The charity employer covenant in pension schemes

Posted by Adrian Lamb on
Following on from the new Code of Practice 3 on Funding Defined Benefit Schemes the Pensions Regulator (TPR) has now issued much more extensive guidance on how to assess and monitor the employer covenant. The guidance has been structured in a straightforward way and TPR recommends that all trustees should as a minimum read the "At a glance" summary. Employers should do the same.

Importantly, for the first time there is charity-specific advice (and for other not for profit employers) in the new guidance. This has been welcomed by many, including the national representative body for workplace pensions, and with good reason.

There are also a number of case studies throughout, and some key points to consider when deciding on the extent and/or frequency of any review. These will be helpful to many charity employers and trustee groups as they wrestle with the difficulty of applying standards and assessments which are really designed for commercial enterprises and trustees of schemes which are sponsored and supported by them.

The guidance builds on the key message from the new Code of Practice focusing on the three key risk areas for defined benefit schemes - employer covenant, investment and funding – and how they interact. So, for instance, how might a change by trustees to the investment strategy affect the funding of the scheme and the employer's covenant.

Key areas

TPR encourages trustees and employers, and the relevant advisers to work together but identifies the following key areas in any covenant assessment:

  • Legal – what is the nature of the employer's obligations to the scheme and their enforceability.
  • Scheme related - the funding needs of the scheme both now and in the future.
  • Financial – the ability of the employer to contribute cash when required.

The annex dedicated to charities/NFPs states that the absence of a profit motive does not change how the employer covenant should be assessed, but the nature of some NFPs’ activities and financing arrangements means some elements of the guidance may apply differently. Two examples considered in the guidance are as follows:

  • The proportion of a charity's income that comes from donations, for example, i.e. to what extent is the charity reliant on donations, compared to public funding or contracts, or funds raised through retail activities, etc.?
  • Restricted funds are also a consideration outlined in the guidance. It encourages scheme trustees to check what restrictions actually apply and so establish whether the restricted funds are "off limits", and not simply take the charity's word that such funds are out of reach to the scheme.

Until now the Regulator's approach on monitoring the employer covenant has, with some justification, been classified by many as "on size fits all" and inflexible. In addition the Regulator's new "sustainable growth" objective, doesn't precisely fit the charity/NFP framework very well so the change of tack is to be applauded.

One therefore welcomes the engagement by the Pensions Regulator with the NFP sector, the Charity Commission and others, and acknowledge that this is a real and tangible shift, which should help scheme trustees and employers understand what is involved in assessing and monitoring an employer covenant.

What has not changed is the need for scheme trustees to take into account the different covenants for different participating employers. It is therefore vital that trustees are clear concerning:

  • Which employers have a legal obligation to the scheme.
  • The extent of that obligation.
  • The strength of that covenant, e.g. the covenant of an employer which is the operator of a number of retail outlets for a charity is likely to have a very different covenant from that of the main charity or even its main funding raising operation, etc.

Of course the new funding code now recognises the need for employers (of all types) to be able to continue to invest in the business. However trustees will then need to assess whether those investment plans will restrict the funds that might otherwise be available to the scheme and, if so, how the scheme might benefit from supporting investment in the business.

Proportionate assessments

So the guidance, along with the revised Code of Practice, if used and applied consistently and appropriately, should be helpful - particularly the emphasis on the need for any covenant assessment to be "proportionate to the circumstances of the scheme and the employer".

However, there are also warnings that "the covenant can change quickly" so trustees should have "well-developed contingency plans so they can take decisive action if and when required".

Again quite how this will be applied in the NFP sector is open to some debate. What seems beyond doubt is trustees will have to ensure that the process which they have in place for assessing and monitoring the employer covenant is fit for purpose – what information; how often; what procedures are in place to identify material changes, etc.

So where might this all lead?

Well there are a number of issues to consider for scheme trustees and employers:

  • Do trustees have sufficient knowledge to assess the covenant of the different employers? If not then some form of external review may be needed from time to time.
  • Are trustees given all of the information they need when they need it?
  • Do the trustees and the employers have an agreed strategy for funding the scheme, taking into account of all the risks that are faced, including investment risk, which is often (but not always) the most significant risk?
  • Are mechanisms in place to ensure that funding arrangements are capable of adjustment to protect the scheme from downside risks and to ensure that a scheme will receive benefit if the sponsor's financial position improves?

The employer covenant is always considered at the time of an actuarial valuation but the guidance is clearly underlining the need for trustees to make sure that they consider this on an ongoing basis. Of course this is what should have been happening and many trustees will have put in place arrangements, sometimes accompanied by non-disclosure agreements, by which the employer agrees to provide financial information (say every quarter); and to consult with scheme trustees before any significant financial changes are made, etc.

This seems bound to raise the issue of contingent assets again – something which may provide some charities with some breathing space if materially higher scheme contributions are unrealistic.

Holistic approach

It is to be hoped that scheme trustees and charities take a constructive and holistic approach to scheme funding and security of benefits. In the light of the continued turbulence in financial markets and the lack of any "helpful" move in gilt yields, all options need to be on the table, and taking a joined up approach to funding, covenant and investment strategy is now essential if scheme and employers are to stand the best chance of addressing what for many is a significant and long term funding shortfall.

One has already noticed a recognition that markets are unlikely to provide any relief in the foreseeable future. The reaction has been different, of course – some have decided to change investment strategy, recognising that those risks need to be more actively managed, others are exploring use of contingent assets, and so on – but the fundamental conclusion is often the same – doing nothing is no longer a viable or appropriate option.

So the guidance, overall, presents a much clearer picture of what is likely to be needed in assessing the employer covenant. It remains to be seen, however, whether it makes the task any easier. The first task may be take stock, including which employers have legally enforceable obligations. And all of this has to take account of each scheme's own circumstances, i.e. the extent to which a scheme is reliant on the employer covenant – so a well funded scheme may be able to have a less stringent process than one which is heavily reliant on substantial future contributions from the employers.

Article originally published in Charities Management. 

About the Author

Adrian has a wide range of pensions experience and expertise in of all aspects of pensions trusteeship, he is ideally placed to help rationalise employee benefits.

Adrian Lamb
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