The Legal 500

Trustees of occupational defined benefit pension schemes (DB schemes) need to know how to assess the strength of the employer covenant as it has become a crucial factor in determining scheme-specific funding and in the progress of corporate transactions. Employers must also be aware that if the covenant is weak, this could stop a corporate transaction in its tracks.

What is the employer covenant?

The Pensions Regulator (the Regulator) describes the employer covenant as the employer's financial position and prospects, as well as its willingness to continue to fund the scheme's benefits.

Scheme funding and the employer covenant

Before 30 December 2005, DB schemes were funded according to the minimum funding requirement (MFR), which values accrued rights on leaving service and takes no account of the cost of future service. It is a very low basis and being fully funded on it means very little.

To encourage pension schemes to increase funding levels, the statutory funding objective (SFO) was introduced in the Pensions Act 2004 (the 2004 Act). The SFO requires DB schemes to hold sufficient and appropriate assets to cover its ‘technical provisions' - the amount required to provide for its liabilities. This new scheme-specific funding basis will generally be much higher than the MFR, and trustees now have the power to set funding targets according to the circumstances of the scheme and the strength of the employer. In the past, many companies had control of, or at least a veto over, the contribution rate. The new regime places pressure on companies to increase funding levels and, in many cases, to divert resources away from investment.

The Regulator has made it clear that it is essential for trustees to form an objective assessment of the employer's covenant in order to make decisions on both the technical provisions and any recovery plan needed. Where the scheme is found to be insufficiently funded to meet its technical liabilities, a recovery plan must be prepared, setting out the steps to be taken to meet the SFO and the period within which that is to be achieved.

Assessing the employer covenant

To assess the strength of the employer covenant the trustees need to obtain information about the employer. The employer is obliged to provide the trustees with any information that either they or their professional advisers reasonably require for the performance of their respective duties. Trustees should also consider using commercially available services such as rating agencies or credit scoring institutions, credit specialist advisers, industry regulators' reports, and information which may become available in connection with the risk-based element of the Pension Protection Fund's levy. Just generally keeping an eye on information regarding the employer which is in the public domain is also sensible.

In addition, the Regulator has indicated that trustees of schemes in deficit should view that deficit as similar to a debt, and have regard to the way that a lending banker would treat that debt. Actuaries have suggested that it is helpful for the trustees to ask themselves:

‘Could the employer take on additional debt in an amount sufficient to extinguish the FRS17 accounting deficit overnight and, if so, on what terms?'

This is a question trustees may look to a third party adviser to answer. In addition, the employer covenant assessment should estimate what the pension scheme could recover in the event of the sponsor becoming insolvent. Trustees should be aware that relatively small changes in the employer's financial structure could have a dramatic effect on what the pension scheme would recover in an insolvency event, and the Regulator expects trustees to protect the scheme against such a scenario.

Employer covenant review

If a review of the employer covenant is carried out by a third party, they will tend to concentrate on the following four areas:

1) Corporate structure

This includes pinpointing who and where the participating employers are, where the company's value lies, and what powers the trustees have in the trust rule and deeds - how much control do they have over setting contribution levels and the winding-up process?

2) Financial position

What assets does the company have, and are any of them undervalued? What would the scheme receive if the employer failed, and what can the employer afford up front? What debts does the company have and who has priority, and how would any statutory debts be split between participating employers - would they be jointly or severally liable?

3) Future proposals

Does the company have contracts in place already which will bring in future business? What risks does the business face in the future? Is there likely to be a material event that could be damaging to the pension scheme?

4) Industry factors

Does the company work within a strong industry and is the company a strong player within that industry? What is the employer's future strategy and what is the long-term future of the market?

All of these issues will be relevant in assessing the employer covenant.

Clearance

The strength of the employer covenant is also incredibly important if the employer is contemplating involvement in a corporate transaction. If the target company has a defined benefit scheme with a large deficit this will impact on the price of the transaction, and possibly whether the transaction goes ahead at all.

The Regulator will normally expect trustees to take independent financial advice on the impact of the transaction or restructuring, and the adequacy of any offer that has been made. Parties to a transaction may wish to apply to the Regulator for clearance if the transaction could have a ‘materially detrimental affect on the ability of the pension scheme to meet its liabilities'. To be financially detrimental there must be a deficit (measured on the FRS17 basis).

Type A events

The Regulator has classified various events affecting a company. The strength of the employer covenant will be relevant to both Type A and Type C events. A Type A event is one which has one of three effects:

1) A change in the group structure of an employer which reduces the overall employer covenant and could affect the ability of the employer to meet a potential statutory debt arising under s75 of the Pensions Act 1995 (which may arise on insolvency, wind-up, or cessation of participation of an employer in a multi-employer scheme). This could include a change of employer or participating employer, or a change of parties connected or associated with the employer.

As soon as the trustees become aware of a potential transaction it is important that they measure the potential effect of any change in the control structure. According to the Regulator, guidance can be found in existing market practice, in particular by looking at commonly applied financial ratios or banking covenants. The most obvious starting point is to compare the credit rating before and after the change of control event. It is sensible for the trustees to organise an independent employer covenant review.

2) A change in priority in the level of security given to creditors with the consequence that the pension creditor (always considered an unsecured creditor) might receive a reduced dividend in the event of insolvency.

3) A return of capital which may result in a reduction in the overall assets of the company which could be used to fund a pension deficit, for example, dividends or shared buybacks.

Type C Events

A Type C event is one which points towards a deterioration in the employer covenant. Type C events generally are not as financially detrimental to the scheme as a Type A event and usually include all notifiable events (notifiable to the Regulator under s69 of the 2004 Act) which provide an early warning of potential insolvency or underfunding. It is not necessary to seek clearance for a Type C event.

Contribution notices and financial support directions

Should the Regulator be concerned that the employer covenant is too weak, then it has the power to impose financial support directions requiring ongoing support of the pension scheme from other group companies, and contribution notices requiring lump sum pension contributions from related companies or individuals.

Conclusion

It is very important that trustees of occupational pension schemes are aware of any changes that might affect the ability of the sponsoring employer to fund a pension scheme deficit. It is advisable for employers to keep the trustees informed of the general financial state of the company, and if they decide to apply for clearance, to involve the trustees in discussions regarding the potential transaction at an early stage.

By Holly Thomson, an associate in the pensions team at international law firm Stephenson Harwood. E-mail: holly.thomson@shlegal.com