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OPDU Report 25 - November 2008 Be prepared: why trustees need help with sponsor covenant assessments Understanding the financial health of a pension scheme’s sponsoring employer should always be of para-mount importance to a trustee, but the latest economic turmoil has brought the issue sharply back into focus. Companies that were recently regarded as robust and stable have become victims of the recent global slowdown. This has served as a stark reminder that nothing can be taken for granted. Trustees have a clear responsibility Further, in a recently launched con-sultation on refreshing the TKU code, the Regulator stated that it intends to reinforce the importance of assessing the employer covenant, which means now more than ever before trustees need to be fully versed on their sponsor’s financial position. Why is it important to undertake a formal assessment? In 2006, the Pensions Regulator chairman David Norgrove, called on trustees to view the pension fund deficit as a loan to the company by the scheme members, and to see themselves as primarily responsible for recovering that loan. In the absence of a comprehensive sponsor covenant assessment it can sometimes be difficult for trustees to establish any kind of recovery plan for the scheme. The vast majority of defined benefit plans are reliant on sponsor contributions for funding, so it is essential trustees appreciate the likelihood of a company failing to meet those obligations in the future. The idea is not to polarise the sponsor and the trustee board, but put the two sides on a level playing field from which they can cooperate and act in the best interests of the members. Undertaking an assessment of the sponsor’s willingness and ability to support the pension fund provides an essential framework for defining risk parameters, setting investment strategy and putting in place contribution schedules. To build a clear picture of the sponsor’s financial standing, trustees must understand the key financial elements which include; profitability, liquidity, operating efficiency, the structure of the funding base, cash generation, credit ratings and other relevant indicators. On the basis of this information, trustees in conjunction with the sponsoring employer can decide the most appropriate degree of prudence for the technical provisions; the time period over which to recover the scheme deficit; and the amount of risk that can be incorporated into the investment strategy.
The key elements trustees need to considerwhen formulating a recovery plan are:
Given that the sponsor covenant effectively lays the foundations for a scheme’s recovery plan, trustees should not underestimate the need for a transparent and independent assessment. While it is possible (and relatively common) for trustees to undertake their own investigation of their sponsor, a lack of consistent assessment meth-odology, and complexities such as corporate restructuring and legal liability are increasingly pushing trustees towards hiring external support and advice. Outsourcing an assessment to a third-party can free trustees to focus on other aspects of running their scheme and often leads to a fuller picture of the sponsor’s financial position. Many trustee boards will be familiar with their sponsor’s company and have a good idea about how the business operates, but their close proximity to the running of the firm can hinder objective assessment. External advisers are also well placed to undertake a thorough methodical review of the sponsor, based on the scheme’s specific situation. While there is no mandatory obligation In a time when there is a greater emphasis on controlling costs and fees, some schemes may be keen to avoid paying out for an independent review. However, the cost of an unbiased assessment need not prove prohibitively expensive, particularly as few trustees will require a full forensic analysis of the firm’s financial position. Ultimately, the amount spent on an independent adviser to undertake an assessment could prove negligible against the cost savings made from having the best information on which to build a robust recovery strategy. In this context it should not be forgotten that a “DIY approach” may incur a substantial opportunity cost. Once the initial covenant assessment is complete, trustees could be putting members’ benefits at risk if they fail to identify a change in the company’s fortunes which then impacts on the security of the pension fund. Returning to Mr Norgrove’s banking analogy, for trustees to be sure that the company can make good on its loan, they need to regularly check on the sponsor’s financial health. A thorough review of the sponsor covenant allows trustees to identify circumstances in which they will need to revisit original valuations and investment strategies, or call on the sponsor for greater reassurance and financial support. By monitoring the covenant on a regular basis, trustees will be able to watch for signals that indicate when a company’s financial position is deteriorating. Once these signals are spotted, the next stage is taking appropriate action or engaging with the company to ensure any down turn does not impact negatively on the pension plan. In some cases trustees have agreed with scheme sponsors a monitoring system which leads to cash payments becoming due to the scheme where the sponsor covenant weakens beyond a prescribed level. In other situations, the use of contingent assets may come in to play which can both shore up the pension scheme and help reduce the