Panellists discuss the extent to which trustees should be looking to review covenants and how to interpret findings and implement changes
Richard Hall, director Lincoln International
Richard is a director in Lincoln International's Pensions Advisory group and provides senior level advice to companies and trustees on employer covenant-related matters. He is a qualified actuary with over 18 years' experience in the pensions industry, including over seven years of advising on employer covenant. He advises on all aspects of the covenant including assessment, monitoring and corporate transactions.
Jonathon Land, PwC
Jonathon leads PwC's pensions credit advisory team in the UK. In 2005 Jonathon seconded to TPR to advise on its clearance process and use of anti-avoidance powers. Since then Jonathon has advised many trustees and employers on pension strategy in a range of situations including scheme funding, transactions and the regulator's powers. His current clients include the Nortel trustees whose case is a leading example of the use of the regulator's powers.
Ian Steward, director, BDO
Ian is head of BDO's employer covenant team within Pensions Advisory. Since 2005 Ian has advised numerous corporates and trustees on covenant related issues in scheme funding and transactional related scenarios including negotiated compromises involving the Pensions Regulator and the PPF and advised the Pensions Regulator on its original Scheme-Specific Funding guidance. Ian is a qualified insolvency practitioner with 20 years' experience of turnaround work and a fellow of the Institute of Chartered Accountants in England and Wales.
To what extent should trustee boards be looking to conduct a covenant review in light of the deteriorating outlook for the global economy and volatility in both equity and bond markets? To what extent will this depend on the financial solvency of the sponsor and how should this be determined?
Richard Hall: The covenant should be reviewed by trustees as part on an ongoing process rather than just when the economic environment is challenging. This is certainly the thrust of The Pensions Regulator's (TPR) latest guidance on the covenant published in November 2010. Nevertheless, the downturn has of course focused trustees' attention on their sponsors, particularly at a time when asset values are depressed and deficits are rising. Trustees may well want to keep a closer eye on their sponsor's liquidity and debt levels, as well as other key performance indicators, as companies cope with the difficult conditions.
A covenant assessment considers the ability of an employer to meet its obligations to its pension scheme. An insolvent employer would, by definition, be unable to support its scheme and would have no covenant. In one sense, a covenant assessment considers the likelihood an employer will remain solvent and able to meet its financial liabilities. We believe it should therefore be forward looking and contain a clear overall assessment of the likelihood the employer will remain solvent.
For any covenant analysis, cash is king. An assessment considers an employer's ability to generate cash to meet its pension and other obligations. It should consider the factors that might affect future cash generation, such as industry prospects and liquidity position. Consideration should also be given to a scheme's position on insolvency, in particular the location of assets and the existence of prior-ranking and equal ranking creditors.
Jonathon Land: Many trustees will currently be sitting on deficits that have ballooned and/or employers whose share price has tumbled.
These issues will be causing real concern for trustee boards, which will be debating whether they are temporary blips or developing trends that are going to persist.
TPR has been promoting the importance of understanding and monitoring the employer covenant for many years now. Trustees who have been following this advice, have had a covenant review and who understand their sponsor will probably feel relatively comfortable. They will have a good feel for whether the employer can underwrite the additional deficit that has opened up and whether the underlying performance and outlook of the employer is deteriorating or not.
Trustees who do not have the same understanding of their covenant are likely to be feeling more nervous and might be feeling their way in the dark when it comes to understanding the solvency of their employer. In these circumstances it would be wise to get an independent covenant assessment.
Ian Steward: The employer covenant should be treated as an asset of the scheme (potentially the most valuable one as, provided it is solvent, it underwrites 100% of member's benefits that are not otherwise covered by the scheme's assets). Just like any other asset, the trustees should monitor: its value - what is the employer covenant worth today? (position); its risk - what could the employer covenant be worth in the future? (prospects); and its liquidity - how can the trustee accelerate transfers of value? (power). In fact, we would go further and suggest that the overall investment management of the scheme and its funding levels should be managed by including the value of the employer covenant.
In an ideal world, therefore, trustees should monitor these elements as frequently as it monitors changes in value of is scheme assets and liabilities. This should be done in all market conditions, not just the current turbulent market. However, where market turbulence has created a significant deficit or caused a significant decline in the employer covenant, trustees should accelerate their valuation accuracy and frequency.
