David Adams explains the role the employer covenant plays in the UK and how the relationship between scheme and sponsor is managed elsewhere in Europe

The employer or sponsor covenant is a unique British twist on the agreement made between trustees or scheme administrators and employers to protect a scheme and its members. As with a married couple’s wedding vows, if either party finds themselves needing to look carefully at exactly what was agreed, it’s a sign that all is not well. But in the case of the covenant, regular reviews can also strengthen the bond between scheme and sponsor.

The covenant is a fundamental element in the sponsor/scheme relationship, but it is also an emergency precaution. “If a scheme is well-funded the covenant is almost an irrelevance,” says Richard Butcher, managing director at Pitmans Trustees. “But it becomes absolutely critical when there are insufficient assets in relation to liabilities.”

Changing view
As scheme deficits grew over the past decade, then the financial crisis cut many schemes’ investment and funding strategies off at the knees, trustees, employers and The Pensions Regulator (TPR) all started to think more carefully about the covenant. TPR issued new Guidance on the subject in November 2010.
Lucy Dunbar, a member of the governance team at law firm Sackers, highlights the fact that this Guidance document altered the wording in the definition of the covenant to describe it as "... an employer's legal obligation and its ability to fund the scheme now and in the future".

"Previously there's always been a phrase about the 'willingness and ability' of the employer to support the scheme," she says. "TPR has got rid of that, recognising that willingness is very difficult to measure. It's focusing now on legal obligations. The Guidance suggests trustees should look at the covenant more regularly, maybe on an annual basis, but to be proportionate."

Donald Fleming is director at Gazelle Corporate Finance and co-author of a new book about scheme governance (Good Governance for Pension Schemes, Cambridge University Press, 2011). "Over the last five years the world has changed and trustees actually have to look at the covenant," he says. "Ten, even five years ago a lot of trustees might have thought 'We know what this company is about, the FD comes and tells us'. Now there is less of that internal knowledge, because governance issues mean trustee boards are losing trustees who are also financial directors and so on, so lose that inside knowledge."

The thrust of Fleming's and his co-author Paul Thornton's argument is that it has become necessary for both employers and trustees to take a more dispassionate view of the covenant, which governs, in a sense, a debtor/ creditor relationship. For the employer this means viewing the scheme in the same risk terms as would be used for any other type of debt capital.

Reviewing the covenant
This makes reviewing the covenant in a truly dispassionate way even more important. But Pitman's Richard Butcher is pleased that TPR has recognised that it is not always appropriate to commission an external assessment exercise. "[TPR] only asks trustees to commission external assessments if they don't believe there's enough expertise on the trustee board to do it [internally]," he notes. "In the past I think they have sometimes been too dogmatic about the need for a formal report and it's just added cost - which has got up the employer's nose."

The employers sometimes have a point, he continues. "Accountants put together a covenant report but a lot of reports aren't very good: they'll regurgitate information given to them by the employer, express an opinion in three paragraphs, then charge you £20,000," he says. "I know employers that will spit blood if trustees commission a covenant report. Where an accountant can add value is in constructing questions for trustees to ask employers. The biggest challenge for trustees is getting sufficient data and being able to understand what it means."

Lucy Dunbar points out that there is no obligation for trustees to commission an independent covenant review. "But I think if you go out there with a proper process there are definitely things that an independent review can bring to
the table," she says. "Trustees need to treat this like a tender process: make sure they work with the correct people and make it clear what they want to get out of it."

Whatever the means chosen by the trustees, there are a number of areas they must ensure are covered properly in the covenant assessment, including analysis of what could happen in the event of the employer's insolvency, the
track record of senior management; and the employer's corporate and capital structure.

Once the trustees have the information revealed in the review process, they must act upon it, urges Marian Elliott, director at actuarial and benefit consultancy Atkin & Co. "It's no use understanding the covenant and not doing anything with that information," she says.

Adrian Bourne, senior consultant at Towers Watson, cites the example of schemes for UK companies that are subsidiaries of larger foreign entities. "These are employers which are quite small, relative to scheme deficits, where a lot of the power is US-centric, or operations are moving from here to Asia, for example," he explains. "With some clients investment in the UK is not what it was. That's a concern for trustees."

The Recovery Plan is also highly relevant. "There's more analysis and thought going into recovery plans and what's reasonably affordable," says Bourne. There may need to be some flexibility. Bourne cites a client, a large global construction company which borrowed heavily in the good times to buy other businesses. "In the current climate earnings haven't materialised, so the UK pension scheme is taking a 'holiday'," he says. "If [the company] had tried to pay off the scheme deficit and service group debt at the same time it could really have got into trouble.

