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Monitoring employer support

Covenant, contingent assets and other security

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At a glance

  • The covenant is an employer’s legal obligation and its ability to fund the scheme now and in the future. The strength of it depends upon the robustness of the legal agreements in place and the likelihood that the employer can meet them. As scheme sponsor the employer underwrites the risks to which the scheme is exposed, including underfunding, longevity, investment and inflation.
  • All trustees should therefore have a framework for assessing and reviewing employer covenant, including regular monitoring. Trustees should regard this as just as important to the security of the scheme as monitoring fund performance. Our research indicates that some schemes already have a sound approach; for others, improvement is necessary.
  • We provide case studies to help trustees take appropriate action. Employers and trustees should work openly together, with trustees committing to confidentiality agreements if needed. Recent experience highlights how quickly circumstances can weaken even very strong companies. Trustees should ensure that the process they have in place remains fit for purpose in rapidly changing conditions.
  • Trustees should ask probing questions to understand the covenant the employer provides for the scheme, and where they have any doubts about their ability to do this, they should engage the right professional help.
  • Covenant should be assessed objectively. The ability of employers or guarantors to meet their obligations should be viewed in the context of the scheme’s exposure to risk and volatility – for example from investment returns and demographic change. Where trustees choose to accept these risks, they should be confident that the employer will be able to make additional contributions to compensate against adverse outcomes.
  • Trustees and employers should prepare plans for realising the employer support standing behind a scheme, should this become necessary. For example, this may encompass the provision of identified contingent assets to increase overall support or underwrite risks, or the agreement of negative pledges with the employer, such as not to grant new security without the agreement of trustees. Without such arrangements, trustees run the risk that they only look to crystallise employer support at a time when the employer has many other competing demands for limited funds, or when it would substantially weaken the employer.
  • We expect trustees and employers to act appropriately in approaching covenant assessment and monitoring. It may not be affordable or appropriate for all schemes to put in place elaborate contingent assets. However, there are a variety of arrangements schemes can consider for increasing scheme security such as positive and negative pledges and sharing in increased cash-flow.

1: Introduction

About this guidance

  1. This guidance has been produced for trustees and managers of all occupational pension schemes with a defined benefit element and sets out practice that we expect trustees to follow in assessing, monitoring and taking action on employer covenant.
  2. The guidance brings together into one framework the support provided by scheme sponsors to pension schemes through employer covenant, and the additional security which may be provided by pledges, non-cash transfers, agreed actions or contingent assets.
  3. The glossary provides explanations of the main terms used for the purpose of this guidance which are shown as emboldened text.
  4. The guidance is divided into four sections plus appendices as follows:
    • Section 1: Introduction
    • Section 2: Covenant
    • Section 3: Security
    • Section 4: Monitoring and taking action
    • Appendices

The context

  1. The regulator expects trustees and employers to take proactive action to ensure that there is adequate security for the scheme. Employer covenant is the legal commitment of the relevant employer to support the scheme. This includes statutory obligations and obligations to make payments under the payment schedule as well as its ability to do so. It may also include other unsecured promises to provide future support to the scheme[1].
  2. Trustees need to understand an employer’s covenant from both a legal and a financial perspective; legally to understand the nature and enforceability of the various promises to pay and financially to assure themselves that they are likely to be met.
  3. The need for trustees to assess employer covenant arises, in part, from their legal obligations to:
    • have appropriate knowledge and understanding of employer liability under pensions law and their particular scheme’s deed and rules[2];
    • determine prudent methods and assumptions for the calculation of their scheme’s technical provisions[3]; and
    • prepare, maintain and revise statements of funding principles, recovery plans and schedules of contribution[4].
  4. The covenant effectively underwrites the risks to which the scheme is exposed including existing underfunding, longevity, investment and inflation now and in the future. It needs to be adequate to offset a variety of different contingencies from short term (eg insolvency or employer exit) to long term (eg increasing longevity).
  5. When reviewing the employer covenant the trustees are seeking to determine:
    • the nature and enforceability of the legal agreements to support the scheme
    • whether they need to be more cautious in their approach to scheme funding
    • whether they should adopt an accelerated recovery plan
    • whether they should negotiate for the acquisition of some more tangible support eg a legal commitment or contingent asset
    • whether they need and are in a position to call in contingent assets or promises made by the employer
    • the level of risk that they are able to sustain in the investment policy of the scheme
    • whether they need to call for an early valuation.
  6. In order to assure themselves that they remain on course to meet their scheme’s statutory funding objective, trustees need to be confident that they can rely on the employer’s support at all times. They can do this by implementing a measuring and monitoring process which:
    • occurs at suitable frequency
    • is of appropriate depth and intensity based on their circumstances
    • is based on appropriate information
    • is based on expert interpretation of that information.

    To the extent that a company already provides certain information within certain time limits to its banks it may well, in principle, not be difficult for it to supply similar information within the same timeframe to pension trustees.

  7. Where there is a need to strengthen employer support to the scheme, this can be achieved by:
    • sponsors agreeing an action plan with the trustees, whereby they commit to certain courses of action now or as result of certain events or triggers; and/or
    • specifying particular assets or cash-flows which will be available to the scheme in certain circumstances and entering into enforceable legal arrangements to secure those agreements.
  8. The assessment of covenant strength by itself does not strengthen scheme security. However it does enable the trustees to base their operational decisions on a better understanding of anticipated corporate sponsor backing. As such, assessing covenant strength is an important pre-cursor for trustees when they are adopting appropriate risk management programmes for their schemes.
  9. The principles outlined in this guidance also underpin our regulatory processes, and we apply them in a risk-based and proportionate manner. Our initial views on covenant strength will inform our initial analysis of the prudence of scheme funding assumptions, and is one of the factors that help identify which funding plans to subject to greater scrutiny.
  10. When valuations use assumptions which appear inappropriate we would normally engage in dialogue with all relevant parties in these circumstances. We approach the situation in a manner that is specific to the circumstances of the scheme and the sponsoring employer and the employer group. In such discussions we also follow the principles outlined in this guidance when trying to understand the appropriateness (or otherwise) of the valuation assumptions and of the recovery plan.v
  11. Economic conditions can vary significantly, even over relatively short periods of time. Different industries may experience lesser or greater volatility in the strength of the constituent employers and individual employers may show greater volatility still.
  12. As such, the strength of the employer covenant may be subject to significant variation (in line with its industry and beyond this) over relatively short periods of time. Thus trustees should be wary about accepting historical evidence alone to justify the ongoing strength of employer covenant. The past is helpful but it is the forecast of the employer’s performance in the future that is more important when considering strength of covenant. Rather they should include assessment of the point in the economic cycle of the employer’s industry and also their assessment of the employer’s position within its economic cycle and critically consider its ability to recover if it is at a low point.
  13. The regulator’s statements in 2009 gave examples of the flexibility of recovery plans. This is based on the principle that whilst trustees should expect the employer to repair any deficit as quickly as affordable, a desirable outcome for the scheme is usually provided by security from a solvent employer.
  14. In many cases such flexibility will still be necessary. To assess whether this is so, trustees should satisfy themselves concerning the strength of the employer to generate improved cash-flow. Where cash-flow has improved, the trustees should consider the extent to which the scheme should benefit from that improved cash-flow capacity and the replacement of contingent assets or other support by actual cash payments into the scheme.
  15. Where employer covenant is weak and not anticipated to improve with market recovery, the trustees should be very cautious about accepting a long or back-ended recovery plan and should carefully consider all of their options.
  16. Throughout, trustees should bear in mind the costs of covenant monitoring and any proposed actions relative to the size of the scheme and the employer and to the potential benefit of the exercise. This framework is not intended to impose unnecessary costs on the scheme.
  17. In particular, this guidance is not intended to encourage trustees to commission standardised (or boiler plate) reviews which do not provide added value to them. For example if trustees have sufficient information (published and/or internal) available to them but have concerns about what the information means for covenant strength, they could consider appointing an external adviser to interpret the information for them. However, a standard review based solely on published information is likely to add little added value to them beyond interpretation of known information. See paragraphs 37-40.
  18. A proportionate approach is likely to mean that in certain circumstances a less detailed measurement or monitoring is required. It is for the trustees to decide whether they feel that a less detailed approach is appropriate but some of the considerations could include:
    • The scheme is fully funded based on conservative technical provision assumptions.
    • The scheme deficit is much less than the value that the trustees can reasonably expect to be available to them if the employer were to go into immediate insolvency (and hence the s75 liability may not be such a prominent consideration at the present time).
    • The results are obvious (eg it is known that covenant is extremely weak and the funding valuation assumptions do not allow for employer support).
    • The employer has agreed to fund the deficit (assessed on conservative technical provisions) over a short period.
  19. Where trustees decide that a less detailed approach is appropriate, they should record their reasoning for such a decision.