How should trustees interpret the results of such a review and at what point do they need to ask for extra contributions or the assignment of a contingent asset to protect the scheme? How can trustees balance any need for additional contributions against the risk the sponsor's ongoing business could suffer at a difficult economic time?
Richard Hall: An assessment needs to contain a result or rating if you like. This enables trustees to clearly understand the strength of the sponsor and also assists scheme actuaries in recommending funding assumptions for valuations. In broad terms, and in line with TPR guidance, the weaker the covenant the more prudent the valuation assumptions and the less likely trustees are willing to accept investment risk.
Once a deficit is revealed following an actuarial valuation, trustees need to agree a recovery plan with the employer. TPR has made it clear it expects trustees to consider whether they might be flexible around shortterm cash demands from the employer if cash is tight due to the economic environment. This might take the form of back-end loaded plans or greater use of non-cash security measures such as contingent assets. For schemes with employers whose long-term ability to provide support is more in doubt then options may be much more limited.
The range of contingent assets companies and trustees have available is evolving. This year we have seen our clients increasingly use contingent asset structures involving Scottish Limited Partnerships to provide security for the pension scheme while at the same time reducing the cash burden on the sponsor. With the right underlying asset, these can be a win-win for trustees and sponsors.
Jonathon Land: Firstly, trustees should not need to interpret results themselves. A covenant adviser should be clearly explaining the issues and options, and giving advice to help trustees develop their course of action.
While trustees should always have been looking at a range of options to secure members benefits, in reality this is a difficult time for many employers to commit extra cash or contingent assets, particularly for those employers with a weak covenant.
This does not mean trustees should accept their employer's proposals without question. The covenant review should explain the sponsor's prospects, available resources and competing stakeholder requirements. From this information the trustees and advisers can build a sensible ask around cash and other assets that the employer can deliver.
In many cases the best security for a scheme will be achieved by supporting the employer through a difficult period, so long as there is a viable long-term business. If this means less cash now, then trustees should think ahead and seek commitments to increase future funding or protect against a further downturn (for example with a contingent assets), as when the good times come around these may still be difficult to negotiate.
Ian Steward: Our view is that a well-funded scheme should aim to be fully funded on a bestestimate basis with sufficient security that on insolvency, the scheme could afford to buy-out members' benefits in full. Trustees should attempt to maximise the best-estimate funding level via investment returns and recovery plan contributions, then seek to create security in the form of contingent assets (or asset-based finance structures) for the buyout deficit.
The trustee needs to create an economically credible funding plan that can balance the need for contributions and security without damaging the long-term solvency of the business. This therefore means different sources of finance that can be complimentary to the employer's overall capital structure need to be considered. This can include, cash, asset-based financing, debt allocation and even equity structures that address both cashflow and security.
However, the trustee needs to be wary of the inflection point - the point at which the employer changes from a stable, solvent company, to an unstable, potentially insolvent company. Beyond this point, the trustee may find it has little time, information or control to manage a restructuring of the employer and its scheme to maximise members' benefits.
What actions are open to a trustee should a sponsor's covenant be weak? At what point does the trustee need to involve the TPR and or the PPF in its negotiations with a sponsor?
Richard Hall: Trustees would need to determine whether the weakness was a short-term cash shortage due to the economic environment or a longer-term issue with the business. For employers with positive future prospects, trustees might be prepared to be flexible about cash in the short term. Where there are doubts about an employer's ability to support its scheme going forward, trustees will try and find security where they can.
TPR would become involved either at the request of the trustees or sponsors given they have failed to agree a recovery plan or because TPR is pro-actively scrutinising an agreed plan. Anecdotal evidence suggests that over 2011 TPR has been looking at agreed recovery plans more closely and requests for additional information and further discussion are more common.
Where a scheme has become a very significant liability relative to the size of the sponsor we have seen situations where the scheme has become separated from the sponsor. This can be with the sanction of TPR and the PPF, such as the debt-for-equity swap for the Uniq Pension Scheme this year, although not always as in the cases of Silentnight and Brintons where the pension schemes were separated from their sponsors under prepack administration processes.
