Ensure your approach to assessing the strength of the employer covenant is robust and effective so that you can decide the appropriate level of risk when setting your investment strategy, funding assumptions and, where necessary, recovery plan.
Take a proportionate approach to assessing the employer covenant for your defined benefit (DB) pension scheme. You should also make sure you carefully consider issues such as whether to take independent advice and how to work with the employer effectively.
For an introduction to covenants, go to employer covenant: overview.
- Take a proportionate approach to assessing the legal, scheme and financial aspects of the employer covenant.
- Consider using an independent covenant adviser if the trustees don’t have the required expertise or objectivity.
- Work closely with the employer and share information effectively.
- Make sure you understand how the scheme will benefit from any employer plans to invest for sustainable growth.
Overall approach to covenant assessments
Assessing the employer covenant regularly is important as it enables you to understand the extent to which the employer can afford to support the scheme now and in the future. You may also want to assess the covenant in response to scheme-related events, such as a scheme merger, or employer-related events, eg acquisitions or share buy-backs.
You need to understand the employer covenant from three perspectives:
- legal: the nature of the employer’s obligations and to what extent they can be enforced
- scheme: the size and funding needs of the scheme, now and in the future
- financial: the ability of the employer to contribute cash when required
The covenant assessment should provide enough information for you to answer a number of key questions:
When to perform an assessment
As a minimum you should review the covenant at each scheme valuation. However, as the covenant strength can change quickly, it’s important you monitor the covenant regularly between formal covenant reviews and take prompt and effective action when you need to.
For more information, go to monitor employer covenant and improve scheme security.
You should weigh up the costs of commissioning external advice against the benefits it could bring through a sound understanding of the extent to which the covenant supports investment and funding risks. Carefully consider the scope of the independent assessment so that it adds the greatest value and costs are controlled.
If you decide to use an independent covenant adviser to carry out the assessment, make sure you identify the areas you need to consider during the appointment and briefing process:
Working with the employer
It’s important that you work closely with the employer and share information effectively. You should agree appropriate ways of ensuring confidentiality is maintained, eg through confidentiality agreements. Make sure they understand that an appropriate covenant assessment is in their interest so that the funding and investment strategy is set appropriately and the scheme doesn’t pose an unnecessary risk to their future sustainability.
Those carrying out the assessment will need a number of pieces of information from the employer and other sources.
If the employer doesn’t provide appropriate information for the covenant to be assessed, you should consider taking a more prudent view of its strength and place less reliance on the covenant when setting the funding and investment strategy. This may mean that higher contributions may be required from the employer.
If the employer’s plans to invest in sustainable growth restrict the funding available to the scheme, you should understand how the scheme will benefit and whether other stakeholders are contributing appropriately. If the plans aren’t detailed enough, you shouldn’t be willing to compromise the position of the scheme to support the investment.
Not-for-profit employers and non-associated multi-employer schemes
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.