Footnotes for this section

  • [1] For further discussion of the employer covenant see the regulator’s Clearance guidance
  • [2] s247(3)(a) and (4)(a), s.248(3) and (5)(a) Pensions Act 2004
  • [3] Regs 5(1) and (3) Scheme Funding Regulations 2005
  • [4] s223, s226 s227 Pensions Act 2004

Key points for this section

  • Covenant is the obligation and the ability of the employer to support the scheme and protects against both short-term and long-term risks.
  • Scheme security can be further strengthened by the use of agreed action plans and contingent assets.
  • Trustees should monitor covenant regularly and appropriately.
  • The future is more important than the past in monitoring covenant.
  • Trustees should review employer cash-flow and consider the need for flexibility in recovery plans.
  • Trustees should act appropriately in monitoring covenant and seeking further security for their schemes and in deciding whether a proportionate approach is justified.
  • We apply the principles outlined in this guidance in a risk-based and proportionate manner in our regulatory processes.

2: Covenant

Covenant and scheme risk

  1. In terms of cash-flow, the employer covenant represents the ability of the employer to provide the necessary cash-flows envisaged to support ongoing accrual, deficit repair agreed in a recovery plan and to account for any adverse performance compared to that assumed in plans.
  2. Strong employer covenant means that the trustees can place reliance on the employer providing support to the scheme in the event of adverse outcomes in unmitigated risks such as investment, longevity or inflation. Therefore a strong employer covenant enables the trustees to follow an investment policy based on a higher proportion of return seeking assets which carry higher risk. As a consequence they would be able to justify a discount rate for scheme specific funding that reflects these anticipated excess returns.
  3. Conversely a weak employer covenant provides less scope for the trustees to adopt such a policy. In cases of very weak (or negligible) employer covenant, trustees need to justify why an investment policy that includes the acceptance of significant risk is in the best interests of the scheme members.
  4. Trustees should not rely on the Pension Protection Fund (PPF) as the guarantor of last resort being a factor enabling them to accept higher levels of risk within the scheme.
  5. Both market conditions and the strength of the employer covenant are volatile and can deteriorate quickly; therefore trustees need to have mechanisms in place to monitor both. Where risks increase, trustees will need to consider whether the employer covenant is still sufficiently strong to stand behind these risks or whether there is a need to increase scheme funding or security. Where covenant strength is deteriorating, trustees need to take steps to increase scheme security before the ability to do so is lost.
  6. Covenant can be assessed only for a limited time into the future whereas the risks that trustees are managing in a pension scheme, such as investment and longevity, have an impact over many decades. Trustees should remember that - in the long term - it is the risk management and internal control processes they put in place and operate that will provide the best protection for the scheme.

Case example 1: Trustees concerned about funding volatility

The cash-flow and solvency of a large financial services company had been severely reduced by the recent economic downturn. As a result, the trustees had become concerned about the ability of the employer to support their scheme to provide full benefits in the future and were unsure whether the reduction in corporate earnings was cyclical or permanent.

Therefore the trustees commissioned an exercise to assess the level of investment risk the scheme could reasonably be expected to take. To do this they considered alternative assumptions leading to differing outcomes in their projections and producing a range of projected funding levels. They considered the lowest outcomes in the range, focusing on the deficit which would arise if they encountered the 5% worst outcome in the next 10 years.

They compared this potential deficit with an expert assessment of the anticipated employer covenant over this period to see if the company could be expected to have sufficient cash to cover this deficit at the relevant future dates. This indicated that they should not feel comfortable that employer covenant would always be adequate to cover adverse scheme experience.

With this information they negotiated with the employer to examine the options available to them including de-risking. They agreed with the employer to retain the current investment structure, in return for which the employer agreed to provide contingent assets to the scheme. This provided the security that the trustees needed to address the potential risk.

Assessing employer covenant

  1. When assessing the employer covenant it is necessary to assess both:
    • the sponsoring employer's legal obligations to the scheme; and
    • its financial position (both current and prospective).

    The employer's willingness to fund the scheme is relevant to the reliance that trustees can place on employer support. However, they should be aware that assurances from the employer that are not legally binding may not protect the position of the scheme. The best evidence of willingness is where the employer is prepared to provide promises that are legally enforceable.

  2. Trustees should understand the legal structure of the group and the order in which creditors may claim insolvency priority over different assets of the group (that is the position or subordination of the pension scheme to other creditors).
  3. The covenant or financial strength of a wider group of employers than those with direct legal obligations to the scheme may be relevant, particularly where:
    • any changes to the sponsoring employer will also affect the financial position of the wider employer group, for example by removing entities from the group or transferring assets (whether within or outside the group);
    • the sponsoring employers have provided valid reasons why the trustees should take the financial position of the wider employer group into account when assessing the employer's financial position;
    • there is existing support for the scheme from the wider employer group, for example in the form of a parental guarantee;
    • there is interdependency between entities in the wider employer group and the sponsoring employer which may affect the sponsoring employer’s covenant; or
    • the financial position of the sponsoring employer is not of sufficient strength to support the scheme.
  4. Employers and trustees should remember, though, that only certain members of the wider employer group (participating employers or those with contractual obligations) may be legally liable to contribute to the scheme. Therefore, whilst the wider employer group is always relevant, trustees should be cautious about over-reliance on the wider employer group.
  5. Any advice provided to the trustees, or decisions made as a result of covenant monitoring or assessment, should be recorded and maintained as part of the trustees records.
  6. Given the complexity of assessing covenant, it is recognised that the process carries cost for the scheme. Nothing in this guidance is intended to produce cost to the scheme disproportionate to the benefit. As such, trustees should consider the materiality of covenant to their decisions on funding, recovery plan and investment and conduct the process in a way that is consistent with their needs.
  7. Similarly, it is not intended to suggest that schemes or employers spend a disproportionate sum on the assessment of covenant relative to the value of liabilities in the scheme.

