Pension scheme trustees must understand employers ability to support defined benefit (DB) funding to manage risk accordingly, the Pensions Regulator (TPR) has said.
In guidance published today, the regulator said trustees' risk-taking should be informed by the employer's ability to address a range of likely "future downside scenarios". For example, trustees should reconsider whether their funding and investment strategies are appropriate if there is any material change in the covenant - the employer's legal obligation and financial ability to support the scheme now and in the future.
The regulator said assessment of the covenant should be appropriate to the circumstances of the scheme and employer, such as complexity of the company's operations.
"Covenant assessments are useful to trustees not just when considering investment or valuation issues," said TPR in the document.
"They can be used in response to other scheme-related events such as transfer value calculations or scheme mergers, as well as employer-related events such as mergers and acquisitions, restructurings or share buy-backs."
According to the guidance, trustees should seek external advice if they lack the objectivity and expertise required to perform an appropriate assessment. Trustees should also work "openly and collaboratively" with employers. An adequate assessment, with "good information sharing", is also in the employer's best interests so the scheme does not pose an unnecessary risk to its future sustainability, TPR said.
It added assessments should look to the future and focus on the ability of the employer to contribute cash to the scheme over an appropriate period.
Since a covenant can change quickly, TPR also said trustees should monitor it regularly between valuations and have contingency plans to take "decisive action" if required.
Lesley Titcomb, chief executive at TPR, said: "Our code highlights how trustees need a strong understanding of a scheme's covenant in order to take an integrated approach to risk management, and use the full flexibility of the funding regime.
"I urge trustees to use this important guide to assess and monitor their employer covenant in a way that is proportionate to the circumstances of the scheme and the need for an employer to grow. We encourage trustees and employers to work openly and collaboratively together."
The National Association of Pension Funds (NAPF) described the advice as a "gear change", calling the document thoughtful, extensive and pragmatic.
"The new guidance will make the whole process of covenant review significantly less arduous for trustees, and will hopefully also help them to save money on advice," said Helen Forrest, policy lead for defined benefit at NAPF.
Barry Mack head of governance at Hymans Robertson welcomed the guidance, adding: "While the guidance highlights that a long-term outlook is important, it doesn't offer much practical advice on how to quantify long-term covenant risk so that it can be integrated with analysis of other pension risks."
This guidance is the first in a series to help trustees apply the regulator's DB funding code of practice. Later this year, TPR intends to produce further support to help trustees, including guides on integrated risk management and investment strategy.