Trustees urged to integrate covenant risk assessment into their regular risk management process

rWhat happened?

The Pensions Regulator has released detailed guidance for trustees of defined benefit (DB) schemes on how they can assess their employer covenant.

The industry has broadly welcomed the new guidance. Helen Forrest, the National Association of Pension Funds’ policy lead for defined benefit, said: “We welcome the pragmatic nature of the document and the thoughtful and extensive approach TPR has taken to engaging with industry in its development.

“In particular, the new guidance will make the whole process of covenant review significantly less arduous for trustees, and will hopefully also help them to save money on advice.”

However, some experts have suggested that the regulator could go further (See “What next?”).

What does it mean for trustees?

Trustees will appreciate practical steps on how to assess covenant. As Hymans Robertson’s head of governance, Barry Mack, says: “It’s the first time the Regulator has provided comprehensive guidance in one place on how to assess and monitor covenant.”

However, the guidance could result in more work for trustees. The regulator has made it very clear that trustees must integrate covenant assessments into their ongoing risk management processes.

“This guidance puts employer covenant at the heart of the valuation process”

In reality though, most well-governed schemes will already work in this way. As Darren Redmayne, head of covenant assessment specialists Lincoln Pensions, says: “[A] misconception around employer covenant is that it is a ‘once every three year thing’. While understanding the employer covenant is critical to triennial funding discussions, the Regulator also expects proportionate ongoing monitoring.”

What next?

Trustees who are unsure of the strength of their covenant, or who may not have a monitoring process in place should take this as a clarion call. Consultancy PwC notes that there is a “large number” of pension schemes where the covenant is still not strong.

“More than ever, this guidance puts employer covenant at the heart of the valuation process. It will make any trustee board think hard about conducting a valuation without a thorough understanding of their employer covenant,” says Jonathon Land, head of PwC’s pensions credit advisory team.

Land continues: “For those schemes with a stronger employer covenant, trustees can be pragmatic about how much work is done. However, where the strength of the employer covenant is uncertain it is very clear that trustees need to get under the skin of the business and really understand the covenant.”

While welcoming the regulator’s guidance as “the first time the Regulator has provided comprehensive guidance in one place on how to assess and monitor covenant,” Hymans Robertson’s head of governance, Barry Mack, believes the regulator’s guidance could go further.

Mack says: “While the guidance highlights that a long-term outlook is important, it doesn’t offer much practical advice on how to quantify long term covenant risk so that it can be integrated with analysis of other pension risks.

Perhaps a next step for the regulator would be to issue some more advice on integration of risks, as Mack suggests.

The regulator’s new guidance can be found here.