Case example 2: UK subsidiary of overseas parent

The sponsoring employer was the UK subsidiary of an overseas parent company based in the USA. The UK pension scheme was significantly in deficit and the UK company was experiencing difficult trading conditions.

The overseas parent provided a letter of recognition acknowledging the UK pension scheme but did not provide a legally enforceable guarantee for the scheme. The trustees believed that the letter of recognition was issued primarily for audit purposes.

In the past, the UK subsidiary had been a core part of the group and a major site of production. However within the last few years production had moved to the Far East and the UK had become largely a distribution operation and less important to the group than previously.

Although the trustees had no reason to believe that the parent company would not support the pension deficit, they were concerned because in the last couple of years the deficit had increased sharply due to the downturn.

The trustees commissioned a covenant review which began by considering the group structure. This highlighted the vulnerability of the trustees’ position. It suggested that the trustees request a guarantee from the parent company (which they had been too nervous to do previously). As a result of negotiations the trustees agreed not to strengthen the assumptions on which the technical provisions were calculated and to a longer recovery plan than they would otherwise have done in return for a guarantee from the parent company. The trustees took legal advice on the enforceability of the guarantee, and in particular its legal enforceability in the event of insolvency.

Assessing the employer's legal obligation to the scheme

  1. Identifying the employers, and analysing and assessing their legal obligations to the scheme, can be a complex process and will normally require legal advice. Employers and trustees should identify:
    • those employers who could be liable, now or in the future, to pay a s75 debt[5]. They will need to ascertain the likely amount of the s75 debt that may become due from each employer in a multi-employer scheme (see also our guidance: Multi-employer schemes and employer departures;
    • those employers required by a statutory schedule of contributions to pay contributions to the scheme and, in a multi-employer scheme, assess the proportion of the total contribution that is payable by each employer;
    • those employers participating in the scheme and who are bound by the scheme's trust deed and rules, and identify the employer's powers and obligations under the deed and rules;
    • those employers whose insolvency could result in the scheme or part of the scheme entering a PPF assessment period and if so the effect of such an insolvency.
  2. In some cases, former employers will be included in the above categories because of the relevant statutory definitions. It is important to remember that some employers may not fall into all of the above categories.
  3. Other legal obligations of either the employer or another entity in the wider employer group to the scheme will also be relevant, for example, obligations created in any guarantee, ancillary deed or agreement.
  4. The legal relationships between the employer and the rest of the wider employer group are also relevant because these could have an impact on the sponsoring employers’ ability to meet their obligations, eg if another entity within the group also has a legal call on the sponsoring employer’s cash-flow or assets.

Footnotes for this section

  • [5] s75 Pensions Act 1995

Assessing the financial position

  1. Once trustees have identified those parties with legal obligations to fund the scheme, they need to consider the financial position of those parties so that they can consider the likelihood that those legal obligations will be met. Both the current and prospective financial position will be relevant. Trustees may require professional advice to perform this exercise.
  2. Trustees will need to decide what information they need to consider in respect of their particular scheme and employers. Professional advice may help them decide what information to seek but it should include:
    • the position of the employer, including its financial strength, intra-group relationships and policies, management records and future plans;
    • the scale of the obligations to the pension scheme relative to the size of the employer’s operating cash-flow;
    • the nature of the industry sector in which the employer operates and the employer’s position within the industry;
    • the position of the economy as a whole;
    • the relative priority placed on the pension scheme compared to competing calls on corporate finances, such as dividend payments, capital expenditure and bonus payments; and
    • an estimate of the value that might flow to the scheme on insolvency of the employer as well as the likelihood of that eventuality (the assessment being based on past and current information and trends).
  3. Appendix A outlines a suggested approach to the financial assessment of employer covenant and the information on which this could be based.
  4. Employers and trustees should work openly together. Employers are required[6] to provide to trustees such information as they or their professional advisers reasonably require for the performance of their respective duties. In order to promote openness, trustees should be prepared to commit to confidentiality in respect of the supply of any information that might have price sensitive implications if released into the public domain.
  5. We encourage trustees to recognise the importance of maintaining a positive working relationship with the sponsoring employer (particularly where there are still members of the scheme who are current employees of the employer). It will usually be in the interests of the scheme members for the trustees to allow the sponsoring employer to maintain the sound health of the company. Sometimes the interests of the members will not be aligned with those of the employer. This would normally occur when the trustees are of the opinion that it is extremely likely that the company is in decline, to the extent that it will be unlikely to be able to support the scheme in the long term.
  6. Assessment of employer covenant strength may not result in an absolute number; many covenant assessors routinely express their views as a category relative to risk in the scheme (for example ’very strong‘, ’strong‘, ’weak‘ or ’very weak‘) whereas some use a more nuanced approach. A higher score or a stronger category means that a scheme may be better placed to accept a higher level of risk (that is anticipated to be rewarded) as the trustees know that the employer, or another party, acts as guarantor to the solvency of the scheme should experience be adverse.

Footnotes for this section

  • [6] Regulation 6(1)(a) of Occupational Pension Schemes (Scheme Administration) Regulations 1996

Considering the use of professional covenant assessors

  1. Trustees are accountable to ensure that they have a sufficiently accurate assessment to enable them to take appropriate decisions and actions on funding assumptions, investment allocation and recovery plan shape and duration. Trustees need to understand the degree of importance of the strength of employer covenant in influencing these decisions and use this to define the level of detail or the areas on which they choose to concentrate in setting objectives for covenant assessment.
  2. When deciding whether they have enough expertise on the trustee board to assess covenant or whether they need to employ external experts, trustees will need to consider their objectives and match those to the skills available. They are likely to need someone who:
    • can understand the key factors that affect employer financial performance;
    • can understand the group structure and the employer’s position within the group (including the legal obligations between members of the group);
    • has experience and expertise in analysing and understanding the information that predicts future changes to company performance; and
    • is not conflicted and is able to provide an independent assessment – not relying solely on the opinion of the employer.

    To the extent that some – but not all – of these characteristics are to be found on the trustee board, trustees might consider using those internal capabilities and supplementing them externally to cover the gaps.

  3. If existing advisers to the scheme are being considered to provide advice on covenant assessment trustees should check that they have access to appropriate legal and financial expertise, as without this they are unlikely to have suitable qualifications to measure covenant.
  4. If trustees decide to take external advice, it is important that they select a covenant assessor based on a robust selection process. Trustees should prepare a role description detailing the outcome they require (see Appendix B for suggested questions).
  5. In preparing their brief, trustees may need to consider:
    • the budget that they can afford and consider reasonable in the circumstances;
    • information from the company that identifies the critical factors that affect company performance; and
    • whether there are any reasons to anticipate events (or circumstances) which are expected to adversely affect employer covenant.
  6. The trustees should allow sufficient time at the outset when deciding who to appoint, as this is likely to produce better results and to save time later in the process.
  7. Once they have appointed external advisers, trustees need to manage their advisers in the same as they manage other advisers. Further advice for trustees on managing their relationship with advisers may be found in our guidance Relations with advisers.

    See Appendix C for some legal considerations involved with contingent assets, Special Purpose Vehicles, and other arrangements for additional scheme support.

