You should regularly monitor the strength of the employer covenant, along with key investment and funding risks.
This will allow you to take action effectively when you need to mitigate risks or improve the position of your defined benefit (DB) pension scheme.
For an introduction to covenants, go to employer covenant: overview.
Key points
- Ensure there is a robust framework that enables you to regularly monitor the employer covenant between scheme valuations.
- Ensure there are well-developed contingency plans that allow you to take action to mitigate against adverse events or improve scheme security when you need to.
Importance of ongoing monitoring
The strength of the employer covenant can change quickly so it’s important you assess the covenant and monitor it regularly, along with investment and funding risks. This will enable you to take prompt and effective action when you need to.
It's particularly important to monitor the employer covenant when there is the possibility of the employer becoming insolvent. If the employer becomes insolvent, members’ benefits may be in danger. Read planning for employer insolvency guidance on the Pension Protection Fund website.
You should take a proportionate approach to the frequency and depth of monitoring based on various factors such as the scheme’s reliance on the covenant and the complexity of the employer’s operations.
Covenant factors to monitor
Contingency planning
You need to decide on appropriate triggers or thresholds based on what changes would have a material impact on the covenant.
Your contingency plans shouldn’t necessarily cover and mitigate all possible events. You should look at the level of risk your scheme is running.
You should discuss key risks with the employer and plan what potential action you might take so that you’re both ready to respond as soon as a trigger is breached.
One-off events, eg a corporate transaction, may affect the covenant and require you to take urgent action.
Improve scheme security
You should consider how you could improve the security of the scheme so that you have more flexibility to manage the scheme’s funding strategy.
Examples of ways to improve scheme security include:
- commitment to increase funding when certain events occur, eg if scheme assets underperform
- provide asset security to the pension scheme, eg credit letters and asset-backed contributions
- guarantees from other entities in the employer’s group
- an employer committing not to perform certain acts without agreeing it with the trustees
- improve the scheme’s insolvency priority
- amend the scheme’s trust deed and rules to give the scheme greater security
Contingent assets
If the employer has offered assets they own to help improve the security of the scheme, you should carefully consider the value placed on these contingent assets. This should reflect its anticipated value after a contingent event has occurred.
You may need a qualified professional to assess the value of an asset.
Consider how appropriate a contingent asset is in relation to the support it provides to your scheme’s funding strategy, eg whether you need to quickly access value from an asset.
Trustee toolkit online learning
The 'How a DB scheme works' module contains information on the employer covenant. You must log in or sign up to use the Trustee toolkit.