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Article:

Assessing the employer covenant of HEI pension schemes

31 January 2019

Factors to consider when assessing the employer covenant of HEI pension schemes

Increased competition, risks arising from Brexit, the Auger review and a very public drive for value for money for students and the taxpayer are current factors presenting threats and uncertainty for the UK Higher Education Institution (HEI) sector. The perfect storm is brewing, with challenges to recruitment and research income combined with competitive pressure (UK and international) to improve facilities.  Overall, this presents HEIs with a conundrum of increasing investment in the face of potentially reduced income (and reduced margins / surpluses as the cost base increases with inflation).

Employer covenant is a measure of the ability of a scheme’s sponsors to meet their obligations to the scheme. It involves an assessment of the financial position and trading forecasts of the sponsors. Striking a balance between investment and expected future income streams, as well as having contingencies and the flexibility to adapt to financial risks are key considerations in assessing employer covenant. In light of the challenges for the sector, independent, professional employer covenant advice has become increasingly important for the Scheme Trustees of HEI defined benefit arrangements.

While due consideration of sector risks is important in assessing employer covenant, there must also be recognition of favourable characteristics such as typically strong balance sheets underpinned by property based assets and an enduring demand for the services provided by HEIs. Recent examples of public bond issues and sizeable private placements have seen a number of HEIs secure long-dated, low-interest debt with strong, investment grade credit ratings, demonstrating the low risk of default perceived by capital markets. Despite the challenges facing the sector, there is evidence of HEIs successfully rolling out significant campus enhancements and achieving growth in student numbers. Each HEI is different and covenants are very ‘personal’.

The UK’s decision to leave the EU will have significant short-term - and quite likely long-term -  consequences for the UK HEI sector, as it has cast doubts over access to EU research funding. Demand from EU (non-UK) students for places at UK HEIs is a mid-term issue already beginning to emerge.   Without a clear message on access to Student Loans Company (SLC) funding, the ability of UK HEIs to recruit and retain the highest calibre teams from across the EU is increasingly difficult. The Auger review may also put further pressure on fees.

Capital expenditure, borrowing and liquidity

Over the last ten years, there has been a seismic shift with limited Higher Education Funding Council for England (HEFCE) capital funding, and now capital expenditure is mainly from reserves. This has increasingly been supplemented by external debt where reserves are insufficient or the nature of the capital expenditure project is more extensive (and taking advantage of the current low interest rates).

The “Financial health of the higher education sector”, published by HEFCE using 2016/17 to 2019/20 forecasts, showed that the levels of capital expenditure projected over this period total £19.4bn. This represents an average annual investment of £4.8bn, which is 48% higher than the previous 4-year average. Sector surpluses are projected at between 1.3% and 3.4% over the forecast period, relatively small margins with which to operate, although at an institutional level these vary significantly.

Cost of pensions funding

The cost of funding defined benefit arrangements is also expected to increase for UK HEIs. The 31 March 2017 preliminary valuation of the Universities Superannuation Scheme (USS) revealed a deficit of around £5bn and the trustees have concluded that the current combined contributions of 26% (employer 18% and employee 8% of pensionable salary) would need to be altered to achieve a combined contribution in the region of 37.4%. Under the scheme rules, any increase required by the Trustees are split 35:65 between the members and employers respectively. This would include an increase in deficit recovery contributions from around 2% to 6%.

While the USS grabs the headlines on account of its sheer scale, a number of pre-’92 HEIs often have an in-house defined benefit offering for non-teaching staff as well as obligations to other public sector defined benefit arrangements such as the NHS Scheme and, for most modern HEIs, a whole host of schemes from USS and TPS to Local Government Pension Schemes, all of which can be significant.

Conclusions

Increasing competition and changes in demand in the sector are driving significant levels of capital expenditure, increasingly being funded by debt. The sector is forecasting increased borrowing, reduced liquidity and relatively thin surpluses over the next few years, while at the same time facing significant uncertainties around student recruitment, access to research funding and higher pension funding costs – and a potentially fundamental change in the funding model.

A key consideration when considering the employer covenant available to the defined benefit pension arrangements of HEIs will be around the contingencies and flexibilities which they have to manage the financial risks of any unfavourable variances to their forecast levels of income or growth ambitions. For example:

  • Do they have clearly defined contingency plans for cost cutting where income targets are not achieved?
  • What are the underlying assumptions in their base case forecasts, and how do these compare to sector projections and research?
  • Has sensitivity analysis been conducted under downside scenarios and, if so, what is the impact?
  • Do they have the flexibility to defer or reduce capital expenditure projects where circumstances dictate?

Despite the challenges, there are also favourable employer covenant characteristics for the sector and there are examples of HEIs successfully completing significant programmes of capital investment and achieving growth in student numbers. The conclusions above are drawn at a sector level and there will, of course, be significant variation at an institutional level. The assessment of employer covenant would need to be tailored to the specific circumstances of the HEI under review.