Case example 3: Trustee board including finance director, considering the need for external covenant assessment.

The finance director (FD) of a large manufacturing company was the chair of trustees for the pension scheme. He was aware that his expertise and experience gave him a dominant position on the trustee board.

Other trustees had limited industry knowledge and were concerned about their ability to challenge any views expressed by the FD concerning the strength of the company and its prospects. Their concern was both to be able to engage meaningfully with the FD and also to demonstrate that their decisions were not affected by any conflict of interest that the FD may have.

Therefore they drew up a well defined brief to evaluate employer covenant and conducted a ‘beauty parade’. The selected advisers interviewed company senior management including the FD and compared the information with that held on their own database.

As a result the trustees were much more confident that they had been able to apply independent checks to the internal covenant assessment provided by the FD.

Key points for this section

  • The level of risk that may be accepted depends on the strength of the employer covenant.
  • Both risks and employer covenant should be monitored.
  • Trustees need to plan ahead for the steps they will take to increase scheme security, if necessary, before the ability to do so is lost.
  • Assessing covenant requires assessment of both legal obligation and financial position.
  • Different employers may have different responsibilities to the scheme which should be considered.
  • Trustees should try to maintain a positive working relationship with the employer where possible.
  • Measure current and prospective covenant.
  • Measurement is complex and requires judgement.
  • This guidance is not intended to cause schemes to spend disproportionate amounts to measure and monitor covenant.
  • Trustees remain responsible for the measuring and monitoring of employer covenant.
  • Trustees should lead the information requirements and protocol.
  • Unless trustees have the expertise and independence on the trustee board they should consider appointing external experts to advise on covenant.

3: Security

Increasing scheme security including the use of contingent assets

  1. Where trustees and employers want to increase the strength of the employer covenant or security of the pension scheme, there are a variety of ways to do so:

    Examples include:

    • agreements to abide by certain performance thresholds and to inform trustees when certain thresholds are breached;
    • granting the scheme insolvency priority alongside other creditors;
    • other improvements in insolvency priority, such as the subordination of other creditors, to improve the outcome for the scheme on insolvency;
    • negative pledges, whereby an employer makes a commitment not to do something such as grant new security without the agreement of trustees or not to increase dividends;
    • commitment to increased funding on certain events, eg should profitability improve (eg step payments in a recovery plan with ’true-up‘) or investments perform badly;
    • a wider corporate group can look to take on joint and several liability for the funding of, or debts due to, the scheme;
    • scheme rule changes: making an amendment to the scheme’s trust deed and rules can change the balance of power to give the scheme greater security;
    • non-cash transfers to the pension scheme; and
    • the granting of specific contingent assets.
  2. Non-cash transfers are arrangements involving the transfer of assets to the pension scheme. These assets might be directly transferred to the scheme or might be transferred to a Special Purpose Vehicle (such as an LLP) which the pension scheme might own fully or partially. In some cases the trustees might own just an income stream from the assets with final ownership of the assets to be determined at a later stage.
  3. Where assets are transferred directly (and particularly when it is through sophisticated SPV structures) the trustees need to clarify whether these investments may be classified as employer related investments. They may need specialist legal advice to help them in this regard. For further considerations on employer related investment see Appendix C and also our statement: Employer related investments.
  4. Contingent assets are assets on which a claim by the pension scheme would exist on the occurrence of one or more specified future events ('the contingent event'), such as movements in corporate asset holdings, increased employer borrowing, employer insolvency or the failure to achieve a specified funding level. Unless the events occur they are not available to the trustees to meet members' benefit payments. They are not included as scheme assets for the purpose of assessing whether a scheme meets its statutory funding objective (ie that assets are sufficient to cover technical provisions) until they are transferred to the scheme.
  5. Some examples of the forms of contingent assets that are widely used commercially are:
    • the provision of a group company guarantee such that the guarantor agrees to make a payment (or series of payments) to the scheme if the contingent event occurs;
    • security over other assets (eg property or securities) such that the asset is transferred to the trustees if the contingent event occurs;
    • a letter of credit; a guarantee or insurance from a third party such that if the employer were to default on payment of contributions to the scheme, money can be drawn against the third party up to a specified amount; and
    • sterling cash put aside in a bank account and charged to the fund. Some or all of the cash would be released to the fund on the occurrence of the contingent events.
  6. In calculating its risk-based levy, the PPF recognises certain contingent assets. The regulator’s guidance covers many of the same factors as the PPF’s levy rules. However there are differences (see below) and trustees should not assume that if a contingent asset is suitable for scheme funding purposes it will automatically be acceptable to the PPF (or vice versa).
  7. Some forms of contingent asset require a third party to act as guarantor or provider of credit. Where this is the case, the trustees should assess and monitor the covenant of the third party and satisfy themselves that it has a sufficient credit rating so that the scheme is not exposed to undue risk of default. The PPF has specific requirements of third parties that it will recognise as guarantors.
  8. Group company guarantees, may be for a specific period or have no time limit. For scheme funding purposes the trustees will need to reassess what protection the guarantee provides in the light of the guarantor’s ongoing financial situation on a regular basis, regardless of the time limit placed on the guarantee. For PPF levy purposes, only guarantees which are indefinite in duration can be recognised. However the PPF standard form of guarantee permits release or reduction in certain circumstances, eg funding improvements.
  9. Trustees should consider the costs of establishing and managing the contingent assets and who will bear these costs. To the extent that such costs fall on the scheme, trustees should ensure that they are fully reflected in all decisions concerning the suitability of the contingent asset and concerning the recovery plan.
  10. Trustees are likely to need specialist legal advice to ensure that any contingent asset is available when needed, is properly enforceable and on particular legal issues such as employer related investment. Employers may wish to take further advice on how the contingent asset impacts on their business.
  11. See Appendix C for examples of common contingent assets and some of the legal considerations involved with contingent assets, non-cash transfers and Special Purpose Vehicles.

Considerations when valuing contingent assets and additional security

  1. The purpose for which a contingent asset is being valued may dictate the method of valuation and the value. It is possible for a particular asset to be viewed differently for PPF levy purposes from the way it is viewed for ongoing scheme funding.
  2. The trustees will need to consider the value they are to place on the contingent asset or security for the purposes of making suitable changes to the recovery plan. For some, such as cash in a designated account, this will be straightforward but for others, such as property or a group company guarantee, careful consideration will be needed before allowing for the contingent asset in a scheme's funding strategy.
  3. For most purposes the valuation of an asset should be at its anticipated value after a contingent event has occurred. Trustees should be aware that some assets which are closely related to the employer may decline in value at the same time the employer covenant deteriorates.
  4. For some forms of asset (eg a property), the current value will not be publicly available. In such cases, the trustees will need a qualified professional to provide an assessment of the current open market (or forced sale, if appropriate) value of that asset.
  5. For other forms of asset the value may be dependent on the continued existence of the employer. In such cases the trustees will need a qualified professional to provide an assessment of the asset in the event of the failure of the employer.

