Employer Covenant Roundtable - An open relationship

CHAIRMAN: Nyree Stewart, senior reporter at Professional Pensions
Nyree Stewart joined Incisive Media in October 2005 spending 18 months working at IFAonline as a reporter covering pensions, offshore and investment before moving to Professional Pensions in June 2007.

Paul Belok, actuary and principal at Aon Consulting
Paul Belok has been with Aon for 20 years, and is actuary and consultant to a number of significant UK pension schemes. He also leads Aon’s proposition in relation to settlement solutions (both insured and non-insured) for DB schemes.

Darren Mason, a director at Grant Thornton,
Chartered Accountant and Licensed Insolvency Practitioner.
Darren Mason specialises in the provision of advice to pension schemes trustee boards and their sponsoring employers in situations of underfunding. He is especially sought after in complex cases, business restructurings and those involving international entities.

Terry Monk, director of Independent Trustee Services
Terry Monk was appointed to the Board of ITS in 2001 and represents ITS at Trustee meetings. He also has responsibility for the development of the ITS services, providing input to the Board in terms of its decision making processes as well as representing ITS at trustee meetings.

June Mulroy, executive director of business delivery at The Pensions Regulator
An ex-psychologist and chartered accountant, June Mulroy worked in large corporates and in banking for over 17 years as a dealer/risk analysis specialist and consultant. She has worked in Switzerland and Paris, the latter being for the United Nations in UNESCO.

Phil Sutton, a partner at the law firm Hammonds
Philip Sutton advises clients on all aspects of pensions law. His particular strengths are in the winding-up of schemes, independent trusteeship, scheme restructuring and insolvency-related issues. Sutton is a member of the Association of Pension Lawyers (APL).


STEWART: The law says a trustee board must set prudent assumptions, but it does not say they must make a formal assessment of an employer covenant. How should trustees determine what is necessary to discharge their duties?

Sutton: In terms of how trustees determine what is necessary to discharge their duties, they need to have regard to the Code of Practice on scheme funding issued by the Regulator. It is not a legally binding document and there are no penalties for non‑compliance, but a court or tribunal looking to assess whether trustees have complied with that law will have regard to conformity of the trustees actions with the code of the practice, so it is a meaningful document in that regard. Having established that, what does the code of practice say about this? It is pretty clear that the regulator expects trustees to have a formal assessment of the employer covenant. Indeed, the Code of Practice describes this as ‘essential’. Trustees ought to have a formal employer covenant assessment as part of their valuation process.

Mulroy: We have guidance not only in the code but also on our website to try to help trustees understand some of the issues. It surprises me a little that it is a new issue because I cannot imagine anybody lending a large sum of money to an organisation without assessing them. I am not originally from the pensions environment so I find it quite odd that anyone would forego an assessment. It is complex, but being a trustee is difficult and that is the reason we set up the e‑learning process to help people understand some of the basics.

Mason: It might not be expressly said that an assessment of employer covenant is necessary to set prudent assumptions, but it is implied in the term ‘prudent’. I do not see how you can set prudent assumptions that have no regard for the ability of the sponsor to underwrite adverse investment performance, for instance. There is a fundamental difference between a sponsor that has the ability to underwrite adverse investment performance and one that does not.

Belok: The theoretical issues are certainly quite difficult for trustees in terms of evidence of how prudence is being interpreted at the moment. In theory it is actually a binary issue: either the company will be there to support the scheme or it will not. There is an argument that the only fail‑safe is to target buy‑out, although we don’t see much sign of this in practice. However I think trustees are certainly recognising, perhaps belatedly, the need to assess the company covenant, seek further information, and take a view on the strength of the employer. My feeling is that many small and medium‑sized schemes are not yet going down the route of seeking an independent assessment, but rather taking a DIY approach.


STEWART: In what circumstances would it be appropriate for scheme trustees to rely just upon the representations of the sponsoring employer’s finance director or board when assessing their covenants?

Mulroy: When I was an articled clerk to a firm of accountants, a figure would sometimes appear in the accounts of a small businesses labelled ‘directors valuation’. That was always considered to be a slightly interesting number. I think it is alright to rely on representations to some degree, but ultimately the finance director and the current board may not be around in a few years’ time and the trustees have to take a very, very long‑term view. Representations should be part of it, but not exclusively. Sometimes it is good to take a very hard outside look at something. I am not necessarily saying that outside people need to do it, but it does need to be candid and frank and to look to the future.

