With the release of the Pensions Regulator’s (TPR) latest guidance on ‘monitoring employer support’ in November 2010,[1] employer covenant has once again been thrust into the limelight. This applies to defined benefit schemes where the risk of pension provision is taken by the employer and not the employee. As scheme sponsor the employer underwrites the risks to which the scheme is exposed, including any underfunding, longevity, investment and inflation change.
Reasonable affordability, however, remains off stage and playing understudy to the headline act.
Definition of employer covenant
Employer covenant underpins the whole scheme funding regime. Without a full understanding of covenant the funding target of technical provisions is likely to be way off, the recovery plan will trigger when it reaches TPR’s inbox causing a considerable outlay of time and expense in providing information or attending conference calls. Additionally, deficits cannot be calculated and the underlying assumptions on investments and discount rates will not be appropriate.
In its Code of Practice, covenant is defined by TPR as the “employer’s financial position and prospects as well as his willingness to continue to fund the scheme’s benefits” often referred to as the willingness and ability to make good any deficits. The recent guidance amended that stance slightly by referring to the ‘legal obligation and ability’ of the employer. Willingness remains a factor, though.
Eliminate shortfalls quickly
The regulator suggests that, in drawing up a recovery plan, trustees should aim for any shortfall to be ‘eliminated as quickly as the employer can reasonably afford’. What is possible and reasonable, however, will depend on the trustees’ assessment of the employer’s covenant’. This message is not always taken to heart. I am aware of a trustee board, presented with the annual accounts, demanding the net profit figure. When we consider that the employer was in the not-for-profit sector and received 70% of its funding from government (being cut by 40% that fiscal year), we see that this initial request from the trustees was far from ‘reasonably affordable’ for the scheme sponsor.
Reasonable affordability
Reasonable affordability is not necessarily all the employers profit and or projected cash flow. One must also examine the operating cash flow of the business – the net cash flow after the business has paid its day to day expenses – as well as the following payments:
- Interest
- Capital expenditure
- Corporation tax
- Dividends
- Recovery Plan payments
During my three years at the Pensions Regulator in Brighton I saw many instances of either trustee boards being recklessly prudent or employers playing down the levels of available funds. TPR will assess reasonable affordability and so should trustees and employers. With a thorough understanding of, and agreement around, what is reasonably affordable for the sponsoring employer to make available to the scheme, the recovery plan process is much smoother for all parties, TPR included. If there is genuinely only £100,000 available for the scheme on an annual basis, there is only £100,000. Not even TPR can argue with that, although they will require the figures to support the assertion!
The basic process
In very broad terms, the basic process should be to assess covenant which leads in turn to:
- Understanding as to the required prudence of underlying assumptions, which leads to;
- An appropriate level of Technical Provisions, the target that;
- Reasonably affordable contributions aim to reduce, over a period of time;
- Giving the length of the recovery plan.
It can be understood when trustees and employers focus on the triggers that have been publicised by TPR – the ten-year recovery plan length being one. This can lead to the process being turned on its head with the frequently-heard line ‘the regulator says we should be under ten years, so that means the contributions need to be £x’. This should be resisted as it very rarely arrives at an appropriate answer, especially for third sector employers who have to contend with an extremely fragile and often complex funding structure.
Weaker employer covenant and longer recovery plans should turn thoughts to increasing the scheme’s security, where possible. This could mean a contingent asset, parental guarantee, profit related increases in contributions or other mitigation. Any proposed asset should be thoroughly investigated with the help of advisers to comprehend its value and suitability. Transfer of a piece of land from employer to scheme may initially seem a great deal, unless the land is tainted, meaning the scheme is then the target for any legal action as a result of, say, contamination of the water supply.
It should be noted that employer covenant and, therefore, reasonable affordability are not set in stone once they have been assessed as various events can have a huge effect on both. I have already mentioned government funding cuts and the impact on charities as one possible reduction in covenant and available cash. In the private sector expiration of a licence on a major product, collapse of a contract to build a large development and removal of lending facilities by the banks are some real life, significant, events that should trigger a proportionate reassessment of both covenant and reasonable affordability.
Employer covenant remains the headline act in the scheme funding process and rightly so. Trustees and employers should also call on reasonable affordability to support that procedure either between themselves or, where they have any doubts about their ability to do this, through professional support.
[1] www.thepensionsregulator.gov.uk/docs/employer-support-consultation-document.pdf