Relevance of security over assets to scheme specific funding and the recovery plan

  1. Many contingent asset agreements ring-fence assets which would otherwise form part of the overall employer covenant, and therefore allow trustees to more clearly anticipate the action they will take should there be a need to increase scheme security in the future.
  2. There are a range of circumstances in which taking security over an asset can affect a scheme specific funding and recovery plan. Examples include:
    • allowing the scheme to invest in a higher proportion of return seeking assets;
    • increasing scheme security should future experience prove adverse;
    • supporting long recovery plans where it becomes difficult to forecast the strength of employer covenant when it may be needed; and
    • reflecting the support of the wider group if they wish to identify with the scheme in this way.
  3. Trustees need to consider the appropriateness of any asset it secures in relation to the support it is providing to the scheme's funding strategy. For example, with a contingent asset where the contingent event is the failure to achieve some specified investment return, the asset needs to be sufficiently flexible and realisable to make up the actual underperformance. In such a case, cash in an account charged to the scheme is likely to be more suitable than a charge over property.
  4. Where contingent assets are being used, trustees must decide how they will structure any recovery plan in the light of the contingent asset.
  5. The trustees should consider a number of different factors before incorporating a call on assets into the scheme's funding strategy, including:
    • the size of the deficit in the scheme
    • the value of the asset to the scheme on the dates any contingent event could occur
    • the pace of funding being proposed.
  6. Trustees will need to enter into a dialogue with the employer about the business case for including a contingent asset as part of the scheme's funding strategy. Trustees should consider whether they are foregoing anything in order to take advantage of a contingent asset or other arrangement, eg does it replace higher contributions in a schedule of contributions, and if so, is the substitution beneficial to the scheme? They should ask employers:
    • why the contributions that might otherwise have been required are not available to the scheme; and/or
    • why a lower level of additional assets is required to cover the technical provisions.
  7. Including a contingent asset in a scheme's funding strategy may reduce the cash-flows into the scheme. This may compromise the trustees' ability to meet benefit payments to members, especially if benefit payments exceed income. The trustees should ask the actuary to identify whether, in the normal course of events, the introduction of contingent assets will accelerate the need for the trustees to realise assets. In the light of this opinion, the trustees will then need to consider whether including the contingent asset remains appropriate.

Recognition of contingent assets in the PPF risk-based levy

  1. The rules governing the extent to which contingent assets are recognised in the risk-based levy are set out in the Pension Protection Fund’s (PPF) ‘Levy Determination’ for the relevant year, plus associated guidance. The PPF’s policies in this area gradually evolve year on year and the latest information is available on the PPF website.
  2. The PPF’s rules for recognition are more prescriptive than the regulator’s general guidance given here. This reflects the fact that an individual set of trustees can make a bespoke analysis of any contingent asset arrangement and the value it offers to their scheme. By contrast, the PPF needs to ensure that it only gives credit for assets of consistent strength, and that they are valued consistently and fairly for the purposes of the levy. For example, the PPF publishes standard forms of agreement for the different asset types and will only recognise contingent assets which follow very closely the standard form. Recognition is also dependent on certification/re-certification of the contingent asset through the regulator’s Exchange system on an annual basis, before the relevant data deadline.
  3. The PPF’s requirements mirror closely the issues which trustees are recommended to consider under the preceding paragraphs. For example:
    • the trustees must obtain and submit a formal legal opinion covering specified matters including enforceability etc, including a foreign opinion where appropriate;
    • jurisdictional requirements and, in the case of third party providers (banks etc), credit rating and regulatory requirements;
    • for security over assets, trustees will have to obtain and submit periodic valuations on a specified basis; they will also have to demonstrate registration of the security where appropriate; and
    • for security over land, certificates of title are also required.
  4. Putting in place a PPF-compliant contingent asset can significantly affect a scheme’s levy bill for the current and future levy years. However it is not a trivial exercise and trustees should seek professional advice well in advance of the relevant data deadlines (currently 31 March each year) if they are contemplating a contingent asset arrangement.

Key points for this section

  • Securing an asset is a way of making employer covenant more tangible.
  • Non-cash transfers may be an addition or alternative to cash funding.
  • Contingent assets commit cash or assets from the employer or another party on the occurrence of a specified event.
  • Trustees should check with the PPF guidance to make sure that the contingent assets are acceptable to them if they intend to use them for PPF levy purposes.
  • Trustees and employers can consider a variety of mechanisms to strengthen covenant and increase scheme security where necessary.
  • Contingent assets can be expensive to manage and trustees need to allow for these costs when considering the acceptability of contingent assets.
  • Trustees must ensure that the contingent asset agreement will guarantee the assets being accessible when needed.
  • When valuing a contingent asset trustees need to allow for its anticipated value after the contingent event has occurred.
  • Taking security over an asset may give the trustees more flexibility in their decisions on funding and recovery plans.
  • Trustees need to satisfy themselves that the assets are of suitable characteristics to justify this flexibility.
  • Trustees must ensure that accepting security over an asset (rather than cash) does not compromise the ability of the scheme to pay benefits when due.
  • Trustees should check PPF guidance to ensure that any contingent assets are PPF-compliant for the purposes of the levy if necessary.

4: Monitoring and taking action

Ongoing consistent monitoring

  1. It is important to recognise that the strength of the employer covenant can change rapidly and therefore trustees will want to ensure they have mechanisms for regular monitoring and review. Trustees need to be in a position to act quickly to strengthen scheme security if they need to do so. Trustees may want to delegate some of the duty to assess and monitor covenant to a sub-committee.
  2. A full review of covenant and its strength should be conducted before each scheme specific funding valuation. This would normally occur at 3-yearly intervals.
  3. As part of this process trustees should consider establishing (or updating) a formal plan agreed with the employer and specifying the process by which changes to covenant will be monitored.
  4. Although the shape of the monitoring plan will be led by the particular needs of each scheme and the circumstances of the employer it is good practice for these plans to contain:
    • key business performance measures which, in the trustees’ opinion, reflect the employer covenant to be monitored (the trustees should consider expert advice in formulating the information to be measured);
    • clear plans for the action which will be taken if performance measures or other metrics are breached such as the transfer of specified assets (or equivalent cash) to the pension scheme.
  5. Trustees should recognise the value of spending time at the outset to establish these plans based on relevant information to be presented in a manner that they can understand and interpret and which enable the trustees to decide when to act. It is good practice to involve the employer in the construction of the metrics and the timings of the process to ensure that information requests are reasonable and can be met
  6. It is likely that the trustees will wish to have external expert advice when constructing the monitoring plan. In the course of ongoing monitoring the trustees may – or may not – require external input depending on their level of ability to understand the monitoring measurements and the implications of those measurements.
  7. In most cases it will be appropriate to review covenant strength annually once the financial results and annual plans of the sponsoring employer are known. The degree of depth of the update and the degree of formality of the annual review should depend on the assessment by the trustees and their advisers of the extent to which covenant has changed materially over the previous year or may be forecast to change significantly in the future.
  8. Trustees should have a standing item on their meeting agendas to note employer covenant. They should compare performance against the monitoring plan that they have set. The importance of this (and therefore the time and depth allocated to the standing item) will depend on the significance of employer covenant to their funding and recovery plans, as well as performance against metrics.
  9. They should check that that there are no company events over the period since the last meeting, or anticipated before the next meeting, that should give cause for a more detailed review or the seeking of immediate mitigation. This standing item should also consider the ability of the employer to generate sufficient cash in the period until the next trustees’ meeting to pay contributions due in that period.
  10. Recent experience highlights how quickly circumstances can weaken even very strong companies. Trustees should ensure that the process they have in place remains fit for purpose in rapidly changing conditions.
  11. One-off events may lead to a need for immediate mitigation because of the impact on the ability of the employer to meet either or both the ongoing funding commitments to the scheme or the ability to stand behind the full cost of securing members’ benefits (s75 debt) if appropriate. Such events may be the departure of an employer from a multi-employer scheme or events which prevent recovery of some or all of a s75 debt, or materially weaken the employer covenant. These are discussed in more detail in our clearance guidance.
  12. In these situations trustees should consider whether they need to call an additional emergency meeting of the trustee board to consider their responses and actions rather than waiting for the next scheduled regular meeting.