Mason: I think that is absolutely right. It is up to the trustees to form a view on the reasonableness of the representations made by management, whether they are oral or in the financial statements, and the forecasts and the assumptions that underpin those. I think the extent to which they do or do not go for internal or external advice to help them in that assessment will depend on the financial acumen of the trustee board itself and the complexity of the business in question.

Monk: I think these issues of conflict are fully recognised by many trustee boards. It is fine having a finance director on the board, and given the choice I would probably rather have him there than not, but the concern is that he will be often be wearing several hats. Some of the information he has relates to the company and its future, which is probably not appropriate to share, perhaps not even with the trustees. Therefore, I think there are times when trustees have to recognise the conflict and manage it, invariably by seeking some kind of external opinion. Ultimately it is the trustees who are on the line if they get it wrong, not the finance director who gives the information.

Sutton: Many trustees are now asking to receive quarterly management accounts or similar to support and help them assess the employer covenant on a continuing basis. The circumstances in which they can simply rely on management representations without access to any external support are likely to be fewer rather than greater in number. I think trustees do generally need to get the support of an external adviser in this context.


STEWART: The negotiation of scheme recovery plans under the new scheme‑specific funding (SSF) regime has brought the conflicts of interest faced by those directors of a scheme’s sponsoring employer also acting as scheme trustees starkly into the light. If the trustees with the best understanding of an employer’s financial position step aside because of these conflicts, what actions can member‑nominated trustees take to ensure they still have the capability to protect the members’ interests?

Sutton: There are a couple of levels to this. Firstly, there is the conflicts’ issue generally. I think many trustee boards benefit from having finance directors there rather than having them run scared from the trustee board, although there are sometimes good reasons why they might want to do that as well. It is really up to the trustee board to have a frank discussion about any conflicts they have and how they are going to manage them.

Belok: Finance directors are obviously the ones most in the firing line here. We have certainly seen a number of them step back from the trustee board because they recognise the conflicts. We also see them continuing to attend and contribute to trustee meetings but not as formal trustees, and obviously absenting themselves during discussions around funding and so forth where there is a clear conflict.

Monk: I certainly agree with what Phil was saying in terms of having professional advice. The first step for trustees in foreseeing the year ahead is to see the issues that are going to come up, before they come up. Therefore, if you are talking about scheme specific-funding you would want to know at what stage a conflict will arise. If you then plan for that conflict, and get the people who are going to have a conflict to understand what their role is in advising the trustees, then you are halfway there. To lose the history of the company on the trustee board is probably the greatest loss the trustee board could have, therefore we very much support the role of lay trustees and the finance director, whatever hat he wears on that occasion. Alongside that – and this depends on the knowledge of the other trustees – you need other professional advice. You would probably expect me to say this, but I think the value of an independent trustee on a trustee board is really highlighted when you see these conflict issues, because they can help lay trustees through difficult negotiations.

Mulroy: I agree with everybody that it would be a great shame to lose that expertise, because it really is essential. We have seen some quite innovative ways of managing that conflict. As you say, the best thing to do is plan for it and then manage it when it happens. For instance, we have seen finance directors either stand aside at certain points in decisions, or sub‑committees have been created so they can be part of the advice process but not the trustee board. There are situations where they stood down in a transaction and an independent trustee took their place during that time. We have seen a huge variety.
I think it is helpful that there are no rigid rules, but we do like to see potential conflicts managed. Where we get the feeling a conflict is more serious, we will sit down with the trustee board and those concerned, advise them of any vulnerability issues they may face and discuss how they can make an assessment. I agree with everybody that it would be a terrible shame if anybodytook any potential conflict as reason to remove themselves completely. That would be a great pity.

Sutton: Planning around conflicts is certainly a key area for consideration. We see situations where executive directors in particular are privy to knowledge about the future plans of the business that would be relevant to the trustee board when looking into current financial issues. For instance, issues such as scheme funding or negotiation around the settlement of a deficit. A conflicted trustee like that cannot ‘unknow’ what he knows, so it is best for him to realise when he is going to come into possession of information that puts him in conflict and to plan accordingly. It is an important lesson for all to take on board.


STEWART: A credit rating can offer trustees a substitute for formal independent advice about the strength of a sponsoring employer. What, if any, reasons are there for trustee boards to seek more in‑depth advice?

