Why covenant matters in DC
17 Sep 2019 - Estimated reading time: 3 minutes
“The company has had an excellent twelve months and we will be increasing this year’s final dividend by 10%”. This kind of announcement might well have the trustees of defined benefit schemes pricking up their ears and looking to proactively negotiate with the company on the level of additional contribution they might get into the DB scheme. But what about trustees of DC schemes? Does the performance of the company – and the strength of the covenant – matter in DC?
With a few exceptions, covenant has never really been on the agenda of DC schemes. But I would argue that DC trustees should pay heed to how well the sponsoring employer is doing – for two reasons.
Firstly, if a company is performing well and paying out large increases in dividends, is it also reviewing the contribution rates being paid into the DC scheme? Admittedly, like a puppy that’s not just for Christmas, an increase in contributions isn’t just for one year. But it does mean the company will be rewarding the employees who have directly contributed to its success via higher pension contributions.
In my view, although their primary role is to ensure the pension scheme is properly run, DC trustees can play an important role in helping employers understand the outcomes that members are likely to achieve at retirement from the pension scheme, based on the current level of contribution rates. I also believe that, where it is appropriate to do so, trustees should seek to influence the contribution rate paid into the DC scheme by the company. After all, the easiest way to improve member outcomes is by putting more money into the pension scheme.
It’s not just when things are going well that DC trustees should keep an eye on the company’s covenant. They should also be concerned when things are going badly. This is because few, if any, companies set aside cash to wind up a DC pension scheme if the company goes bust. Wind up costs can be quite significant – and in the case of a DC scheme these costs are most commonly paid directly out of members’ pots when a company goes under. At a time when employees are likely to have lost their jobs, they could also lose money from their pension pots to fund the cost of winding up the DC scheme. There’s no Pension Protection Fund for DC members.
Unfortunately, there are a limited number of options for trustees in this second scenario. While the company is still solvent, they could perhaps request that an escrow account is set up to cover the costs of wind up - but with the company already in financial difficulties, this is unlikely to gain agreement. Or they could build up reserves to pay 2 years of invoices - with 2 years being TPR’s expected windup period. If it’s mandatory for the protection of master trust members, surely members of single trust schemes deserve the same protections? Windup costs are largely fixed and not dependent on member numbers. For example, investment and legal advice is the same whether you have 100 or 1000 or 10,000 members. Trustees of smaller schemes and legacy schemes might consider noting this in their risk registers. And this brings us to another strategic option.
Trustees could actively propose the transfer of members into a master trust arrangement. Again, this would require a commitment of cash from the company to pay for the advice needed for the transfer but arguably this is one of the key scenarios where trustees should be using their powers to propose the transfer, rather than simply waiting for the worst to happen.
So covenant does matter in DC – whether things are going well or badly. Any review would not need the same depth of analysis that trustees of DB schemes require, but at least an annual review of how well the company is doing would be a useful thing to have on DC trustees’ agendas.