Actions to take based on monitoring of covenant

  1. Trustees should consider the effect that employer covenant has on the issues they face in the way that they manage the scheme including:
    • how current funding is to be maintained
    • how the deficit is to be made up if necessary
    • is the investment strategy appropriate?
    • can the scheme justify the level of risk it is carrying?
    • do the trustees need to review the assumptions for funding valuations?
    • is the scheme exposed in the event of insolvency; how is this to be mitigated?
  2. In some cases, the ability of trustees to oblige the employer to improve the employer covenant will depend on the powers that they have under legislation and the scheme documentation. If the trustees are unsure what limitations there are to their ability to take action they could consider conducting a 'balance of powers' review to establish the extent and the limitations of their powers. Trustees should also recognise their fiduciary duties and ensure that the act in the best interests of the scheme members.
  3. They should be prepared to act early and quickly if the metrics or triggers in their monitoring plan are breached or if they are aware of corporate events that may have a materially detrimental effect on the security of members’ benefits. They should engage actively with the sponsoring employer to discuss the situation at the earliest opportunity, as other creditors would. If these discussions do not lead to acceptable outcomes then the trustees should be prepared to act to protect the scheme.
  4. Where the monitoring plan does include specified actions, the trustees need to actively consider implementing it. This could include calling on contingent assets or increased funding as specified in the plan where applicable.
  5. Where an event (whether internal or external) has raised a serious concern about covenant or its strength, the trustees need to be prepared to take actions that go beyond the monitoring plan actions. These might include:
    • bringing forward the next actuarial valuation to quantify the current scheme funding level
    • adjusting the valuation assumptions to reflect a view that covenant may be weak
    • realigning the investment portfolio to be consistent with a weaker covenant.
  6. If the trustees have serious concerns they are encouraged to contact the regulator at an early stage to raise these concerns. The regulator will consider whether regulatory assistance may help resolve the situation.

Case example 4: Competing demands for cash; back-end loaded recovery plan

A medium sized, growing company in a developing industry had positive cash-flow but had competing demands for that cash.

In particular, they were in the middle of a major new product development which they were convinced would secure the future of the company and provide significant continued growth. Therefore they did not feel able to fund the deficit in the pension scheme as requested by the trustees.

The trustees commissioned a covenant review specifically to consider the future prospects for the company both with the new product and without the new product.

The advisers spoke to senior management and then used their general financial forecasting expertise to confirm the reasonableness of the projections.

As a result the trustees negotiated with the company, agreeing to extend the recovery plan (and hence reduce the early year payments) in return for an agreement that the recovery plan payments would increase in a specified way in line with profitability.

Case example 5: Negotiating a win-win solution

A substantial successful company with strong positive cash-flow which was several times larger than its scheme had agreed an investment strategy with a high return-seeking element on the back of this strength. A major division encountered substantial difficulties as a result of the arrival of a strong competitor from overseas which sought to buy UK market share.

The remaining divisions were still able to provide support for the scheme but the margins on which the technical provisions and investment strategy were based were disappearing. The employer had breached the covenant monitoring plan metrics that it had agreed with the trustees at the previous valuation. The employer appealed to the trustees to allow it to reduce existing contributions so that it could limit the impact on shareholder sentiment of a dividend cut and invest to counter the new threat.

The trustees met with the employer to consider the position urgently.

After negotiation they agreed to the following program:

  • a short term reduction in employer contributions for the next two years
  • increased contributions in subsequent years
  • realignment of the portfolio to reflect weaker covenant strength
  • more conservative assumptions leading to increased calculation of technical provisions
  • guarantees from other parts of the group to provide extra security to the pension scheme in the short term.
  • agreement by the employer to a rule change to increase the powers of the trustees to wind up the scheme
  • a limited cut in the dividend for the current year; together with
  • a statement from the employer to investors that dividends will be increased in future years as the pension scheme deficit reduces.

    The company invested the cash saved by the contribution and dividend reductions into the development of new products to compete more effectively.

    The overall result was that the share price was relatively unaffected because the market had priced in an expected small dividend decrease and was encouraged by the statement, the intention of future dividend increases and the accord between the company and the trustees.

    Therefore both the company and the trustees felt more positive about the prospects for both the security of the pension scheme and of the sponsoring employer.

  1. The regulator expects trustees and employers to take proactive action to ensure that there is adequate security for the scheme. However, we recognise that in some cases such action will be ineffective, or unavailable because employer covenant is negligible or, in extreme cases, effectively nil. In these cases trustees will need to consider all of the options available to them.

Key points for this section

  • Conduct a full covenant review before each scheme specific funding triennial valuation.
  • Agree a monitoring plan with specific triggers.
  • The triggers should enable the trustees to take appropriate action before covenant weakens too far.
  • Review annually based on updated financials.
  • Standing item on covenant on each trustee meeting agenda (specific scheme/company circumstances to determine level of detail).
  • If significant corporate events occur be prepared to take appropriate action.
  • Trustees should act early if they anticipate that covenant will weaken or has weakened.
  • Actions will include those set out in the monitoring plans or calling in contingent assets, realigning the investment portfolio, bringing forward the next actuarial valuation and/or strengthening the valuation assumptions.
  • If trustees have serious concerns they should involve the regulator at an early stage.

Appendix A: Assessing the financial strength of employer covenant

Assessing the employer's financial position

  1. Assessing an employer's financial position can often be a very complex process. The level of detail necessary for such a financial review should be proportionate to the level and materiality of (i) the scheme size relative to the size of the sponsoring employer, (ii) the deficit within the scheme and (iii) any potential detrimental events where these are anticipated.
  2. The relevant factors to consider in assessing the current and prospective financial position of the employer may vary depending on the circumstances and may include:
    • the nature and prospects of the industry in which it operates;
    • its competitive position and its relative size within that industry;
    • its management ability and track record;
    • its financial policies;
    • its profitability, capital structure (including balance sheet and financial leveraging), cash-flow and financial flexibility; and
    • its credit rating (if any), which may have some bearing on these considerations. However, the credit rating on its own should not be seen as a substitute for an independent review, unless the detail of the analysis behind the rating is made available and is acceptable to the trustees.
  3. In many circumstances the nature and structure of a wider corporate group than the legal sponsor of the scheme will also be relevant, including the ultimate owners of the employer or the corporate group. The extent of a review of the corporate group will depend upon the reasons for the review and on the nature and materiality of any event which might be detrimental to scheme security.

