant is robust and effective so that you can decide the appropriate level of risk when setting your investment strategy, funding assumptions and, where necessary, recovery plan.
Take a proportionate approach to assessing the employer covenant for your defined benefit (DB) pension scheme. You should also make sure you carefully consider issues such as whether to take independent advice and how to work with the employer effectively.
For an introduction to covenants, go to employer covenant: overview.
Key points
- Take a proportionate approach to assessing the legal, scheme and financial aspects of the employer covenant.
- Consider using an independent covenant adviser if the trustees don’t have the required expertise or objectivity.
- Work closely with the employer and share information effectively.
- Make sure you understand how the scheme will benefit from any employer plans to invest for sustainable growth.
Overall approach to covenant assessments
Assessing the employer covenant regularly is important as it enables you to understand the extent to which the employer can afford to support the scheme now and in the future. You may also want to assess the covenant in response to scheme-related events, such as a scheme merger, or employer-related events, eg acquisitions or share buy-backs.
You need to understand the employer covenant from three perspectives:
- legal: the nature of the employer’s obligations and to what extent they can be enforced
- scheme: the size and funding needs of the scheme, now and in the future
- financial: the ability of the employer to contribute cash when required
The covenant assessment should provide enough information for you to answer a number of key questions:
When to perform an assessment
As a minimum you should review the covenant at each scheme valuation. However, as the covenant strength can change quickly, it’s important you monitor the covenant regularly between formal covenant reviews and take prompt and effective action when you need to.
For more information, go to monitor employer covenant and improve scheme security.
Independent assessments
You should weigh up the costs of commissioning external advice against the benefits it could bring through a sound understanding of the extent to which the covenant supports investment and funding risks. Carefully consider the scope of the independent assessment so that it adds the greatest value and costs are controlled.
If you decide to use an independent covenant adviser to carry out the assessment, make sure you identify the areas you need to consider during the appointment and briefing process:
Working with the employer
It’s important that you work closely with the employer and share information effectively. You should agree appropriate ways of ensuring confidentiality is maintained, eg through confidentiality agreements. Make sure they understand that an appropriate covenant assessment is in their interest so that the funding and investment strategy is set appropriately and the scheme doesn’t pose an unnecessary risk to their future sustainability.
Those carrying out the assessment will need a number of pieces of information from the employer and other sources.
If the employer doesn’t provide appropriate information for the covenant to be assessed, you should consider taking a more prudent view of its strength and place less reliance on the covenant when setting the funding and investment strategy. This may mean that higher contributions may be required from the employer.
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 and whether other stakeholders are contributing appropriately. If the plans aren’t detailed enough, you shouldn’t be willing to compromise the position of the scheme to support the investment.
Not-for-profit employers and non-associated multi-employer schemes
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.
Detailed guidance
You should regularly monitor the strength of the employer covenant, along with key investment and funding risks.
This will allow you to take action effectively when you need to mitigate risks or improve the position of your defined benefit (DB) pension scheme.
For an introduction to covenants, go to employer covenant: overview.
Key points
- Ensure there is a robust framework that enables you to regularly monitor the employer covenant between scheme valuations.
- Ensure there are well-developed contingency plans that allow you to take action to mitigate against adverse events or improve scheme security when you need to.
Importance of ongoing monitoring
The strength of the employer covenant can change quickly so it’s important you assess the covenant and monitor it regularly, along with investment and funding risks. This will enable you to take prompt and effective action when you need to.
It's particularly important to monitor the employer covenant when there is the possibility of the employer becoming insolvent. If the employer becomes insolvent, members’ benefits may be in danger. Read planning for employer insolvency guidance on the Pension Protection Fund website.
You should take a proportionate approach to the frequency and depth of monitoring based on various factors such as the scheme’s reliance on the covenant and the complexity of the employer’s operations.
Covenant factors to monitor
Contingency planning
You need to decide on appropriate triggers or thresholds based on what changes would have a material impact on the covenant.
Your contingency plans shouldn’t necessarily cover and mitigate all possible events. You should look at the level of risk your scheme is running.
You should discuss key risks with the employer and plan what potential action you might take so that you’re both ready to respond as soon as a trigger is breached.
One-off events, eg a corporate transaction, may affect the covenant and require you to take urgent action.
Improve scheme security
You should consider how you could improve the security of the scheme so that you have more flexibility to manage the scheme’s funding strategy.
Examples of ways to improve scheme security include:
- commitment to increase funding when certain events occur, eg if scheme assets underperform
- provide asset security to the pension scheme, eg credit letters and asset-backed contributions
- guarantees from other entities in the employer’s group
- an employer committing not to perform certain acts without agreeing it with the trustees
- improve the scheme’s insolvency priority
- amend the scheme’s trust deed and rules to give the scheme greater security
Contingent assets
If the employer has offered assets they own to help improve the security of the scheme, you should carefully consider the value placed on these contingent assets. This should reflect its anticipated value after a contingent event has occurred.
You may need a qualified professional to assess the value of an asset.
Consider how appropriate a contingent asset is in relation to the support it provides to your scheme’s funding strategy, eg whether you need to quickly access value from an asset.
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.