Trustees’ guide to trust
3 Nov 08
How can the people responsible for the pension fund be sure the employer will keep the promises made? Alan Thomson introduces new guidance from ICAS
by Alan Thomson
The current economic climate poses a number of challenges to all businesses but consider the position of pension trustees. They are expected to judge whether their pension scheme will be able to pay out all future liabilities over many years. A significant element of this may depend on the ability and willingness of the sponsoring employer to support the pension scheme – factors which in the current economic climate may be much more uncertain.
As the Pensions Regulator (TPR) states in its guidance, Funding Defined Benefits, “It is essential for the trustees to form an objective assessment of the employer’s financial position and prospects as well as his willingness to continue to fund the scheme’s benefits (the employer’s covenant).”
Pension trustees need to be able to assess whether the employer can support the scheme. They also need to consider whether the employer is willing to support the scheme.
Take the example of an employer who has funded business expansion with substantial borrowings and now has a high level of debt compared with shareholder funds. The employer is exposed to changes in the interest it has to pay and may need to refinance loans. How do trustees evaluate the impact of this on the employer’s ability to fund the pension scheme now and in future?
Jim Boyle, an actuary at SBJ Benefit Consultants, and a member of the ICAS Pensions Working Party, which has drawn up a guidance booklet for pensions trustees on the employer covenant, gives a hypothetical example. “An engineering company provides a range of specialist equipment to offshore oil platforms and its main customers operate in the North Sea. The business is currently very profitable. Projections show that oil production in the North Sea will steadily decline over the next twenty years but that production will still be viable. The employer’s business plan is dependent on continued oil production in the North Sea and on the oil price remaining at or above £x per barrel.
“An evaluation of the financial position of the employer over the short term ought to be relatively straightforward with readily available information from the company’s financial statements and from market information. However, the value of the employer covenant may be very sensitive to changes in oil prices. With a view to protecting the pension fund, the trustees should investigate:
• The risk of changes to the oil prices;
• The impact of changing oil prices on the employer covenant; and
• The extent to which the employer is able to mitigate risks by, for example, diversifying its business and pursuing new markets.”
None of these risks are easy to determine. If the evaluation of the company’s long-term prospects indicates a potential risk to its ability to fund the pension scheme in the longer term, the trustees may seek greater security up-front, for example, by requesting higher contribution rates, linking contributions to company profits or cash flow, or putting in place a contingent asset such as a bank guarantee.
It may be difficult to know where to begin when evaluating the employer covenant, so ICAS has produced a guide that outlines a range of issues, with practical illustrations that may be relevant when evaluating and monitoring the ability and willingness of the employer to support the pension scheme.
The guide also discusses some factors for trustees to consider when deciding whether to appoint external advisers to evaluate the employer covenant, including:
• Whether the trustees have adequate expertise and time to undertake their own evaluation of the employer covenant;
• When a trustee with financial expertise may assist and guide the trustee board, but it is not necessarily appropriate to expect them to undertake a financial analysis of the employer; and
• Where the initial data analysed by the trustees indicates areas that require more detailed investigation.
As John Moffat of Grant Thornton, a member of the Pensions Working Party,
notes: “The trustees may decide to undertake the evaluation themselves. Alternatively, the trustees should be able to gather much of the underlying information for the external advisers.
“Although external advisers may be instructed to provide an evaluation of the sponsoring employer, this doesn’t remove the responsibility from the trustees: trustees need to understand and articulate their requirements, specify the terms of any third party appointment, be able to assess any subsequent report and, if necessary, act upon it.” n
The guide Pension Trustees: Getting the Balance Right in Evaluating the Employer Covenant can be downloaded free from the ICAS website at www.icas.org.uk/businesss