Putting employer covenant at the centre of your DB scheme’s plans

The Pensions Regulator puts employer covenant at the heart of DB pension scheme journey planning.

Assessing a DB scheme’s employer covenant

When undertaking a triennial valuation for a defined benefit (DB) scheme, trustees’ first considerations should be how strong is our employer covenant? And how much risk can it underpin? 

Assessing a DB scheme’s employer covenant alongside funding and investment risks is not a new concept for DB schemes – TPR has guided trustees to adopt robust integrated risk management (IRM) processes to ensure that these risks are appropriately balanced. However, TPR is now introducing the requirement for DB schemes to go beyond IRM and have a long term journey plan that is explicitly linked to employer covenant strength and its longevity. 

Assessing a DB scheme’s employer covenant: what should I consider?

TPR’s new funding requirements means an employer covenant will require far greater levels of consideration for many DB schemes

To set a long-term objective, as required by TPR, trustees must question and understand the sponsor’s ability to support the scheme. Here are some questions to consider when thinking about assessing employer covenant:

Visibility (1-3 years)

On a forward looking basis, do you know how much free cash your sponsor(s) will generate, and how much of this is “reasonable” for the DB scheme to receive?

Reliability (c.6 years)

How many years are you comfortable that your sponsor can generate these levels of free cash flow? How does this compare to the level of funding and investment risk the DB scheme is running?

Longevity

How long can you rely on the ongoing performance of your sponsor(s)? How sensitive is ongoing performance to changes in demand and other risks such as climate change?

Long term journey planning

Answering the above questions will be key to forming a DB scheme’s long term journey plan, establishing an appropriate funding target and investment de-risking strategy, and the ability of the sponsor to underwrite scheme risks. If you are unable to form a view on visibility, reliability and longevity, it could undermine your valuation.

Nearly all schemes need to assess their employer covenant on an ongoing basis, particularly with respect to future prospects. Going forward, many schemes will need to take independent employer covenant advice, some of which will be for the first time, to be able to demonstrate to all stakeholders that these risks have been given due consideration. 

Along a scheme’s journey plan there will be “bumps in the road” to navigate, and that is where integrated covenant, funding and investment monitoring plays its role.  Constant monitoring and responding to events as necessary is required to achieve the end goal. 

TPR’s new funding requirements mean trustees will need to question and understand a sponsor’s ability to support their scheme in far more detail than they have perhaps done in the past
Thomas Austin

Director, Employer Covenant

Mercer has the breadth and scale to guide you on the covenant

At Mercer we have always made employer covenant the starting point of our funding assessments, adopting a “covenant first” approach. We have a team of covenant specialists who work closely with our funding and investment experts across the breadth of the UK. Strength in all three of these areas is a distinctive feature of what Mercer can offer, although we also provide independent covenant advice alongside third party advisors and have a great deal of experience doing so in a seamless and integrated manner.

There are many scenarios where we provide employer covenant support, including:


Restructuring distressed businesses with defined benefit pension schemes

Many businesses have defined benefit pension schemes (also known as final salary schemes), where they have promised a pension to current and/or former employees. Whilst the funding position of many of these pension schemes has improved over recent years, a large proportion remain in deficit, requiring significant ongoing funding. The provision of UK pensions is heavily regulated by the Pensions Regulator, and in circumstance where businesses become financially distressed, any proposal to reduce, reshape or remove contributions altogether comes under a high degree of scrutiny. Where pension schemes have been considered to be seriously mistreated, there are potential civil and criminal consequences for “connected parties”, which includes Directors (personally) and associated businesses. However, there are a number of pension solutions that can be used to provide financially stressed businesses the time and space they need to restructure, including:
  • Improved security or guarantees
    by providing a pension scheme with improved contingent asset support, companies can negotiate lower payments to their pension schemes in the short / medium term.
  • Capital backed journey plans
    for a fee, third parties are willing to provide additional funding to pension schemes, which can reduce their cash funding requirements on an ongoing basis.
  • Consolidator
    in certain circumstances, a pension scheme can be transferred to a third party, who will take on the responsibility for the scheme, removing it completely from the business’s balance sheet.
  • Scheme compromise
    in extreme circumstances, the Pension Protection Fund will agree to take on a business’s pension scheme if it represents the best outcome for the business and scheme members.
Where a business has a defined benefit pension scheme and is assessing its restructuring options, it is key to:
  • Take action early
    the solutions outlined above range from weeks to months to implement.
  • Manage your stakeholders
    pension schemes are key stakeholders and should be treated the same as other important creditors, lenders etc., in a restructuring scenario.
  • Take advice
    pensions, and the way in which they are regulated, are complex – taking advice from experts gives you the best chance to deliver a solution that protects / enhances business value.

Mercer’s employer covenant team has a background in corporate restructuring and insolvency and have been helping distressed businesses manage their pension liabilities for over 20 years – when we are involved early in the process, we are able to deliver the best outcome for all stakeholders whilst managing regulatory risk.

If your business / client is facing financial challenges and is unsure how to manage pension risk, please contact our employer covenant team for a confidential, no obligation discussion. 


We are here to help you put employer covenant at the centre of your strategy

Our large covenant team draws on Mercer’s funding and investment expertise to provide you with a full range of advice. Because we advise trustees and corporate sponsors we understand the issues and challenges from both sides of the table. This enables us to take a pragmatic approach that gets the job done with the minimum of stress and cost — while providing the assurance you and your members require.

We can also provide training sessions, explaining the importance and interplay of covenant and the changes TPR has and is introducing, which might be a useful way to introduce our team to your trustees, especially in the run up to a triennial valuation.

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