Belok: A credit rating is useful in terms of giving a high‑level view and something we advocate trustees keep tabs on and monitor regularly. It is important the trustees are looking at the right measure; in other words, if they are unsecured creditors, are they looking at ratings that are applicable to similar categories of debtors rather then people who are effectively higher up the pecking order? Unless it is pretty clear that the financial strength is extremely high then you will have to look at things in more granularity and get more detail. The time horizon you might be looking at could also be longer than the rating agencies are assessing.
If the sponsoring employer is not the parent company, then ratings may not be available for that specific entity from S&P or Moodys, although obviously you would have something from D&B. Again, there are issues about what light that really sheds in terms of the time horizon trustees may be looking at, which could well relate to a 10‑year recovery plan. Ultimately, credit ratings are a help, but they are not the total answer.

Sutton: I agree. They are part of the armoury trustees have, and it may be an early warning system for them more than anything. If they are monitoring the credit rating of their sponsoring employer and notice a change in it, particularly an adverse change, then that is an early warning sign that they may need to start discussions with their employer. However, unless you are looking at an investment grade type of organisation, it is not something trustees should necessarily rely on exclusively.

Monk: My view is that it is a good starting point. There are so many issues though. Paul mentioned what part of the group and what company they are looking at. Indeed, are they looking at the right assessment in the first place? We have seen a number of schemes where we look at the D&B rating and work out the PPF levy only to find that the rating relates to the wrong company and not the principal employer.
At the end of the day, D&B and all the other rating agencies are only producing ratings on published information, which is out of date purely by the fact that it is historical. The trustees have a far more onerous task – to monitor the trends and changes happening to the employer, therefore I think it needs to be complemented by something else.

Mulroy: It would be slightly disappointing if people were just looking at the credit rating, which has a very specific purpose and is often a very short‑term view of what somebody would give credit for, and that is typically somebody who is selling something to somebody else. If people are just looking at the credit rating then it somewhat implies to me they don’t have a proper and open relationship with the company, which would be quite worrying. It is more important they have a relationship with the company with dialogue that encourages good information. Looking at nothing more than the credit rating is a fairly passive relationship and would be very worrying, especially if there was a very large deficit.

Mason: Trustees need to understand what the credit rating is measuring and how they can use it. Some will measure default, some will measure the risk of insolvency – there is not a perfectly positive correlation between the two. Moreover, if you have a rating that suggests you have a high risk of insolvency, it doesn’t tell you what you would get back if the business became insolvent and what strategies might you employ to improve that position.
Would the scheme see a full recovery of its full buy‑out deficit, would it only be a fraction, or nothing? If there is not a full recovery then the question is to what extent they can rely on the earnings stream to fund the scheme. A rating alone will not give you the financial data necessary to negotiate a recovery plan, guarantee or additional funding.

Stewart: If they already know their sponsoring employer is weak, what, if anything, can trustees do about it? Where is the real value in this sort of process?

Mason: I think it is part of their overall risk assessment. If the trustees have not made an assessment of the sponsor’s ability to underwrite adverse investments then they cannot manage overall scheme risk. Having assessed that the sponsor is weak, they do have the ability to adjust the investment strategy, whether that is moving away from equities or increasing the hedging in the scheme because they know the sponsor has limited ability to underwrite that adverse investment performance. They could also look to improve the basic covenant if their sponsor is part of a larger legal group. Identifying the sponsoring employer as weak can drive trustees to consider seeking a parental guarantee, for instance, to improve the overall covenant of the pension scheme.

Sutton: Building on what Darren and Paul have said, the key issue is that the trustees and the company enter into a dialogue. If the trustees understand the company is weak, since money doesn’t grow on trees, obviously the problem won’t go away in a puff of smoke. Establishing dialogue means trustees will effectively increase their chances of improving the position by just working away at the margins and not letting opportunities pass them by; for instance, around parental company guarantees and looking to other assets to support the funding. Entering into such a dialogue on a continuing basis is critical.

Monk: Being a trustee of a pension scheme is very much akin to running the business. Surely the main objectives of trustees is to ensure thee employees’ benefits are secured, and ideally – although it is not specifically the trustees’ role – to ensure they still have jobs at the end of the week and get paid. Trustees must have the right dialogue with the employer ensure both objectives, if possible, are achieved. If they are not, and the company looks terminally ill, so to speak, then they would want to look at other situations – as Darren spoke about in terms of break up – and where they can recover and strategically place themselves to proatect members as much as possible.
Where there is the possibility that the employer can recover – and this is where a much more detailed covenant review comes in – then the trustees have to take a stake in the benefit of that recovery. If the company says it needs certain funds to invest in the company to expand it, which in turn will increase profitability, that is fine if they can believe in those plans and hence have a stake in that profitability and a share in the up‑turn of the business.

