The LGPS 2022 triennial valuation: employer covenant considerations for both funds and employer

The 2022 triennial valuation is one of the most significant events in the LGPS calendar.

As LGPS funds and employers prepare for the release of the initial set of contribution rates from the fund actuary, an increasingly important consideration in the valuation process will be the assessment of the employer covenant.

The Pensions Regulator defines employer covenant as “the extent of the employer’s legal obligation and financial ability to support the scheme now and in the future”.

Scheme support is often interpreted by covenant practitioners as an employer’s ability to pay cash to support their obligations to the fund. The main focus is typically on the ongoing basis (to cover the cost of future accrual and any ongoing deficit) but the cessation basis (to cover any deficit that might arise following an employer’s exit) is also important.

In the LGPS, consideration of employer covenant has been of increasing importance in recent years as both funds and employers recognise the challenge of managing pension liabilities over the long term. This is especially important for Tier 3 employers who do not possess tax/levy raising powers, or a government guarantee.

We have explored potential covenant issues that can affect fund/employer valuation discussions below.

Changing market conditions

Since the 2019 valuation was completed, there have been significant changes to the global economic landscape. After an initial shock to markets following the onset of the coronavirus pandemic, unprecedented fiscal and monetary support from central authorities contributed to a surge in asset values, which will have improved the funding position of many LGPS employers.

However, the reopening of the UK economy following the numerous national lockdowns led to a surge in consumer demand, causing inflation to rise, which has been exacerbated by the reduced availability and increased price of goods due to constraints in supply chains. This situation has been further compounded by the Russia/Ukraine crisis and the resulting disruption that has been caused to the energy and commodity markets.

The net effect of all of this is that most LGPS funds are expected to have improved funding positions and employers will likely be presented with reduced secondary contributions. However, largely due to inflation expectations and anticipated lower investment returns, employers may also see increased primary contributions at the 2022 valuation.

We also expect cessation deficits to have increased since the 2019 valuation, although this may depend on the specific funding arrangements applicable to individual employers.

Affordability and stability of contributions

Regulation 62.6 of the 2013 LGPS Regulations states that the fund actuary must have regard to certain principles when preparing the valuation. One such principle (Regulation 62.6(b)) is “the desirability of maintaining as nearly constant a primary rate as possible”. However, this must also be balanced with Regulation 62.6(d), which is “the requirement to secure the solvency of the pension fund and the long-term cost-efficiency of the Scheme, so far as relating to the pension fund”.

The challenge of maintaining stable contributions with the solvency and long-term cost efficiency of the scheme is a complex one. Whilst it provides a check on contributions increasing significantly from one valuation to the next, the solvency objective can also take priority to the stability objective, particularly if there is uncertainty about an employer’s long-term ability to support the scheme.

When it comes to assessing contribution affordability at the valuation, both LGPS funds and employers should consider affordability within the broader context of an employer’s covenant.

Questions for funds to ask include:

1. How does the employer generate cash and how is this used by the employer?
2. What is the employer’s forecast cash flow, and is the proposed level of contributions affordable, whilst still maintaining some level of margin for potential downside scenarios?
3. What are the avenues for potential covenant leakage which may reduce the covenant in the future? 
4. How much debt funding does the employer have and what are the details of those arrangements (e.g., type, repayment, maturity, security, covenants, etc)?
5. Does the employer have any competing calls on its cash reserves (including the repayment of support measures that arose from the coronavirus pandemic)?
6. Can the employer offer the fund security to underwrite a longer-term funding target (which might lead to reduced contributions)?

Questions for employers to ask include:

1. What work has the fund carried out to understand our covenant?
2. What factors has the assessment been based on?
3. How do the proposed contribution rates fit into our cash flow forecasts and our wider strategic plans?
4. If the initial rate of contributions is unaffordable, then what level of contributions is affordable? What information can we provide to the fund in support of this?

It is important that both funds and employers engage proactively on matters concerning contribution affordability and the employer covenant so that any issues can be addressed at an early stage in the valuation process.

Post-valuation planning and monitoring

Once the 2022 valuation has been completed and employers have been issued with their new rates and adjustment certificates, LGPS funds should continue to monitor the covenant for signs of change during the inter-valuation period.

It is important that funds engage with employers if any covenant concerns are identified. Should a change of contributions be required, then LGPS funds can now enact this under the contribution flexibility powers that have been introduced to the 2013 LGPS Regulations.

We also anticipate that the provisions of the Task Force on Climate-related Financial Disclosures (‘‘TCFD’’) will be introduced to the LGPS. One aspect of TCFD that LGPS funds will need to consider is the employer covenant, specifically with regards to the effects of climate change and how this could translate to both physical and transition-related risks.

Our team has a wealth of experience in considering these issues from the perspective of LGPS funds and employers. We are experts in assessing the employer covenant, managing employer covenant risk, and can help with advising on contribution affordability both during and post, the 2022 valuation process.