UK covenant semantics
Almost 18 months into the financial crisis, UK pension funds are still struggling to ensure employer covenants will protect pension plans should a company go under or be unable to plug the deficit. But lessons have also been learned in that time. This suggests trustees are at least improving their own governance.
Analysis from Hewitt Associates found employer covenants are not necessarily stronger than in previous years. But pension fund boards are now much better informed about the status of their sponsoring companies, in part because trustees better understand information provided by finance directors about the revenue potential and financial status of an employer.
“There are some trustees who have very in-depth company knowledge because they are executives at a company, and this has helped their understanding of a sponsor’s status,” said Hewitt principal Aidan O’Mahony.
“That said, a lot of trustees receive updates from finance directors once or twice a year and they can get lost in the detail. So what we try to recommend is that they look also at the five-year trends from past reports. If they review those, they can also see whether guidance given by finance directors in the past matches what happened,” he said.
Trustees also had to raise their game and knowledge in the last 12 months. Reading covenant agreements has required them to “wear many hats”, according to O’Mahony, and build knowledge of corporate finance, accounting and law.
The demand for independent trustees has therefore grown, as they can bring experience of working with other schemes to the table, while retired finance directors have provided valuable skills to trustee boards in recent months.
Whereas pension trustees were at the beginning of 2009 concerned with whether a covenant was ‘strong’ or ‘weak’, the priority now is cash flow and pensions affordability. In situations where sponsors argue they have a strong covenant but are strapped for cash, the company has instead sought longer recovery periods of 15-20 years and used limited corporate cash to pay dividends or, in some cases, make acquisitions.
“There was one company that was not paying dividends and had a big pensions deficit,” said O’Mahony, “but trustees got an agreement that if the company started paying dividends again, the pension fund would get a percentage-matched payment. It made sure the trustees were not at the end of the queue again when things improved.”
Despite the improvements made to trustee governance knowledge in recent months, establishing whether a covenant is strong or weak is still not an easy process. Hewitt believes it is perhaps because there is nothing against which trustees can measure their own sponsor’s covenant. “We need to have more precise definitions of ‘strong’, ‘average’ and ‘weak’ as well as benchmark comparisons to help trustees understand what the various words mean in terms of financial strength and risk of default. If a sponsor is assessed as ‘average’, it would be useful to know if there is a one in five, or 20, or 100 chance of defaulting,” continued O’Mahony.
“The key thing is that a sponsor’s covenant is influenced by its [industry] sector. Even where they say they have got the strongest covenant in their sector, if the sector bombs, that is scant consolation. You need to get them to explain a little more, otherwise it is just semantics”.