    Relevant considerations may include:

    • the legal domicile of the entities within the wider corporate group, including the ultimate owners;
    • any restrictions or limits on capital and cash-flows within the group;
    • whether there is interdependency between the wider group and the employer, for example:
      • whether the employer is providing services to the rest of the group;
      • whether the employer services debt that sits elsewhere in the group;
      • whether there is security over the employer's assets in respect of any debt; or
      • what additional funds, if any, exist within the wider employer group that the scheme may have recourse to, either through a financial guarantee or other legal right.
    • what additional covenant, if any, is provided by the wider corporate group, and whether the structure of the group adds strength to the covenant of the employer;
    • any investment timeframe of the ultimate owners, covering the manner in which they extract returns on any capital invested and whether the ultimate owners have any legal obligations to support the scheme;
    • the potential for the scheme to have access to additional funds from the wider corporate group; and
    • the nature and enforceability of any contingent asset provided to the scheme by the wider group.
  4. Employers and trustees should be careful to review the financial position of the employers and the wider corporate group in the context of each entity's legal relationship with the scheme and the extent of its enforceable obligations.
  5. The scheme is usually an unsecured creditor of the employer. The insolvency priority of an unsecured creditor, with regard to the realisation of the assets of a company in the event of insolvency and when compared to other creditors, is broadly summarised below:
    1. creditors with fixed charges;
    2. preferential creditors;
    3. creditors with floating charges;
    4. unsecured creditors (usually including the pension creditor);
    5. subordinated creditors;
    6. equity
  6. Trustees and employers should also keep in mind the long term nature of the employer's pension obligation, and should therefore consider the employer's long term future.

Information from the employer

  1. Information that may assist with the assessment of employer covenant may include the types listed below. The level and type of information that is appropriate will depend upon the specifics of the company and the industry in which it operates. Types of information may include:
    • updates on the group's financial position, including key performance data and future business plans;
    • statutory company accounts (and management accounts if appropriate) to ascertain its profitability, capital structure, cash-flow and financial flexibility;
    • independent business reports;
    • confirmation of compliance with banking and other creditor covenants;
    • information relating to security that has been or will be granted;
    • any reviews of the scheme, or any plans or proposals in relation to the scheme;
    • information from rating agencies or credit scoring institutions;
    • information from credit specialist advisers;
    • information that relates to the risk-based element of the PPF's Levy;
    • any new developments in the credit advisory services market aimed at assisting the trustees to evaluate the employer's financial position; or
    • publicly available information such as press reports, broker briefings and the employer's website.
  2. Employers should recognise that it is in the best interests of all concerned to have properly informed, knowledgeable and competent trustees. To achieve this, they should share information relating to the employer covenant and plans for the scheme and any event that may affect the pension scheme security with the trustees at the earliest opportunity.
  3. Employers are required to provide to trustees such information as they or their professional advisers reasonably require for the performance of their respective duties.
  4. Trustees should be prepared to commit to confidentiality agreements in order to promote the sharing of information.

Appendix B: Appointing a Covenant Assessor

Considerations for drawing up a brief for a covenant assessor

  1. It is important that trustees ensure that they commission a report that will support them in their decision making and is proportionate, in cost and depth, to the benefit they will gain from it. Therefore trustees should be wary of standard box-ticking reports but spend some time considering what they want from a report and assessing the services offered by potential covenant assessors.
  2. The following is a non-exhaustive list of questions that may help trustees decide how to approach covenant assessors and to draw up a brief for them to quote for. Each scheme’s circumstances are unique and the brief set by specific trustees may be specific to the needs of their scheme. Therefore the list that follows is not intended to necessarily be appropriate in its entirety to all schemes. Rather, trustees should regard these questions as prompts to use as they feel appropriate.
  3. Understanding the firm’s experience and expertise:
    • How many other pension fund clients do they advise:
      • in total?
      • within the same industry as the sponsoring employer?
      • of similar size to the sponsoring employer?
    • Supply biographies, qualifications and experience of people who will be conducting and checking the assessment.
    • How many professionals do they have acting in this capacity? Are they financial, legal or both?
    • Supply relevant references (it is advisable to ask for more than will be checked to enable the trustees to choose from among the references offered).
  4. What process should be followed for covenant assessment?
    • What information requirements would they have:
      • as essential?
      • as preferred?
    • What information and recommendations would be provided by different types of assessment:
      • generic?
      • desktop review only?
      • desktop review plus discussion with sponsoring employer senior management?
      • other?
    • How will they handle the situation where the employer is not willing to share information?
    • How does the approach differ where the sponsoring employer is a subsidiary of an overseas parent company?
    • What process would the assessor follow and what timescales to delivery?
    • Costs and in particular confirmation that the costs include all requirements of the trustees (including a formal report where applicable)?
  5. What should the report include?
    • Ask firms to supply a sample format of their report.
    • How do different firms rate the strength of covenant:
      • number/value?
      • rating?
      • category?
      • other?
    • Are there specific issues about the employer or the wider group’s structure or finances that you would like to understand?
    • Do you want advice on what is ’reasonably affordable‘? Considered over how many years?
    • Do you want to link covenant to recommended actions:
      • by reference to a monitoring plan?
      • by reference to contingent assets?
      • linked to valuation assumptions for scheme specific funding, recovery plans and to the scheme’s investment policy risk profile?
    • How will you use the report as an aid to decision making?
    • What emphasis should there be on past performance, current performance and anticipated future performance of the sponsoring employer?

Characteristics of a suitable report

  1. The suitability of a report will depend on the employer’s and the scheme’s specific circumstances but in general it should:
    • be based on reliable statistics (either published or unpublished and provided by the company) but should also be forward looking and anticipate any future changes to covenant;
    • measure only those factors/parameters that are relevant measures and predictors of covenant (this should include business metrics as agreed by the company as being key indicators of performance);
    • indicate how much the employer is predicted to be able to reasonably afford over the next 3 years. The report should include the assumptions underlying this assessment and a statement of how vulnerable this assessment might be to alternative future conditions;
    • indicate suitable trigger points for actions to be included in the monitoring plan. These trigger points should reflect the points at which the trustees should start to have concerns about future company performance;
    • be presented in a way that trustees can understand and which allows them to interpret the information in a way that allows them to act appropriately based on the report;
    • contain a contextual summary (if the report is lengthy) which indicates the key results and any indicated actions;
    • provide a measure of covenant. This could be in a category (eg ’strong‘) or a monetary amount. In any case the report should provide the trustees with a clear indication of how likely it is that the employer will be able to support the scheme.
    • (where this is not the first time that trustees have measured covenant strength) show a comparison with covenant strength as at the previous scheme specific funding valuation; and
    • help the trustees to understand that the pension scheme is only one of the creditors of the employer and to be able to pay pension contributions (or a recovery plan) the employer must also be able to satisfy fairly their obligations to other creditors and investors if the employer is to continue as a viable entity.
  2. If the trustees want the report to consider the willingness of the employer to finance the scheme, then it should specify what past or present evidence the willingness is being assessed on.

