By Richard Farr
With the deadline for the Pension Protection Fund (PPF) levy approaching on 31 March 2015 it made me think about its wider impact on businesses and in particular about the Employer Covenant and its implication for audit reports.
With a third of operating businesses with DB schemes now struggling, and changes to Financial Reporting Council (FRC) rules meaning that auditors need to declare if pension scheme liabilities might kill a company three to five years hence (rather than in the next 12 to18 months, as was previously the case), companies will need to take this issue much more seriously. It is now much more difficult to sign companies off as a going concern, which in turn is likely to prompt shakeups across the DB pensions landscape as employers are forced to act.
The Employer Covenant was established in 2005 and outlines the legal obligation and financial ability of an employer to honour their DB scheme. Changes within the pension industry as a whole, coupled with more rigorous regulatory requirements for company’s going concern statements mean, however, that the Employer Covenant has a new role to play. Its importance is moving outside of DB scheme management and into audit reporting more widely.
According to the latest Pension Regulator (tPR) figures, 33% of all UK DB schemes have employers who are struggling and whose going concern status is being questioned. In addition, the Pension Protection Fund (PPF) has introduced the new risk-based levy mentioned above using Experian’s credit rating model. Companies who have DB schemes will know by now what credit risk band they have been placed in, with One being the best and Ten the worst. Unlike the much maligned previous provider (Dun & Bradstreet), the new rating system takes into account the risk of the DB scheme itself causing the insolvency of the Employer, and therefore is much more likely to be taken seriously by directors and trustees. Additionally, the FRC’s new statement regarding going concern has meant that the forecast period under review now extends beyond the 12 to 18 months that existed historically. This new guidance was published following Lord Sharman’s 2012 recommendations but it has been met with what could be diplomatically termed, a mixed response.
The FRC’s statement may have caused consternation and, in fact some amusement, within company boardrooms, who could argue against the efficacy of forecasting beyond 12 to 18 months due to a lack of credible data. However, in the case of companies with a DB scheme, its presence means that the scheme’s own forecast, which is available and which extends over a number of years, will have to be looked at in detail. These scheme forecasts can be derived using Value at Risk (VaR) modelling, the statistical system which the tPR has recommended Trustees use in their negotiations over future funding.
The VaR analysis provides the probability of deficits occurring over discrete periods and, dependent on the level of prudency assumed (with weaker credit rated employers accorded more prudency, for example), the model can calculate a credible forecast of the scheme deficit a number of years in the future.
There is an important consequence of being able to predict these longer term trends. If the projected size of the deficit in three to five years would most likely kill the company, then there is a real going concern issue, not only for the company directors but also for the trustees. It is therefore now much more common place to have this VaR modelling analysis available and will become increasingly more so.
While the lip service sometimes paid to the commissioning of Employer Covenant Reports by trustees and their advisers is gradually diminishing in the wake of tPR pressure, there is a real question to be asked over whether boardrooms will have similar learning curves. Auditors increasingly request to see Employer Covenant analysis before they can sign off on directors’ going concern statements.
The concept of the Employer Covenant was created by my team when I was at tPR as an essential tool to help the trustees assess the strength of the employer. I never foresaw that, 10 years later on, this tool would have to evolve to justify going concern assumptions for audit reports and I sincerely hope that all the Employer Covenant providers are up for the challenge.
Richard Farr is head of pensions advisory at BDO.
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