Report for duty

The requirement for trustees to undertake covenants assessments at regular intervals has been the greatest single change since June 16, 2003 when changes in the pensions regulations prevented solvent employers from walking away from their pension scheme obligations without funding them.

Thereafter, the Pensions Act 2004 armed trustees with much greater leverage in negotiations with employers over funding levels. Since the Pensions Act 2004 came into force in 2006, guidance and market practice from The Pensions Regulator has built up to help trustees in this difficult area of scheme stewardship.

Code of practice
The Pensions Regulator’s regulatory code of practice 2003 on funding defined benefits, states: “It is essential for the trustees to form an objective assessment of the employer’s financial position and prospects, as well as his willingness to continue to fund the scheme’s benefits (the employer’s covenant). This will inform decisions on both the technical provisions and any recovery plan needed.

“In order to undertake such an assessment, the trustees will need to obtain information about the employer. Some of this information is likely to come directly from the employer.”

TPR’s revised clearance guidance, September 2007, provides further guidance and the Society of Pension Consultants website carries a useful guide, Monitoring the Employer’s Covenant.

Faculty of Actuaries president Stewart Ritchie describes the employer covenant as “the difference between the ongoing funding position and the funding position if the employer went bust. For small to medium-sized enterprises (SMEs) the gap is very large indeed and it is a big thing for the trustees to get to grips with. The smaller the employer, the greater the need for the trustees to monitor the covenant.”

Covenant reviews need to be regarded as an ongoing monitoring exercise, as the employer’s financial position can change quickly. With the current uncertain economic environment, the need for regular assessments has rarely been greater.

Trustees have a panoply of advisers they can call on to assist with covenant reviews. In addition to their actuaries and accountants, there are specialist advisory firms such as Gazelle Pensions Advisory and Penfida, credit ratings agencies, and commercial investigators such as Kroll.

Penfida was involved with the attempted takeover of Sainsbury’s last year and in the disposal of Ford, while Gazelle’s clients include Cable & Wireless, Cadbury Schweppes, Tate & Lyle and Uniq. Hewitt Associates offers a service in conjunction with Grant Thornton, and Mercer has linked up with Kroll, part of the Marsh McLennan group.

But how are trustees coping with covenant reviews in practice?

A survey by Gazelle Pensions Advisory, published in January 2008, shows that trustee boards have adopted a wide range of solutions to deal with conflicts of interest in employer covenant issues, some of which may prove unsatisfactory in adequately safeguarding members’ interests.

The key findings were that over a third of trustee boards (35pc) do not currently seek any independent advice on employer covenant issues and few of these expect to do so in the future.

The survey also found that half of trustee boards of the UK’s largest pension scheme respondents were concerned about the possible future impact on the employer’s covenant of a takeover, with 30pc saying they were more fearful than five years ago. The main concerns were about acquisitions by private equity firms and foreign-based businesses headquartered outside the EU.

The three principal types of adviser used to give guidance to trustees on employer covenant issues were actuarial consultants (42pc), accountants (35pc) and specialist corporate financial advisers (27pc).

Gazelle Pensions Advisory managing director Paul Thornton says: “It is alarming that in the case of over three out of 10 schemes, no independent advice on covenant issues is taken at all. More alarming still is the finding that eight out of 10 of these self-reliant boards think independent advice will also be ‘unnecessary’ in the future. There are an increasing number of situations where the complexity of the transaction requires specialist advice from experience in the corporate financial sector.”

Grant Thornton partner Darren Mason believes that trustees should be seeking independent advice on these issues.
He says: “All too often with trustees it’s easy to draw initial conclusions about a company’s covenant that may be incorrect on further examination. Trustees may look at their sponsor and see on a profit and loss basis it is profitable and has loads of assets in its balance sheet, but if all those assets and profits are subject to a bank’s security structure in a group situation then on insolvency the return to a scheme can be disastrous.”

The survey, which also questioned trustee boards about their handling of conflicts of interest when dealing with employer covenant issues, found that in a third of trustee boards, conflicted trustees absented themselves from the discussions. In a quarter of trustee boards, conflicted trustees did not vote, and in 23pc of cases, the independent trustee chairman dealt with the issue. Nearly a fifth of trustee boards (18pc) took no measures to deal with conflicted trustees and 10pc referred the issue to a sub committee of “unconflicted” trustees.

Thornton says: “The real need at such times is for a genuinely conflict-free approach utilising a blend of independent trustees, independent advice and un-conflicted trustees.”

Lane Clark & Peacock principal and head of credit analysis David Poynton says: “We are already seeing a vast range of responses to the issue of employer covenant. Some trustees appear to be paying lip service to it and in-house covenant assessments of just a single page are not unheard of.

“When assessing what action to take regarding the assessment of their covenant, trustees might wish to consider what the position would be for them personally if the employer was to become unable to meet the promised benefits.

“An independent covenant assessment removes any concerns over potential conflicts of interest and, as with any procurement issue, trustees should review the market and ensure they know what services are available, at what cost, and what benefits they expect to receive. I believe it will just be a matter of time until trustees of all DB schemes routinely obtain an independent covenant assessment.”

KPMG partner in restructuring Finbar O’Connell agrees: “It is very important for the trustee board to have independent trustees who are outside direct employment of the company. Trustee boards need strong advisers who can remind everyone of their respective roles.”

O’Connell adds that practice is evolving and that KPMG had become involved in a case where TPR had directed the trustees to seek external advice because it had concerns that certain issues had not been looked at. The case involved a group restructuring, and the scheme had financial calls on various companies within the group to make contributions.
“TPR was not happy that the trustees had properly investigated whether they would be in a worse position post-restructuring than pre-restructuring,” he says.