"Trustees are a lot more knowledgeable and proactive about corporate activity," he continues, considering the example of the forthcoming merger between Avis, which is a major US corporate and Avis Europe, which until now has been a quite separate listed company. "At the moment Europe has the franchising arrangements for China, which is a huge growth market. Under this merger those revenue streams could go to the US. The trustees may think this means the covenant is weakened. So maybe they will look for a guarantee, or to strengthen or speed up the recovery plan."

Beyond UK
Elsewhere in Europe, while there
is no exact equivalent of the covenant, the relationships between schemes and sponsors have also come under pressure in these unstable financial times. In Belgium the contractual relationship between sponsors and scheme rests upon two documents drawn up between them: the management agreement and the financing plan.

"One important provision [in the management agreement] is around whether the pension fund under-takes an obligation of means or an obligation of results," says An Van Damme, attorney and partner at Brussels law firm Claeys & Engels. "In Belgium no fund until now has run under the second system, because the funding requirements would be much stricter. So when you have a situation as in 2008, when the value of the assets fell dramatically, the employer has an obligation to fund the pension scheme to bring financing up to the required level."

That required level is defined in the financing plan, which makes
a distinction between short-term technical provisions (what every beneficiary would be entitled to if the pension scheme were wound up immediately – the absolute minimum) and long-term technical provisions. The latter is more prudent than the short-term provisions, based on fundamental factors including the asset allocation strategy. If the funding drops below the long-
term provisions level but not short-term provisions level there is some scope for flexibility in the recovery plan. Below the short-term level a recovery plan must be implemented inside a year.

"All these issues have had a lot of attention since the economic crisis," says Van Damme. "We see frictions with sponsors that are themselves in financially difficult situations. But it's not really under debate that we would change that system. If we did we would end up with much more strict funding requirements – and I don't think that's what sponsors want."

In the Netherlands the 'triangle' of pension schemes, employers and employees at the heart of scheme governance has also come under pressure. There is no legal obligation for Dutch employers to make additional contributions to underfunded pension schemes, so the schemes are compelled to keep extensive reserves as a financial buffer. In the 90s, as the good times rolled, many were effectively over-funded, to ratios of 150 to 200 per cent, and passed some of the surplus to sponsoring employers. "In return financial agreements were made between employers and funds to make additional payments in case of underfunding," says Corine Hoekstra, a pension lawyer at Bergamin & Gielink in Rotterdam. "The employers thought 'The buffers are so high we will never be obliged to pay these extra contributions'."

The trouble was these contractual agreements were not always well defined. "In the past few years, due to the crisis, lots of these funds, which previously might have had buffers of 150 per cent, dropped below 100 per cent coverage, in some cases to 80 per cent," says Hoekstra. "So some funds are now asking for the employer to pay an extra lump sum and there are cases in which the employer declines, or refuses to pay as much as the pension fund wants. Legal proceedings have taken place to deal with these issues." The good news for the Dutch system is that the 2007 Dutch Pension Act (Pensioenwet, PW) now stipulates a need for clarity in these types of contractual agreements between the employer and the scheme.

Other mechanisms
Elsewhere, schemes are backed using other mechanisms, such as the book reserve and insurance model often seen in Germany. But might pension schemes be making a mistake to rely too much even on something as seemingly reliable as a major insurer? "There is always some residual exposure to solvency risk," says Donald Fleming. "Even if your scheme is heavily backed by insurance capital, one thing that's come out of the whole financial crisis is that people have had to revisit some of the certainties built into assumptions around bank solvency, insurance solvency and sovereignty.

"The 'risk-free' route of return on government debt can flip quite quickly, as we've seen in the Eurozone. A few years ago it was taken for granted that big global banks didn't go bust. If even European states could go bust and you're backed by insurance capital, how strong is that, if a lot of it is invested in sovereign bonds? Everything in finance is interlinked. That must be a lesson. I think there was some complacency before."

For Fleming it all comes back to examining the security of a scheme's funding dispassionately. "It's about looking at things from a creditor perspective," he says. "Certainly for the larger corporates in the UK that's beginning to be understood. Trustees look at their fiduciary responsibilities from a 'what happens if it all goes wrong?' perspective. But they're still married to this company, for richer, for poorer."

And there must be some realism as to the results that can be achieved, warns Bourne. "It can be difficult: you may learn a lot, but if the company is in genuine trouble and can't give you a guarantee there is a 0limited amount you can do about it," he says. "You can't always get to where you want to be."

Written by David Adams, a freelance journalist

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