Appendix C: Legal considerations when considering arrangements to increase scheme security including contingent assets

  1. When considering the issues which relate to contingent assets, non-cash transfers Special Purpose Vehicles or other arrangements for additional scheme support, the trustees are likely to require independent specialist legal advice. Key areas for advice are likely to include the structure of the arrangement, the underlying assets (eg, the contingent asset, or any other asset on which the scheme will rely for support through any payment or transfer obligations in the arrangement), any entity providing support, and the impact of insolvency on the arrangement. Some other issues to consider are highlighted elsewhere in this guidance.
  2. The trustees may need to, amongst other things, ask their lawyers:
    • to confirm that the agreement is directly enforceable by the trustee and whether there are any jurisdictional or other limitations on that enforceability, and to advise what remedies will exist for any breach;
    • whether or not prior to the agreement the underlying asset is unencumbered. Encumbered assets may still be appropriate as contingent or underlying assets if the trustees are aware of the encumbrance and remain comfortable, with appropriate advice, that they will receive the value that they have attached to the asset should the contingent, payment or transfer event occur;
    • that prior to, as part of, or subsequent to any agreement, no party may take an interest in the underlying asset which is preferential to the scheme's interest or may reduce the scheme’s interest;
    • what the effect of the agreement is and how durable it is. For example, if the contingent, payment or transfer event is the insolvency of the sponsoring employer, then trustees should ask the lawyer to confirm the likelihood that the contingent asset will in fact be available to and enforceable by the scheme once the insolvency event has occurred (the value that will attach in insolvency should be separately considered);
    • to advise on whether the mechanics for payment to the scheme are appropriate, including any time limits by which payments should be made;
    • to liaise with the trustees’ financial advisers to assess the general outcome on insolvency, including legal issues such as whether the scheme as a creditor of any entity providing support might be subject to structural subordination because realisable assets are held by its subsidiaries, or whether other creditors could have charges or otherwise rank ahead of the scheme;
    • whether the contingencies or other trigger events are appropriate to the circumstances and match the trustees’ expectations of what the arrangement will achieve;
    • whether there might be any overriding claims on underlying assets (for instance if they form part of regulatory capital requirements for the relevant entity, employer or group);
    • whether the arrangement could be amended without the consent of the trustees;
    • how amounts payable are described or defined (eg, how ’buy out‘ might be defined in the arrangement);
    • to advise on any measures that might be put in place to ensure that any assets or entity relied on by the trustee does not significantly reduce in value (eg, ring-fencing, a trust in favour of the scheme, suitable custodians, or appropriate security);
    • whether the trustee will be entitled to receive information updates about any underlying assets or entities providing support;
    • whether the trustees are fettering their discretion in any way by entering into the arrangement;
    • what effect the winding up of the scheme may have on the arrangement;
    • what control, if any, the trustees will have over any relevant assets (eg whether the trustees will be able to influence how assets held in escrow or by a Special Purpose Vehicle are invested);
    • to advise on the drafting generally, as well as the appropriate form of the documentation (eg whether a deed is appropriate if there is no consideration provided by the scheme);
    • to advise on whether any entity providing support already has obligations to the scheme (eg because it is already a participating employer in a ’last man standing‘ scheme) and if so, whether the arrangement could be less valuable than it initially appears to be;
    • that whoever is providing the underlying asset has authority to do so; and
    • that the arrangement would be consistent with:
      • the employer related investment (ERI) restrictions in section 40 of the Pensions Act 1995 and the Occupational Pension Schemes (Investment) Regulations 2005 (SI 2005/3378) (see further below);
      • statutory requirements for investments by trustees (including section 36 of the Pensions Act 1995);
      • a scheme's statement of investment principles;
      • the trustees’ fiduciary duties; and
      • any other investment provisions of the scheme.

    This is not an exhaustive list. Which legal issues trustees and their lawyers will need to consider will depend on the circumstances and the specific type of arrangement proposed.

  3. Contingent or other underlying assets need not always be located within the UK. There are likely to be particular legal issues arising where the asset is located outside the UK and/or the agreement is subject to the law of another country. As a result, trustees are likely to require legal advice from a lawyer or lawyers qualified in the relevant jurisdiction or jurisdictions (eg in the jurisdiction referred to in the governing law clause of the documentation), including advice on insolvency issues.
  4. The regulator's view is that certain investment arrangements that may be agreed by trustees and employers, including some Special Purpose Vehicles such as limited partnership structures could be ERI. Employers and trustees should take legal advice as to whether any proposed asset could be considered as an ERI breach.
  5. The regulator cannot provide a definitive interpretation of the law and this guidance must be read in conjunction with the relevant legislation.

Appendix D: Glossary of terms

Term Definition
Balance of powers review A review of the significance of the relative powers of sponsoring employer and trustees, particularly in making amendments to the scheme rules, setting contributions, agreeing recovery plans and wind up and the extent to which either party has the right to act unilaterally, including the implications of legislation which may override the scheme rules in relation to powers.
Contingent assets Assets on which a claim by the pension scheme would exist on the occurrence of one or more specified future events ('the contingent event') such as an employer insolvency or the failure to achieve a specified funding level. In other circumstances they are not available to the trustees to meet members' benefit payments. In particular, until the contingent event occurs, they cannot be included as scheme assets for the purpose of assessing whether a scheme meets its statutory funding objective (ie that assets are sufficient to cover technical provisions).
Covenant The covenant is an employer’s legal obligation and its ability to fund the scheme now and in the future. The strength of it depends upon the robustness of the legal agreements in place and the likelihood that the employer can meet them. As scheme sponsor the employer underwrites the risks to which the scheme is exposed, including underfunding, longevity, investment and inflation.
Covenant assessor An organisation or individual offering services to pension scheme trustees to provide an assessment of the employer covenant.
Insolvency priority

A rule that stipulates the order of payment - creditors before shareholders - in the event of liquidation. The priority rule is used in bankruptcies to decide what portion of payment will be received by which participants. The order of priority is usually

  1. creditors with fixed charges
  2. preferential creditors
  3. creditors with floating charges
  4. unsecured creditors (usually including the pension creditor;
  5. subordinated creditors
  6. equity

Debts to creditors will be paid first in the order of priority and shareholders (partial owners) divide what remains

Key business performance measures The value of the key indicators (whether ratios, monetary amounts or key actions of the business) which are anticipated to be key predictors of future employer covenant levels.
Negative pledge An enforceable provision which prohibits the employer from creating any security interests over certain property specified in the provision. It constrains the employer in issuing further debt that will rank before the pension scheme in priority without the consent of the trustees.
Non-cash transfer Transfers of assets to the pension scheme. These assets might be directly transferred to the scheme or might be transferred to a Special Purpose Vehicle (such as an LLP) which the pension scheme might own fully or partially. In some cases the trustees might own just an income stream from the assets with final ownership of the assets to be determined at a later stage.
Positive pledge An enforceable provision whereby the employer agrees to undertake specified actions if a specified contingent event occurs.
Return seeking assets Return-seeking investments fall into the category of ’active investment management‘. A return-seeking fund is constantly reviewed and finessed by the investment manager to take advantage of yield opportunities and protect capital.
Step payments A structure in the recovery plan which provides for employer contributions to increase in future years at specified increases if specified targets are missed or if a defined contingent event occurs. A level recovery plan with a single step would have employer contributions which are level until the year of the step payment and then remain level at the higher rate thereafter.
Technical provisions The 'technical provisions' are an estimate, as required in Part 3 of the 2004 Act made on actuarial principles, of the assets needed at any particular time to make provision for benefits already accrued under the scheme. These include pensions in payment (including those payable to survivors of former members) and benefits accrued by other members which will become payable in the future.

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