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Covenants stressed in testing times

UK pension fund boards and trustees are probably facing their biggest test yet when it comes to meeting their fiduciary responsibilities. Whereas a year ago employer covenants were rarely discussed and viewed as part of an occasional desktop review, executives have "been complacent" about its importance, according to one consultant. And the collapse of companies such as Lehman Brothers and Woolworths has forced pension boards to realise they could be held to account were the sponsoring employer to go bankrupt in the wake of recession and the employer covenant arrangements found wanting.

Consultants and regulatory officials have been quick to warn trustees not to be too pushy with demands on employer funding if they find they actually have weak covenants. And a huge array of funding options are now be considered.

But the moral pressure of acting responsibly on behalf of members means pension funds are being required to take new steps; sign non-disclosure agreements by the corporate sponsor so they can gain unprecedented access to corporate financial information; weight the funding to reduce to 30% now and climb gradually later on; and maybe decide whether the promises sponsors make to trustees can actually be met by through profitability; or whether a company could in fact be a "basket case", according to Anthony Light, head of covenant assessment at Aon Consulting.

"More and more trustees are becoming interested in what is going to happen in the future," says Light. "If a company says it is going to generate 8% in profits, you need to know how they are going to do that, and not achieve 2%. It is a job to make sure you don't push the company under because the best security is the sponsoring employer. You must seek [funding] as fast as they can afford to, but not faster than they can afford to. If you force the company to put money into the scheme rather than pay the electricity bill, you don't do your members any favours."

Interestingly, Aon has found some clients already in negotiations as one smaller employer, for example, has consulted its defined contribution members about postponing contributions for a year, while 20% now have some form of inter-company or parent group guarantee.

But are trustees confident they have the skills to make what could potentially be ‘make or break' decisions about corporate financing? Aon Consulting conducted a survey of its members in the first half of 2008 and found of the 200 UK trustees asked, 34% felt they had a strong covenant but a weak funding level while another 16% said they had a weak covenant and a weak funding level.

The study showed 76% of Edinburgh-based trustees - and therefore potentially attached to banks and financial services firms - at that time felt they had strong enough covenants.

Data compiled by Hewitt Associates also suggests most industries are exposed to recession so trustees will also be required to question whether their sponsor fits into those brackets and whether the pension fund is secure enough (see table).

 "Most trustees received a very unwelcome Christmas present in the guise of falling equity investments, low gilt yields and recession-hit sponsors," said Aidan O'Mahony, principal consultant at Hewitt. "This triple whammy is a wake-up call for many trustees who are now finding out that a good covenant analysis should see through the current economic ups and downs."

It is also not just underfunded schemes questioning the quality of their employer covenant and contingency plans. Sally Bridgeland, chief executive of BP Pension Trustees Ltd told delegates of the MultiPensions Conference in London the scheme was 125% funded, but she still has worries about the ‘what ifs'.

"My main challenge has been getting to grips with the entire relationship between the sponsor and the pension fund. I want a contingency if something happens to commodities and equities and they were to converge, because it could mean our employer would not exist. It has really brought home that even if we are fortunate, there are challenges. It does mean I'm thinking about contingencies if something happens to the sponsor," said Bridgeland.

David Poynton, head of credit analysis at Lane, Clark & Peacock, says trustees can "if nothing else, look people in the eye and say we did everything we should do" if they shore up the employer covenant and ensure funding or contingencies.

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