Mulroy: Denying a problem exists is not a great way of solving it. Although on the whole I think we have been heartened by the way people want to do the right thing by schemes, we have not noticed many people saying ‘let me give you a lot more money.’ Sometimes the ‘I am a weak, poor, humble person’, or ‘we are a very weak company’, might not be quite as true as you think. There might still be ‘gold in them thar hills’.

Belok: Terry alluded to trying to keep employees’ jobs, but there is also an issue about the future accrual of benefits. Often trustees think perhaps that is a partial objective of their negotiations with the employer, but you can envisage situations where by continuing to accrue benefits you are diminishing the level of cover and the likelihood of full benefits being paid for those members who have already accrued benefits. I gather there have been examples where trustees have felt obliged to go to the employer and tell them to stop accruing benefit because the situation is so poor.

Sutton: We have definitely seen those situations from the legal perspective and have been advising trustees around the whole issue of whether continuing future accrual is in the general interests of the members. In some instances, the result of that analysis has been that they should cease to accrue future benefits, and that is the right thing to do.

Monk: I guess it is almost a question of sharing the pain and sharing the gain.

Mason: We had a case with a sponsoring employer who did not want to see the scheme closed to future accrual and we used that weak assessment of the business to elicit a parent company guarantee enabling the scheme to remain open to future accrual.


STEWART: Commentators have claimed sponsoring employers often see the process of employer covenant assessment as an unwanted and unwelcome intrusion on their business. Which strategies have been successful in creating a collaborative environment for negotiation of the scheme recovery plan?

Mulroy: I do wonder whether this is somewhat of an urban myth, because there are rather a lot of them around. Most employers are so used to being scrutinised by everything and everybody: they borrow money, they have banking covenants, they have shareholders, and they have to publish things. I’d be slightly surprised if there are many employers who see it as an unwelcome intrusion. They might be slightly irritated that it adds to their work, but since they are used to doing that anyway, they will already have that information.
There are certain circumstances when employers are very aggrieved that it happens, particularly with things like hostile takeovers where it comes into quite an emotionally charged mix. It is important they get a confidentiality agreement and honour it. We sometimes see things coming out in the press that have been less than helpful during a transaction when everybody really needed to stay quiet.
It is quite difficult at times, but it shouldn’t be that difficult. They usually blame us actually, which is fine – we don’t mind that. We have helped a lot of people. Much of what we do is forms of mediation. That mediation can be quite tough because the conversations need to be among equals and they need to be open. Sometimes sponsoring employers are not used to that with the pension fund trustees, but they are certainly used to it in other ways.
We just have to get the pension fund and the trustees on the agenda in the right way. It is interesting because we get the opposite comment from finance directors, who say that big chunks of their life are now taken up with how to deal with the pension fund, and the business has become almost a secondary factor at times. Most of them welcome that debate and sometimes it needs to be managed a bit, but it is just a question of getting them through that process.
We have been involved in situations where we have had trustees in one room and the company in the other room refusing to talk to one other, but we gently get them into a dialogue. It is a learned process. As I say, in our experience it is more the commentators saying this than employees.
Sutton: One of my most interesting experiences was acting for an employer who was hell‑bent against having a covenant review done in a particularly sensitive situation. The trustees did have a review done and the employer found it really helpful to get another perspective on some of the issues it was facing. Ultimately, its main complaint was the fact it had to pay for it!

Belok: Probably the big question for employers is why trustees have not gone down this route previously. There is an education process that perhaps trustees need to take the initiative on in terms of explaining to the company the new environment, the new pressures they are facing, the guidance from the regulator and so forth, and making sure they have good channels of communication working. When it comes to funding, I think it is important to have that discussion at an early stage.
The wrong way to do it is for the trustees to go in and hit the employer with their demands out of the blue and expect an instant response. They need to prepare the ground beforehand, and ensure that the employer gives agreement to the timetable and the plan that is set out for the funding process. In terms of what could be called the collaborative environment, ultimately it can come down to individual personalities, and with the best will in the world there will be some people (hopefully not too many) who take entrenched positions that will make collaboration difficult.

