The employer covenant - what is it and how do I assess it?

“Assessing the employer covenant is complex and requires openness and cooperation between trustees and their sponsoring employers”
The Pensions Regulator, June 2009

Understanding the employer covenant is crucial as it indicates the ability of an employer to fund its pension scheme and underwrite investment risk. The assessment of covenant is used to inform decisions on the actuarial assumptions and the recovery plan, and in the case of corporate transactions is used to determine the need for mitigation.

A thorough understanding of the employer covenant can significantly improve your position. Our team comprises specialists (including accountants, actuaries, lawyers and insolvency specialists) who advise corporates, trustees and other stakeholders across the UK, helping them to understand:

• Who is really in control - the employer, the bank or the trustees?
• Who in the group is obligated to fund the pension deficit
• Whether the buyout debt would be recovered in a hypothetical insolvency
• How their covenant compares to others in their employer’s industry
• What is a “reasonably affordable” level of cash funding and an appropriate recovery period
• What alternative forms of security to cash are available
• How the Pensions Regulator would view their situation, for example where funding agreements are outside the Regulator’s triggers
• How to manage conflicts of interest
• Whether their approach would stand up to external scrutiny

Our holistic approach considers several indicators of covenant strength, including the employer’s legal obligations to the scheme, its forecasts and markets, and the scheme’s position in a hypothetical insolvency.

We firmly believe that a comprehensive, independent and fact based assessment of covenant promotes a cooperative and productive relationship between trustees and employers, and forms the basis for constructive discussions between these stakeholders.

Please contact one of our Pensions Credit Advisory Team to discuss your situation and our services.

Case study 1
We were engaged by the trustees to assess their covenant during scheme funding negotiations. We identified that the covenant was weaker than the trustees thought and that the actuarial assumptions were out of line with current market practice. The outcome of our advice was that the trustees and employer agreed to a significant increase in the technical provisions deficit and level of cash funding.

Case study 2
We were engaged in 2005 to provide covenant advice to an international engineering group. Our initial review showed that the employer covenant was weak as the scheme was large compared to the group and the group was not trading well. We worked with the trustees to negotiate a recovery plan that was commercially sustainable for the group, allowing it to invest cash in improving trading performance and reducing debt. We also agreed contingent funding arrangements which resulted significant cash amounts being paid to the scheme.

Since 2005 we have regularly monitored the covenant resulting in enhancements to the scheme as our most recent review showed that trading performance had significantly improved (and hence so had the covenant) meaning that the trustees could negotiate a higher level of cash funding.