sponsor’s Pension Protection Fund levy payments. Recent sponsor covenant assessments Assessing and monitoring the sponsor must always be done on a scheme specific basis because elements that are profoundly important to some businesses will bear little relevance to others. Trustees with sponsors operating in the retail sector will have different ‘trigger’ points than boards in the manufacturing or banking sectors. For example, we have seen from the recent share price volatility in financial markets that some key measures for a bank’s covenant strength not only come from the structure of its capital base, which includes the make up of its liabilities (retail deposits, commercial deposits, inter bank deposits), but also general public confidence. As investors lost faith in the security of the banking sector, more and more institutions were hit by the crisis. In the retail sector, some companies are having difficulty in meeting their rental liabilities as they fall due. Some retailers are trying to renegotiate rent terms and landlords are often having little option but to agree. At the same time, many retailers are heavily dependent on the Christmas sales season for their annual results and need strong cash flow to see them through this crucial time. Trustees need to identify the key issues their own sponsor is facing and work with them to ensure the business stays afloat and that the pension scheme remains fully supported. In periods of intense market volatility, the need for a thorough and methodical covenant assessment, supported by a process of ongoing monitoring, becomes even more pertinent. The unprecedented activity in world stock markets of late has seen many pension fund surpluses pushed back into deficits, and recovery plans that seemed suitable as recently as six months ago may no longer be appropriate. In the past some trustees have agreed extended recovery periods, some as long as 10 years, even where their covenant was considered strong by all concerned. In those cases where an extended recovery period was agreed and where the deficit has been compounded by recent market volatility, the trustees will be asking how the situation would look if the historical deficit had been recovered in full before now. Further, as finance directors and treasury departments feel the pinch of recession across their business, the pension fund may start to fall down the sponsor’s list of priorities. A system of methodically monitoring the sponsor covenant means trustees can address changes to the sponsor’s position before the situation reaches crisis point. Trustees should avoid waiting until the next triennial valuation to air concerns about pension funding and act to protect members’ benefits at the first possible opportunity. While the fundamental aim of understanding the sponsor covenant is to underpin the retirement benefits of scheme members, carrying out an assessment also keeps recovery plans within affordable limits for the sponsor. No investment strategy or schedule of contributions should lead to the sponsor’s business becoming insolvent, and both sides need to work cooperatively to devise a strategy that works for all concerned. Trustees should aim to implement an assessment and monitoring process that involves the sponsor and opens up the channels of communication on a regular basis. Pushing the sponsor towards insolvency or administration obviously presents a very real danger for members both in terms of job security and pension payments, and with the global slowdown likely to see many more firms on the brink of default, trustees need to tread with care to protect the long-term financial stability of the plan. While the advent of the Pension Protection Fund has provided hitherto unknown security for defined benefit plan members, the benefits paid out under the PPF could equate to far less than individuals were expecting from their own occupational plan. For example a senior executive expecting a pension worth £60,000 a year at age 60 could have his payments capped at £25,000 under the PPF regulations, which represents a considerable cut in retirement income. Pension scheme members will always expect trustees to act in their best interests but the latest global financial crisis will have brought the issue to the fore and reminded savers about the fragility of their investments. Covenant risk can be managed but only if trustees fully appreciate the extent of that risk in the first place. Without a full and thorough assessment of the sponsor’s covenant, deciding how to secure the scheme, eg through contingent assets, becomes impossible. As we have seen so recently, no company is immune from collapse and trustees need to be well prepared for almost any financial eventuality. Top tips to take away The key points to remember when it comes to conducting an effective covenant assessment are: be prepared – don’t leave a sponsor covenant review until circumstances force your hand; be thorough and methodical whilst adopting a proportionate approach; undertake regular monitoring – keep a close watch on the changing fortunes of the business and the pension scheme; and seek advice – appoint independent support where necessary. The ongoing financial uncertainty and increased interest from the Regulator will only see effective covenant assessment grow in importance. Understanding the sponsor’s business is a vital element in any deficit recovery strategy and should be seen as crucial to all trustees responsible for securing members’ retirement savings. David Poynton |
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