Hymans Robertson partner Patrick Bloomfield says that trustees’ options are limited and that his firm’s approach is always to be practical. “A DB scheme is like a loveless marriage after 40 years. The employer is a long-term business partner that the trustees are stuck with. The time and trouble that the trustees go to should be proportionate,” he says.

Bloomfield recommends schemes should normally carry out a covenant review every three years when there is a funding valuation, unless there is an event in the intervening period, such as a M&A activity, a merger or an approach by a private equity buyer, which might trigger an earlier assessment.

“There have been some strong directions from TPR that requires some evidence of what trustees are doing to monitor covenants,” says Bloomfield, but at the same time warns that trustees need to be on their guard against information overload. “There are a lot of people who have vested interests in giving trustees more information than they need.”

Mason believes that how often a covenant review is carried out varies from scheme to scheme, suggesting a series of points that advisers should check schemes next to.

He says: “Is the business one that needs regular ongoing monitoring? Is it one where you need to get a professional back to look at it quarterly? Or is it one where you can empower the trustees to monitor it themselves by giving them a few key performance indicators? That is the sort of view you should be getting from your adviser.”

Interpreting reports
There is also the small matter of interpreting the reports that trustees are given by their advisers. Who is best placed to explain the assessment to the trustees? Bloomfield believes that trustees will instinctively have a feel about the information they are given and that if they feel more confident, they can ask the financial director to go through the company’s accounts with them.

While trustees will always accept cash injections where these are offered, Bloomfield says that trustees should be willing to consider contingent assets such as property, a fixed charge against fixed assets, the sale of particular assets or other investments. Some companies will offer a “negative pledge” whereby the company undertakes not to make a material change in the business without consulting the trustees first.

Kroll partner and head of pensions advisory Gary Squires has a team of 12 people focusing exclusively on helping trustee boards with covenant reviews. He sees the main drivers for the increase in covenant reviews as scheme-specific funding, leveraged transactions, restructurings and the increase in potential insolvencies.

Kroll was involved in advising Sea Containers (the first company to receive a financial support direction from TPR) and in the Federal Mogul/T&N case.

Squires says: “We typically work with other advisers such as the actuary, accountant, lawyers and investment advisers and we have an employer covenant assessment model that helps present the information in a graphical way so that the trustees can understand it easily. It is important for a covenant adviser to present the information in a clear, but non-patronising way.”

In 2006, Kroll received more than 60 instructions for covenant reviews, mainly from large companies such as Alliance Boots, BAA, Yell and DSG.

Hewitt Associates consultant Gary Trotter warns trustees about the need to consider how they frame the parameters of an assessment review.

He says: “Trustees need to decide what questions they want answered and need to have a good think upfront about exactly what they want to gain from the assessment. Otherwise they can end up with a mammoth report that doesn’t answer their needs.

“TPR advice is fairly woolly, but is quite exacting about process. Trustees need to document all their thoughts about the covenant and need a good record what they have done and why they have reached the conclusions they have. This is such a developing area that people are still finding their feet. Consultants have a role to play in helping trustees scope the ambit of the advice they receive. The key is good documentation and how to get the review to feed through into funding and contribution levels.”

Capital Cranfield independent trustee Mike Anthony says the employer should be required to sign off the factual content of the support he is supposed to be giving to the scheme, when the trustees are compiling information on the scheme for the assessors to examine.

“It can be tense when the FD wants to dot every ‘i’ and cross every ‘t’. Once the covenant review is received back, the employer should not normally be allowed to see it. But TPR can demand to see it and the trustees would be ill-advised to ignore such as request. The covenant review is fairly critical as part of a recovery plan and the review will only be valid for around a year. A forensic report will last around 15 months.

“If, thereafter, the trustees can get the chief executive or FD to talk about the ongoing finances of the company at regular intervals, then maybe it will last another three years until the next actuarial valuation.”

The range of fees payable for an independent covenant assessment can range from around £5000 for a high-level monitoring process, where the covenant is currently so strong the employer could pay off any deficit in a few months if it chose to do so, to in excess of £100,000 for a detailed report where the corporate structure is complex and there are financial difficulties.

But some advisers say that there is plenty of publicly available information that trustees can obtain to do much of the work themselves, such as from Dun and Bradstreet and ratings agencies such as Standard & Poor’s and Moody’s.
Former Downing Street pensions adviser and adviser to a number of trustee boards Ros Altmann says: “Reviews are vital, not just when companies are weak, but when companies are strong because if there’s a change in the company’s finances, the trustees can act quickly. If the company is doing well, the trustee should take the opportunity to get more money from the sponsor. It’s basic governance.

“You have got to understand the position the sponsor is in. You are an unsecured creditor of the company; going into the PPF entails a significant reduction in benefits. It’s about being more commercially aware. A lot of trustees are confused about the bases for measuring scheme deficits. It’s the buyout basis that is crucial.”

The Pensions Regulator’s June Mulroy says that trustees have handled reviews very well, although some charities and SMEs had found it quite challenging.

She says: “We do sympathise but, at the end of the day, we have to treat everyone the same. The problems have been more on the emotional side than on the logistical side. We don’t give advice other than for trustees to buy in a little extra support, or to consult with trustees at other charities, or in similar companies.

TPR board member Laurie Edmans comments: “I’m a great fan of covenant reviews. If we had had this requirement 20 years ago, we wouldn’t be in our current muddle.”