Covenant liability is 'pitfall' in multi-employer schemes
UK - Trustees need to understand who is liable for the pension scheme, particularly in a multi-employer scheme, as the financial crisis could lead to more parent companies looking to sell off or withdraw equity from successful subsidiaries.
Speaking at the National Association of Pension Funds (NAPF) annual trustee conference, Grant Thornton argued an assessment of the strength of the employer covenant can be triggered for a number of reasons such as a scheme-specific funding (SSF) valuation.
Darren Mason, insolvency practitioner at Grant Thornton, pointed out transactions could also lead to covenant assessments, for example when a company wants to sell a unit, or there is an equity withdrawal by a parent company which is in trouble and needs to draw on the funds of a subsidiary, something which has started to increase recently.
He said trustees need to understand where the covenant actually comes from, whether it is funded by future earnings, or whether it is reliant on inter-company debts being repaid, for example by the parent company, in which case he argued trustees should look less at the future earnings of the sponsoring employer and look at the covenant of the parent company.
Mason said: "The employer covenant is largely a given, so our job is to quantify that. Every scheme has an investment strategy with inherent risks, we work out the risk of a 'one-in-20-year' event and the impact that would have on the scheme deficit to see if the employer would be able to cover that."
If this event caused the deficit to increase by £50m, for example, and the employer only makes £1m a year in earnings, there is likely to be problems for the company in its ability to repay this within the 10-year recovery period recommended by the Pensions Regulator (TPR).
On the other hand, if the employer can cover the deficit, it "may look towards a less risky investment strategy" to try and minimise the impact on its finances.
Mason added: "Honest, open and frank discussions with employers is necessary, as the employer needs to understand the risks the scheme is running."
However he pointed out a "key pitfall" for assessing the covenant of multi-employer schemes is trustees not understanding who is liable for the scheme, as a guarantee from the parent company may not be as valuable as it seems.
"It does not matter how genuinely the directors of the parent company want to fund the scheme, the ability of putting money in can be taken away from them by shareholders," said Mason, and instead the money could be directed towards other areas such as re-investment or even dividends.
Meanwhile, Andrew Conquest, insolvency practitioner at Grant Thornton, said in the case of an insolvency trustees need to be aware of any group security arrangements, as these could mean creditors with the parent company could take priority and no money could travel through to the pension scheme.
He added: "Trustees need to look at where the scheme is in the pecking order, and in terms of a transaction, see what the scheme's position is before and after. You have to understand how you monitor the covenant, and there are various tools available or you can employ an external party. Just doing a covenant assessment and then putting it in a drawer for three years until the next valuation is not the right way to do things."
IPE is looking at employer security as the subject of this week's Talking Point.
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