‘How green is your covenant?’
Transparency of employer covenant strength may help achieve a more sustainable funding cost and thereby prolong DB scheme – and employer – lifetimes, whilst benefiting members.
By Chris Mullen, Managing Partner and Kevin Le Grand, Consultant, Arc Pensions Law.
In the world of DC schemes, there is currently a strong focus on the risks to members and the need for transparency of terms, including value for money, investment risks and security/governance issues. Educating and giving support/guidance/advice to affected members is also seen as a key issue, recognising that members are assuming the risks themselves and are having to make decisions on difficult issues with the potential for serious negative impacts on their financial positions, should they make the “wrong” decisions.
Many members with DC benefits for current service will also have accrued DB benefits built up for past service and, for some, these will represent a substantial proportion of their overall entitlements. Such members are becoming more familiar and, it is reasonable to suppose, comfortable with the concept of DC and the environment within which DC operates. Freedom and Choice is effectively providing encouragement/temptation to approach accrued DB, as well as DC benefits, in a more flexible way, and it’s increasingly likely that members will be open to the idea of transferring their accrued DB benefits across into a DC environment.
In considering whether or not to do so, they are likely to take a view on the risks involved, including balancing the perceived security of the DB benefit with that of the likely DC arrangement if they were to transfer. Currently this consideration is endorsed by the law, by requiring that a member who is contemplating exercising their right to transfer has first to obtain independent financial advice, if the proposed receiving arrangement is DC.
The myth of the guarantee
In simplistic terms, the choice may be thought of as foregoing the “certainty” and “guarantee” of the DB “promise” for the uncertainty and risk of the DC arrangement, where the ultimate benefit will depend upon such imponderables as the rate of future investment growth and prevailing interest rates at the time of drawdown, as well potential changes to the legislative and tax environment. But how accurate is such a picture in reality? What if the information available to the members – or the lack of it – leads them to form an erroneously positive picture of the security of their DB benefit? And what if this is actively discouraging members from exercising their freedoms, potentially to their detriment and – where the scheme is significantly underfunded – the detriment to the employer’s business and therefore the security of other members?
The usual approach to this ‘balance of risks’ is predicated on the assumption that the DB benefit, with the extensive regulatory regime governing it, together with the backing of the sponsor’s covenant, will always provide a more secure benefit than any DC arrangement, with its clear uncertainties. However, as the recent intensive media coverage of the British Steel Pension Scheme and most recently the BHS Pension Scheme and their respective deficits reminds us, that is not necessarily the case.
One of the reasons why the DB benefit may not be as secure as the member probably expects, is that the employer covenant that underpins the security may in practice be poorer than is thought and may fall well short of a ‘cast iron guarantee’. How many members would consider the option of a transfer out more favourably, if they had more information – indeed, any information – about the actual strength of the sponsor’s covenant and the related risk of their DB scheme going into the PPF with consequential reductions in their benefits?
The strength of that covenant may be apparent (or should be) to the scheme trustees and/or their advisers and to the Regulator, but members themselves are unlikely to possess any information about the strength of the covenant – and even if they do, may have no clear grasp of its implications in terms of the risk to their benefits. They are unlikely to see the assessment, but even if they were to do so, they are most unlikely to be able to understand and correctly interpret what they are reading.
It might be argued that this is not a problem, since it’s the duty of the trustees to look after members’ interests and as long as they are fulfilling this duty and take action upon their assessment of the employer’s covenant, that is all that is required. But this ignores the fact that the trustees’ duties are to the members as a whole – not just to those who have an option to transfer out, or to those who would be most adversely affected by a move into the PPF (such as members on larger benefits). It would be a brave set of trustees who actively sought to encourage some members to transfer out of the scheme, on the basis of their most recent assessment of the strength of employer’s covenant. Such members have distinctive interests to protect, and in any event are likely to take an individual view, that may well be different to the trustees, of what amounts to adequate security when it relates to their personal benefits. Yet to protect their own interests properly they require information that they mostly do not have and, were they to receive it, would be unlikely to be able to understand, without expert help.
In addition, although the Pensions Regulator expects trustees to obtain a formal covenant assessment, it is not compulsory, which can mean that no-one – apart from the sponsoring employer itself – is considering how likely it actually is that the full DB entitlements of all members of the pension scheme will actually be paid. Whilst solvent, the employer owes duties to its shareholders, not to its creditors, such as the trustees, and has no obligation to undertake a covenant assessment at all, let alone furnish a copy of any assessment to the trustees.
Information that members should routinely receive
To remedy this defect, and put members in the position where they can make a properly informed decision about whether to remain ‘invested’ in the DB Scheme – and. implicitly, in the employer’s ability to pay contributions as they fall due – or move across to a DC environment, there is a clear need for two changes to be made:
First, that a regular assessment of the strength of the employer’s covenant should be compulsory, and
Second, that this assessment should be published to members, albeit in a simplified form.
The benefits of such changes seem clear, but what are the risks? It is well known that the assessment of the covenant and the future prospects of the business is far from an exact science, with no two covenant assessors likely to agree, at least, not without significant negotiation and compromise. So the industry – perhaps led by the Pensions Regulator or the recently-formed Employer Covenant Working Group, created “with the aim of addressing the need for greater consistency, recognised leading practice and improved standards in covenant advisory work” – would have to work to develop an agreed standard or set of standards which may be applied universally for the purpose of this regular published assessment (much as prevailing accounting standards constrain how pension costs are reported in company annual accounts).
