What drives your Employer Covenant?

Richard Smith

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Spence & Partners latest blog for Pension Funds Online –

In a world where gilt yields continue to hurt pension scheme funding levels, even at a time when the markets are performing well, support from scheme sponsors is crucial. All the more reason why Trustees should have a strong framework in place to understand and monitor their employer covenant.

This is one of those statements which is easy to make and less easy to implement. Properly assessing the strength of a company and then monitoring the way that changes is no easy task.

Many trustees complain of bland covenant reports which simply re-present financial statements from their company, difficulty in obtaining timely information and then a struggle to identify the main drivers behind the company covenant.

Monitoring the performance of a company is a full time job for many investors and creditors – so the work that goes into doing this properly should not be underestimated. Nonetheless, trustees need to find a way of putting in place a proportionate monitoring process which can be expected to flag up early warning signals, should there be a shift in the fortunes of the sponsoring employer.

There is no easy checklist of what should be included in this monitoring framework. The metrics for trustees to monitor will vary depending on:
– the circumstances of the sponsor,
– the size and complexity of the company,
– the extent of the funding gap relative to the size of the employer.

Having said that, Trustees can work with their covenant advisors to identify the main drivers behind their specific sponsor’s performance and to set out which questions they should ask at each quarterly or annual review, in order that any potential weakening in the covenant can be picked up and dealt with at an early stage.

Understand the industry

One way of identifying these metrics might be to start with the industry that the company belongs to. There may well be global factors which can reasonably be expected to influence all companies within a particular industry and which are relatively easy for trustees to monitor.

Take the metals and mining sector for example – the price of commodities, the cost of labour in the areas in which they operate and the cost and availability of long term financing will all impact on companies within this industry.

Of course, these factors won’t impact all companies in the industry in exactly the same way, but understanding the key drivers behind their sponsor’s industry gives trustees the ability to question company management about how they are dealing with these challenges or capitalising on positive market movements.

Understanding industry metrics also helps trustees to avoid concentration of risk between the scheme sponsor and the pension scheme. If, as in the example above, a sponsor is heavily exposed to the price of commodities then a significant investment in commodities may not be a sensible strategy for the pension scheme. The last thing that trustees want is to see the value of their own assets falling, just at the same time as their sponsor is facing unfavourable market conditions.

Of course, there is much more to monitoring company performance than looking only at the industry in which an organisation operates.

However, this high level understanding of their sponsor’s market can be a very useful tool in the kit for trustees which can focus discussions in a cost-effective manner and inform the types of further analysis that might be required.

Pension Funds Online

Richard Smith

Post by Richard Smith

Experienced pensions actuary and expert in accounting for pension costs, liability management exercises, dealing with the pensions issues arising from M&A activity and scheme funding.