when is it right to say goodbye to the employer covenant?
10 January 2019
The last month or so has been a real milestone for the fledgling DB consolidation industry, with the first potential deal taken to the Pensions Regulator for approval, DWP’s public consultation being released and the Pensions Regulator issuing guidance on the approach it expects trustees to take when considering transferring members to a consolidator.
Fundamentally, moving into a consolidator means that members will lose their employer covenant and its ability to provide funding to the scheme over time. This will be in exchange for a capital buffer provided by a combination of both the exiting sponsor, through a final contribution to the scheme, and the consolidator’s investors.
The need for joined-up thinking
If a proposal to consolidate is put to a trustee board by their sponsor, it is likely to be one of the most important decisions that they will have ever been asked to make.
Instinctively their starting point may be to focus on the covenant implications of such a proposal. However, as has been the mantra of the Regulator for several years, they really will need to make sure they are considering the key facets of such a proposal – the impact on covenant, funding and investment risks - on an integrated basis.
Transfers to consolidators are in effect corporate transactions, which professional covenant advisers are well practised at assessing by undertaking “before and after” analysis. However, historically the characteristics of the company after the transaction usually bear some resemblance to the characteristics before, with little change in the scheme position. Indeed, it has usually been the role of the covenant adviser to recommend how the scheme’s funding and investment risks could be re-balanced based on the impact of the transaction.
In the case of consolidation, there will be no further recourse to the current covenant after the transaction and the dynamics of the scheme will have fundamentally changed. As such, it will be more important than ever for covenant advisers, scheme actuaries and investment professionals to work very closely together to help trustees decide whether transferring is in the best interest of members.
In contention for consolidation – the likely suspects
Standing back from all this, there are likely to be some schemes where the case for consolidation will be more apparent. For example:
- Well-funded schemes which have employers within an industry which is highly vulnerable to changes in demographics, technology and general trends (but with insured buy-out not affordable in the near term).
- A well-funded “zombie” scheme (i.e. one with negligible covenant support), which cannot afford insured buy-out but through a transfer to a consolidator could reduce its risk exposure.
- Schemes that are attached to a weak subsidiary of a much larger organisation with deeper pockets, but where the scheme has no legal recourse to the larger parent company. There may not be an appetite from the parent to fund to an insured buy-out, but a smaller payment to enter a consolidator may be palatable.
- As part of a corporate transaction where a payment to remove the pension scheme from the target’s balance sheet may allow the deal to happen (which would improve the funding position of the scheme through a cash-injection to reach the consolidator’s funding level, that may otherwise not be on the table).
In other situations, the pros of moving to a consolidator may be more blurred. However, the Regulator has strongly advised that it expects professional covenant advice to be taken in all circumstances where consolidation is being considered.
Given the increasing maturity of schemes over time and the distance to buy-out for many, the development of a competitive and well-regulated DB consolidation industry is likely to provide better outcomes for some members than would otherwise have been the case. Trustees that receive proposals to consolidate will need to consider the pros and cons on a holistic basis, and integrated covenant analysis will be at the centre of most decisions.
Footnote – Regulation of the covenant market?
As a footnote to the above, the DWP consultation noted that it expected external covenant assessments on consolidation proposals to be undertaken by a “regulated provider”. At present the covenant market is unregulated, so it will be interesting to see if this is part of a wider play by the authorities to have greater involvement in setting standards within the industry.
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