This would, admittedly, be no mean feat and doubtless there will be many who would claim that it cannot be achieved, that every business is different and that standardisation and simplification of the assessment either cannot be achieved at all or can only be achieved by sacrificing accuracy. All of which is no doubt true, but none of which should prevent a sincere and concerted attempt to achieve a good outcome.
Assuming such a standard or set of standards could be agreed upon, actually publishing the assessment also involves a number of risks, such as that publication will –
- accidentally divulge commercially sensitive information, or
- result in an interpretation which may lead to members taking the “wrong” decisions on the back of it, or
- lead to predators attacking the business, or
- result in the share price being negatively impacted and possibly even bring about the insolvency of the company, none of which potential consequences should be lightly dismissed.
A misleading or misunderstood covenant assessment entering the public domain may therefore damage a perfectly viable business. The risk of this happening is potentially even greater if the output from the assessment is in a simplified format, aimed at giving something that members with low levels of financial literacy can read and understand, since this could result on important detail and nuanced language being foregone in favour of brevity and simplicity.
On the other hand, if publication is universal, it seems less likely that these outcomes will, in practice, become a reality simply because the market will have to digest similar information on many, many companies. And if dividend payments and/or the share price is negatively impacted because the market has better understood the actual ability of the company to meet its pension liabilities over time, then perhaps that readjustment is necessary and overdue? Can one really argue against the provision of more, better quality information on such an important issue?
The upside of a more open approach to the employer covenant
Neither should the potential for positive outcomes be overlooked. If publication of the employer’s covenant strength tempts a number of members – especially those with larger benefits, who are not yet approaching retirement and who face the greatest risk of reduction in the PPF – to transfer out of the DB scheme into a properly-regulated DC environment, it would speed the derisking of the scheme, and some employers might welcome that with open arms. Might it be considered a “win, win, win, win” if –
- the member is happy with his or her choice,
- the employer sees the cost of funding the scheme reduced, the prospect of paying off the deficit increased, and/or the period to achieving full funding shortened
- the security of the remaining members (and, potentially the job prospects of those who are still in service) are thereby improved, and
- consequentially, the shareholders benefit from the company’s improved financial prospects?
If that were considered overall to be a Good Thing, how could it best be done, balancing the interests of the members, giving them effective information to enable them to take decisions, without risking damage to the supporting business, which inter alia provides (at least some of) them with their employment?
One could envisage a system whereby a quite complex set of agreed criteria (mostly financial) would be used along with an agreed methodology to produce a “score” which is then translated into a simple system – perhaps RAG – for reporting to the members, perhaps through the medium of the scheme annual report and accounts or when communicating any changes to the funding plan.
To ensure true transparency the detailed background would be made available to members or their advisers on request and not published as of right, although the employer should assume it will enter the public domain. The background assessment should be done on a standardised basis, but thought needs to be given, when determining that basis, to the possibility that the employer’s managers and advisers would be able to manipulate the employer’s situation to paint a picture of the business that best suits their purpose (whatever that might be), rather than necessarily being aligned to the interests and security of the members’ pension benefits.
In practice, that may not matter too much though, since there is a natural tension between – for example – an employer wanting to de-risk the DB scheme through (inter alia) encouraging members to transfer out, and producing a covenant assessment that might encourage that, and the impact such an assessment could have on the business in the eyes of shareholders and the wider business community.
Even if details of the employer’s covenant strength is published in simplified form, it will be helpful to ensure that members’ understand what they are seeing, and aren’t unnecessarily panicked by it. The Pensions Regulator has produced a wide range of guidance to date which seems pretty comprehensible, even to a lay person, so it would seem pessimistic to assume that tPR, or even the latest incarnation of Pension Wise, could not also do something similar to help guide members to better understand the employer’s covenant. Nonetheless, it may be prudent to continue to require members, if they wish to transfer out of the DB scheme to DC, to take independent financial advice and for their IFAs to be trained in understanding the implications of the standard annual covenant strength report. Perhaps one or more triggers could be installed which, if activated, would e.g. automatically give members the right to take a transfer from the DB scheme without having to obtain financial advice. For example, if the RAG system is used, a Green or Amber warning may trigger a need for advice, yet a Red warning would mean members could exercise their right to transfer without taking such advice.
For too long members have been kept in the dark about one of the most serious risks that comes from being a member of a defined benefit pension scheme – the risk the sponsoring employer will not in fact be in a position to fully fund all of the scheme’s benefits and that in consequence, should the employer go insolvent, members’ benefits will be cut back because the scheme is transferred into the PPF. This may have led to false comparisons about the relative security of a DC environment and the obvious remedy to this problem is to create an opportunity for members to achieve a greater level of understanding of the risks they are running with their DB benefits, coupled with the ability – at least in some cases – to do something about it, by exercising their statutory right to transfer out of the scheme. If the industry were to decide to move down this route, with suitable caution, there could be real benefits for all parties – members, trustees, employers and, it should not be forgotten, pensions policy makers too.
Views expressed are those of the authors and not of Arc Pensions Law
The views in this article are intended for general information purposes only and should not be used as a substitute for professional advice. Arc Pensions Law and the author(s) are not responsible for any direct or indirect result arising from any reliance placed on content, including any loss, and exclude liability to the full extent. Always seek appropriate legal advice from a suitably qualified lawyer before taking, or avoiding taking, any action. If you have any questions on the points raised in the above, please do not hesitate to get in touch.