Mason: We find there is a minority of sponsors who think they can side-step the liability by not engaging with the process, but on the whole engagement is good. Trustees have a right to reasonable information from the sponsor so they can discharge their duties in the area of assessing employer covenant. In a way, it is difficult for sponsors to hold out and refuse to give the information that is needed.
Perhaps looking at it from the other side, I often think it is best to try to sell it to the sponsor, rather than just demanding information even though the right is there. It is quite an easy sell when you tell the sponsors ‘If you are a strong employer and if you are able to give us information that is not in the public domain that enables us to form that view, you might end up with a funding target below FRS17 because the trustees will have the confidence in the sponsor’s ability to underwrite adverse investment performance and so will feel comfortable with higher levels of return on investment assumptions. Would you not like to be able to disclose that and tell your bankers and other funders?’ To an extent, it sells itself.
If you look at the other end of the spectrum, if the sponsor is in financial difficulty, trustees have a lot of power to defer payments into the pension scheme to see the company through a period of difficulty. The ultimate goal for everybody is the survival of the business and full payment into the pension scheme and all the members receive their full benefits.


STEWART: Do you think that is starting to happen? Are employers starting to recognise that trustees are as powerful as banks and other stakeholders?

Mulroy: Certainly they are recognising the need for partnership and dialogue. Certainly, some of the deficits are larger than the capitalisation of the company. You are all far more likely to be able to work well if you work together. When you have enough fights on your hands, to pick another one would not seem sensible at all.
Going back to the other point, if you were trying to buy a house and the vendor refused to let you have a survey, would you go any further? No. It is really along that line. The two are inextricably linked together as a pension fund is with their sponsoring employer, so why not work together to solve the problem rather than trying to do it at a distance where it cannot work?

STEWART: In the same way that an actuarial valuation is undertaken on a periodic basis, should an employer’s covenant also be assessed periodically, or should trustees just wait for a specific event to revisit their assessment?

Mason: Many trustees now have the power under their trust deed and rules to fix contributions. They do not need to wait for a trigger event such as the scheme funding valuation or the clearance application before they assess the employer covenant and decide whether or not they need to adjust funding levels into the scheme or look at their investment strategy.
Trustees can often be brought into a transaction process late. Why wait to get a basic understanding of the covenant afforded to your pension scheme and have it thrust on you at the last minute and told ‘we want to complete on Friday and we need you to support that’? It is all about building a dynamic assessment of the business. It cannot just be done at one point in time, put in the filing cabinet, and considered that that tick box has been ticked. Trustees need to make an initial dynamic assessment but they need to have certain touchpoints going forward where they revisit that assessment to check that it still holds true.

Mulroy: I agree. We try to encourage a continuing relationship rather than one that just fires up with an event, whether that event is refunding, merger acquisition, or something to do with the way the company is operating. It can be over‑egged if people are having one every week or month. Clearly, that would be silly, but there is nothing wrong with taking a pulse. If you are trying to see how somebody is, one of the first things a medic does is check the pulse. If you consider it to be a pulse‑point of the relationship, then maybe you should do it on a regular basis rather than waiting for difficulties or catastrophy. If the company is working with you, you would have that sort of relationship anyway.

Sutton: In terms of the frequency of the employer covenant review, there are clearly event-driven circumstances where that is essential. However, as part of the SSF regime negotiation, in our experience one of the things trustees seek – and I think wisely so – is access on a formally agreed basis to the continuing provision of management financial information. That would provide an early warning of need for fuller investigation. I think that is a key tool trustees should aspire to.

Belok: I certainly agree that constant monitoring is needed. Particularly if there is a deficit it is important that trustees are tracking that on a regular basis. Personally, I would like to see the employer covenant as a standing item on trustees’ agendas. It is a reporting opportunity, so if there is anything emerging or has emerged that is useful for the trustees it should at least be given some consideration each time they meet. It potentially gives them the opportunity to decide whether there is a need to do a more formal interim assessment of the position rather than wait for the next funding review.
Monk: I cannot really add much to that. A covenant review is not just for Christmas. It should be done on a rolling basis. I think all the points Phil made are absolutely right. There has to be a series of what we might call key performance indicators that are not solely reported at the trustee meetings. Things can happen between trustee meetings. Indeed, trustee meetings do not always happen that frequently. It has to be agreed between the trustees and the finance director of the sponsoring employer that if certain trends change during the course of the year, they should be reported at any time and not necessarily just at a trustees’ meeting.

Belok: I think Terry’s point is very valid. It is important that trustees put in place some mechanism for tracking the covenant and have some triggers so that if something does arise they can respond as a matter of urgency. They can look to incorporate prior warning of developments in an agreement with the employer so that any substantive change is highlighted as early as possible. Trustees need to avoid being in the situation where they read in the papers that a significant part of the business has been sold off for example, by which point it is potentially too late to take action. We advocate the creation of an agreement between the company and trustee board to create a flow of informatio to allow for an ongoing assessment of covernants.

Mason: I think those performance indicators are something that the trustees should insist they receive as part of an initial co