• Persistent economic turbulence needs regular covenant monitoring
• 37% of schemes monitor covenant annually or less frequently
The impact of market turmoil on pension funding is likely to intensify the Pensions Regulator’s (TPR) efforts to ensure that regular monitoring of the covenant by trustees takes place, says Mercer. The company is advising trustees to anticipate this move and ensure that the covenant – the strength of an organisation supporting a pension scheme - is regularly monitored.
According to Darren Masters, principal at Mercer, “Covenant should already be on the agenda of every trustee meeting and TPR advises that trustees should monitor covenant between valuation dates. Recent market turmoil shows just how fast conditions can change and this demonstrates the need for more frequent monitoring and, if appropriate, trustee action. Triennial covenant reviews, as are still done by many trustee boards, may not be enough when company finances can be adversely impacted at the same time that pension liabilities are growing significantly.”
The continuing economic turmoil that hit the markets starting in the summer of 2011 saw the FTSE 100 index lose 600 points over August and gilt yields fall by 0.5%. Given the impact that volatility has on pension scheme funding levels, investment returns, company balance sheets and more significantly to many parts of the wider economy, covenant monitoring should be given greater priority, especially as Mercer believes this turbulence is likely to continue for the near future.
TPR has taken steps to improve covenant monitoring by issuing trustee guidelines having stated in mid–June 2010 that “some schemes had a sound approach. For others improvement was necessary”. However, Mercer’s recent Trustee Survey gives an insight into the level of improvement that is required. The survey found that the covenant was one of the areas that trustees addressed the least when meeting. As a topic of discussion, ‘Covenant’ ranked 6 out of nine topics areas. While it was discussed more frequently than Admin (9), Risk Management (8) and Member communications (7) it was addressed less than Governance (5), Fund Monitoring (4), Funding Strategy (3), Investment Monitoring (2) and Investment Strategy (1).
Of most concern, however, was the finding that while two thirds of respondents monitored their covenant more than once a year, over a third (37%) said that they monitored it annually or even less frequently and many of these schemes will be exposed to rapid fluctuations in the strength of their sponsor companies and scheme funding volatility.
Almost half of trustees said that they assessed the covenant themselves. This can be a sensible solution where trustees are sufficiently independent, have adequate knowledge of the sponsor and any wider group, the relevant skills to be able to obtain and analyse the key data and reach appropriate and considered conclusions and importantly have adequate time to devote to the covenant assessment role. However, market turmoil and its effects are complex and there is an increasing need for trustees to use specialist advisers to ensure that they reach the right conclusions and take the right steps to protect scheme members’ interests.
While formal covenant monitoring might take place annually, covenant discussion should be on the agenda at every meeting, with discussions and decisions minuted as necessary. This combined with a reporting framework from the employer that includes informing trustees about significant events that might affect the covenant strength will enable trustees to demonstrate appropriate governance over covenant risk.
“Raising the issue of concerns regarding covenant strength can lead to difficult discussions with scheme sponsors but it is only through those discussions that trustees and sponsors can reach a sensible and properly negotiated funding solution” said Mr Masters. “TPR views covenant monitoring as just as important as monitoring investment performance and expects trustee boards to approach it directly, but in a risk-based and proportionate manner. We have seen much more scrutiny from the TPR in this area and we expect that trend to continue.”
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