Pension insight: assessing the covenant strength of a charitable employer

With the third code of practice ‘Funding defined benefits’ released in 2014, there has been an increased focus by the Pensions Regulator on employer covenant. There has also been recognition of the challenges faced by charities in assessing this area. Making an objective assessment of any employer’s ability to support their scheme is a critical part of the scheme funding process. We outline some of the factors to consider when looking at the main covenant areas.

Group structure and legal powers

Considers the legal/structural position of the participating charity in its group, and the support accessible from the group on an ongoing basis.

Factors to consider:

  • Who are the employers, and what is the role to the group?
  • What is the balance of legal powers between the scheme and employers?
  • What is the constitution of the charity?

Recent trading, forecast trading and cash flows

Considers the recent trading, forecast trading and cash flows to assess the ability to fund the scheme on an ongoing basis, and understand the cash generation of the charity.

Factors to consider:

  • Understanding the key risks and attributes of the charity’s source of income
  • Are the income streams diversified?
  • What amount of cash is used for pension funding compared to other uses?
  • Historical forecasting accuracy – prudent or over-optimistic/achievable and aspirational?
  • Certainty of income – is the balance of risks and opportunities incorporated into the forecasts?

Affordability (should be considered in relation to the analysis in the recent trading, forecast trading and cash flows section)

Assess the ability to fund the scheme on an ongoing basis.

Factors to consider:

  • Understanding the level of expenditure that is discretionary is critical
  • Is it reasonable to curtail certain charitable activities? Is it reasonable to divert additional funds to a pension scheme?
  • If a higher proportion of income were diverted to a pension scheme, would this damage the charity’s brand?

Balance sheet - ongoing and exit

Considers the current balance sheet to assess the financial risk profile of the charity and the potential return to the scheme in wind up or insolvency scenarios

Factors to consider:

  • Adequacy of available liquidity, including consideration of debt maturity and working capital swings
  • The impact of the reserves policy. Does it give the charity sufficient flexibility and resilience to withstand unforeseen events?
  • The insolvency of charitable employers is a niche area.
  • Applying standard insolvency assumptions used for commercial entities could miss critical structural factors

Wider group

Considers the financial position of the wider group and its ability to support the participating charity and so the scheme

Factors to consider:

  • What access and support is provided by the wider group by either a willingness to support the employer/scheme and have legal agreements in place?

Market

Considers the market position of the charity, and the long term outlook for the markets and their characteristics

Factors to consider:

  • Market size and employer’s share of it
  • Impact of oversight from the sector regulators, such as the Charity
  • Commission or Homes and Communities Agency, for example
  • Take into account the impact of UK and global long term trends on the long term covenant