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What is a Covenant?
An employer covenant refers to the strength of a business in supporting a pension fund. The Pensions Regulator defines it as “the extent of the employer’s legal obligation and financial ability to support the scheme now and in the future.” This covenant is the primary support for the funding and investment risks that pension schemes face. It is important to understand the quality of this support and the associated risks to ensure effective risk management. This is central to our work.
Understanding the Strength of the Covenant
The covenant involves two main factors: first, the business’s ability to support the pension scheme over time, and second, its capacity to contribute cash if there is a shortfall. The Pensions Regulator’s guidance on integrated risk management highlights the employer covenant as one of the three key risks to which a pension scheme is exposed. In fact, the other two risks—funding and investment—cannot be fully managed unless trustees first evaluate the strength of the employer covenant and its ability to cover them which is one facet why covenant tracking is so critical.
Why Monitor the Employer Covenant?
Employer covenant risk is not fixed: companies and markets are always changing. Therefore, it is crucial to actively monitor the scheme’s covenant. While the Pensions Regulator advises monitoring the employer covenant at least annually, many trustees review it more often, especially if the perceived risk associated with the employer covenant is higher.
It is essential to assess and critically evaluate the employer’s ability to make deficit repair contributions as part of its recovery plan. Determining affordability can be complex, and there is no simple solution to assessing how much an employer should contribute to its scheme. The answer can depend on several factors, such as the scheme’s funding status, its risk volatility, the employer’s other cash-flow needs, and how other stakeholders are treated.
Affordability: A Complex Challenge
With pension deficits still at high levels and many sponsors impacted by Brexit and COVID-19, determining the affordability of contributions is often challenging. It requires balancing competing demands on cash flow carefully.
How We Can Help You as a Trustee
We can assist you in developing solid, balanced views on the appropriate contribution levels, considering the unique circumstances of both the pension scheme and the employer. This ensures that the pension scheme is treated fairly.
We focus on the key issues of investment and funding risks over the long term, evaluating the likelihood of the employer covenant supporting those risks if required.
We track changes in the strength of the employer covenant and assess the specific impact of events and transactions affecting the employer’s organization as the scheme’s sponsor.
We provide tailored insights on how the covenant interacts with the pension scheme’s journey plan over time, offering a long-term perspective. We also provide practical recommendations for next steps, options for improving the covenant, and factors to consider when planning the scheme’s progress toward its long-term goals.
We help you prepare monitoring frameworks based on the main risks facing your schemes. These are integrated with your investment monitoring and include actionable contingency plans for dealing with negative events as they occur.
We offer flexible, scheme-specific training modules, which can be combined and customized to meet your particular needs.
Discover: AI-Powered Covenant
Discover uses Artificial Intelligence (AI) to make external covenant analysis more accessible, particularly for employers with small pension liabilities (<£50m). It provides access to a wide range of covenant experience, collected in our ratings database and captured with cutting-edge technology.
Based on key quantitative and qualitative data, Discover offers an employer covenant rating on a four-point scale, explaining the main factors driving the rating, benchmarking these metrics, and providing relevant recommendations.
A Unique Approach to Covenant Assessment
As one of the largest covenant assessment teams in the market, we can tailor our approach to your specific circumstances and industry. Our independent status ensures that we are not conflicted.
Our background in corporate finance and our multi-disciplinary team allows us to focus on the most important issues for trustees. Additionally, our wider team can offer specialized support if your needs extend beyond covenant assessment, such as for distress, end-game planning, or ESG reporting.
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