The IMF has issued a new warning that high inflation and the conflict in Ukraine could push the world economy to the brink of recession. Trustees should consider how the employer covenant could be impacted by current economic and political conditions, and in particular the risks of: 

• high inflation; 
• increases in interest rates; 
• the Russia – Ukraine conflict; 
• the impact of COVID-19 on sponsoring employers; and
• Brexit. 

The Pensions Regulator’s latest Annual Funding Statement has warned trustees of the need to consider the impact of global events on their pension schemes and the employer covenant. 

What is the employer covenant?

The employer covenant is the sponsoring employer’s legal obligation and financial ability to support a pension scheme, now and in the future. It is important to regularly assess the employer covenant to assess the extent to which the trustees should manage fund risks, given the covenant effectively underwrites these.

Trustees should be prepared to act quickly in considering how changing economic and political conditions may affect the employer covenant. 

How can current economic and political events impact the employer covenant?

Clearly economic trends, such as high inflation, may substantially impact scheme investments. However,  Trustees should also think about how current events might affect the scheme’s sponsoring employer and therefore its ability to fund the scheme: 

• high rates of inflation may increase costs for a sponsoring employer; 
• the shortfall in oil and gas driving higher global energy and fuel prices could significantly impact the profits of some employers who use large amounts of energy; 
• employers may be disrupted by the impact of COVID-19 where supply chains are still affected by ongoing lockdowns (such as in China) and due to experiencing the withdrawal of COVID-19 related government support; 
• interest rate rises could result in increased borrowing costs for employers; and
• the ongoing events in Ukraine and the associated sanctions could have an impact on the employer covenant. 

Whilst trustees cannot eliminate all of the risks to their pension scheme, it is crucial that trustees understand and actively manage these risks and  re-assess the employer covenant as soon as they are aware that there are any new risk factors or changes. 

Trustees should keep an open dialogue with the sponsoring employer in order to best understand how the business and employer covenant are impacted by any challenges and any actions that management are taking to mitigate such impact. To assist with this it is often helpful to enter into a formal information sharing framework so that both parties are clear what information will be shared and when. The new notifiable events regime, once in place, will provide a statutory footing for information sharing in certain circumstances and therefore engaging with information sharing will be to the benefit of both employers and trustees. 

Monitoring the covenant

Trustees should continue to monitor the employer covenant and consider the overall impact that current market events are having on the sponsoring employer’s business. The Pensions Regulator has recommended that Trustees categorise risks in one of three ways: 

1. Current market events that have had limited impact on the business – where there has been no balance sheet weakening and cash flow has remained strong; 
2. Current market events which have had a material impact, but trading has recovered or is recovering strongly, or some impact is anticipated but expected to be short-lived – this would be where any weakening of the balance sheet can be repaired over a short period and the medium term prospects have not been negatively impacted; and
3. The impact of current market events continues to be material – this is where the pace of recovery is uncertain and could take years, or the business may never fully recover. 

Trustees should consider obtaining specialist advice to help them understand and monitor their employer covenant, particularly if the covenant is complex or deteriorating or if it has been materially impacted by current market risks (such as where risks fall into the categories at 2 and 3 above). 

Given the current economic conditions facing pension schemes in the UK, a renewed focus on employer covenant will be important to ensure that Trustees understand the position of the scheme should the worst happen, and can take steps to mitigate such risks in advance.