Jonathon Land: When a covenant is weak the key question to answer first is whether there is a viable business and a reasonable likelihood of the employer being able to meet the scheme's funding requirements.
If the answer is ‘yes' then the trustees and employer may look at a back-end loaded or profit linked recovery plan, combined with an additional security package.
In cases where the answer is ‘no', either because there is not a viable business, or it is simply not big enough to fund the scheme, then there is a range of options the trustees should be looking at. These include traditional PPF restructuring, or more radical and innovative options including deficit for equity swaps and other solvent restructuring arrangements.
In the ‘no' scenario it is critical that trustees know the views of management, lenders, shareholders, TPR and the PPF if they are to get the right outcome for members. All of these stakeholders will want to control the process, but the ones who do will usually get the best outcome. All too often we see trustees who think that the outcome is a foregone conclusion rather than taking a proactive approach and looking at innovative solutions, which may get the best result for members.
Ian Steward: Trustees need to ask two questions: (i)Would it be in the best interests of members to maximise the value of the employer through a significant recovery plan, solvent sale or insolvency process and over what time period would value be best maximised and how could this be achieved? And (ii)Once maximised, would the scheme be sufficiently well funded that it could continue to operate on a going concern with the aim of paying members' benefits in full or should it enter into a PPF assessment period or wind-up? (In each case with a reduction to members' benefits.)
The two key factors to answer this question are an assessment of the employer covenant - what it is worth to the scheme today (position), how this could change (prospects) and how the scheme can capture it (power) and an assessment of the deficit on a buyout and PPF basis and a projection of whether these deficits (the buyout drift and the PPF drift) are expected to get materially worse over the short term.
Trustees should seek early engagement with TPR, especially where PPF deficit is degrading materially, and create a credible restructuring plan for the employer and the scheme.
How should trustees communicate such a covenant review exercise with the employer and how can they work in partnership with the sponsoring firm to ensure a continuing good relationship between both parties.
Richard Hall: We find covenant assessment exercises usually work best with the involvement of both the trustees and the employer. In our experience companies are more likely to accept the findings of a review if they have had input into the assessment process. It can be particularly helpful to allow the sponsor to comment on the draft covenant assessment to check for technical accuracy.
The sponsor can do its part by providing its trustees with sufficient information to monitor the covenant and by agreeing appropriate responses to changes in covenant in advance. Regular presentations to the trustees can go a long way to reassure trustees and help maintain a positive relationship. Also where there is a planned corporate event it is beneficial for all parties if the trustees are involved at an early stage. Trustees will not want to hold up a corporate event unnecessarily but they will need to do sufficient due diligence to ensure there is no detriment to the covenant.
Jonathon Land: Pension trustees are often a major stakeholder of their employer and TPR has said for a long time that trustees should act like a commercial lender. We fully support this view and encourage trustees to communicate on a level footing with employers.
This means taking a balanced and constructive approach that is neither subservient nor overly demanding. Trustees should be open and honest about their concerns with the employer and share the results of their covenant review, whilst employers should provide the trustees with the information they require (as they would a lender). Trustees and employers also need to be aware of conflicts of interest and make sure these are recognised and managed to avoid any real or perceived independence issues.
Finally, both parties should ensure they are not winning battles but losing the war. In our experience, with some careful thought there is usually a win-win solution that can be found that provides protection for members' benefits whilst maintaining an effective ongoing relationship between the trustees and employer.
Ian Steward: If the employer covenant is either (i) so large that on an insolvency of the employer, the scheme would be fully funded on a buyout basis and/or (ii) the employer has a low risk of insolvency and could afford to fund cashflow or deficit shortfalls in funding on a best-estimate basis, then the scheme can be considered as a creditor of the employer. As a consequence, the Employer is likely to be in the driving seat for proposing an appropriate level of funding.
However, for the majority of schemes, this is not the case, and the employer is a key risk factor for the scheme and as a consequence the scheme is a key risk factor for the employer. They are in partnership. The employer needs the scheme to invest its assets and manage its liabilities to minimise future cashflow calls (as does the scheme). Equally, the scheme needs the employer to provide an appropriate level of cashflow and security funding to support the investment strategy.
Once this partnership is accepted, then the employer and the scheme need to work together to create a long-term funding strategy that is both economically credible and regulatory compliante
