Is our employer covenant robust and sustainable enough? That’s a question trustees of defined benefit (DB) pension schemes in Ireland should be asking on a regular basis. While this question is always relevant to DB pension schemes, recent regulatory changes have guided trustees to look at it more closely going forward. Michael McElligott, Director, shares his thoughts.

A strong and enduring employer covenant is fundamental to the security of member benefits in a DB scheme. It is the sponsor’s legal obligation and reflects their financial ability to support the scheme long-term – acting as protection against any current or future risks that DB pension schemes take (e.g. investment and funding risks). In many ways, it is binary (i.e. you either have an employer covenant or not), and where the covenant fails you must usually wind-up with the assets you have at that time. This may mean that members’ benefits are curtailed, in particular, the benefits of deferred and actives.

All too often, however, the sponsor’s ability to support the pension scheme is taken largely on trust and / or based on discussion with a company representative, rather than a critical assessment of whether they will be able to underpin the future liabilities of the scheme – including when the economic background is challenging for the sponsor.

The Pensions Authority in Ireland has become increasingly vocal on this subject. It points out that, in many cases, the guiding factor for Trustees is sentiment or historical employer support rather than any meaningful analysis of the prospects and balance sheet of the sponsor to underpin the sustainability of the scheme.

A reason why the latter is often not undertaken is the fact that a solvent sponsor could walk away from its pension obligations. This is even where the full costs of members’ benefits have not been and will not be met. However, we do believe not many would choose this option today given the damage this may have reputationally.    

Furthermore, the long-term planning that trustees are undertaking in Ireland (i.e. setting 15-20 year journey plans to low-dependency / transfer to an insurer) implicitly assumes the sponsor will be around over the long-term. However, most pension schemes in the market have minimal evidence or analysis to support the appropriateness of the time horizon and risk profile for the scheme.

Employer covenant risk even more pronounced in Ireland

Yet getting this right couldn’t matter more. If a sponsor can’t provide the DB scheme with long term financial support, that seriously threatens members’ benefits. Pensioners and future pensioners relying on retirement benefits from employers and former employers’ pension schemes may not receive what they are owed in full.

A robust employer covenant should be front and centre of the pension scheme’s strategy, with material risks mitigated where possible.

This is particularly important in Ireland given employer covenant risk is pronounced under the Irish regulatory regime for the following key reasons:

1. Protection / compensation for members of a pension scheme whose sponsor becomes insolvent is limited (protections under section 48A fall significantly below that paid by lifeboat funds like the Pension Protection Fund (PPF) in the UK);
2. Most pension schemes in Ireland do not have a claim on the assets of their sponsors in an insolvency situation. So, there is no prospect of substantive additional returns to the scheme to top-up the assets / improve benefits as it is wound up; and
3. Most pension schemes are funding to a relatively weak funding basis resulting in a significant gap to the full cost of members’ benefits (i.e. the cost of transferring these benefits to the insurance landscape). This also means that there are long de-risking time horizons in Ireland…… and where covenant is concerned, time is risk.

Change is starting to come in Ireland

Fortunately, recent regulatory changes in Ireland are already changing the conversation. Two main developments now mean managing employer covenant risk is becoming more important:

• The Code of Practice for trustees of occupational pension schemes and trust retirement annuity contracts, issued in November 2021 requires trustees to assess the strength of a DB pension scheme’s employer covenant as part of the newly introduced own risk assessments (ORA). The Code of Practice explicitly states that trustees ‘must ensure that their ORA considers… the trustees’ evidence-based view of the strength of the employer covenant’.

• The EU’s IORP II Directive sets a higher governance bar for occupational pension schemes. It encourages making risk awareness and management central to the running of a pension scheme – including assessing and managing employer covenant risk.

Following these two regulatory instruments, DB pension scheme auditors in Ireland are intensifying their focus on the health not only of the DB pension scheme, but also the sponsor itself.

Gaining a greater understanding of the employer covenant

All trustee boards need to fully understand the risks in a pension scheme. And right at the heart of that is the issue of whether or not the employer has – and will continue to have – the ability to underwrite the payment of the promised pension benefits. This is particularly the case in Ireland given the characteristics of the framework noted earlier.

As the market-leading employer covenant specialist in the UK, Cardano helps trustee boards build up the detailed picture they need of how robust the employer covenant is over the short, medium and long-term.

That 360º perspective allows them to make informed strategic decisions on crucial questions such as:

• how to meet funding shortfalls, when assets are less than liabilities
• appropriate levels of investment risk, in the light of the sponsor’s financial characteristics / flexibility
• appropriate timelines over which to rely on sponsor support (and frame journey plans / de-risking strategies)

As we move from a predominantly hands-off approach to the employer covenant, to a more involved and demanding one on the part of pension trustees, this should result in a greater chance of members receiving their benefits in full, and safer financial futures and more peace of mind as a result.

• DB schemes
• Employer covenant
• Pension Trustees