On 4 December 2024, The Pensions Regulator (TPR) published revised DB covenant guidance which it refers to as being the ‘last piece of the jigsaw’ for the new funding and investment regime. It expands on the covenant references in TPR’s new DB funding code (the Funding Code).
Schemes now have clarity as to TPR’s expectations on covenant assessment. The assessment now includes new components on cash flow, reasonable affordability, maximum affordable contributions, the reliability period, covenant longevity and contingent assets. Covenant is a core element of the revised regime and is key to the analysis of supportable risk in the journey plan and the appropriateness of the recovery plan.
In keeping with the Funding Code there is an emphasis on the assessment being proportionate and reflective of the employer’s support and the scheme’s circumstances. In summary, a more detailed assessment will be needed in cases of higher risk or low funding levels and a less detailed one when the scheme is well funded, has low risk or is small in comparison to covenant support levels.
Worked examples are provided throughout the guidance on those aspects that require ‘the highest level of judgement’ from trustees. It also covers not-for-profit and multi-employer scheme considerations.
TPR has not consulted on the guidance but notes that it will amend the guidance when required and will include industry feedback which can be provided through covenantguidance@tpr.gov.uk.
The background – legal definition of employer covenant strength
The funding and investment regulations include, for the first time, a legal definition of employer covenant strength being:
- the employer’s financial ability as regards its legal obligations to support the scheme; and
- the support that can be reasonably expected from legally enforceable contingent assets.
They provide the legal setting for this financial ability framework including the ‘new’ covenant reliability and longevity parameters of the covenant assessment.
Financial ability = cash flow, prospects, covenant reliability and covenant longevity
When assessing financial ability, the trustees must take into account:
- cash flow;
- other matters which may impact the future ability of the employer to support the scheme – business performance, development, resilience and insolvency likelihood (prospects);
- how long the trustees can be reasonably certain of:
- reliance on the covenant assessment (the reliability period); and
- that the employer will continue to provide support (covenant longevity).
TPR’s updated guidance provides the necessary detail that trustees will need to determine the strength of the employer’s covenant in accordance with the legal definition.
When should an assessment be carried out?
A covenant assessment should be carried out at least in conjunction with each valuation. Covenant assessments should also be undertaken when other events occur, for example, scheme mergers and employer-related ones such as a corporate transaction or during sponsor distress. The extent to which an assessment should be carried out between each valuation and whether a detailed covenant assessment is needed will depend on scheme and employer circumstances. Trustees should be able to justify and document their approach.
Does professional advice need to be obtained?
The guidance does not go so far as to say that trustees must obtain professional advice when undertaking an assessment. Trustees must consider relevant risk factors when deciding if to do so, for example, whether they have the requisite experience and expertise or there are issues with objectivity or the employer relationship. Professional advice may also be required where there is high reliance on the covenant, or the covenant is complex or subject to material adjustments.
Trustees should satisfy themselves that they can comply with the guidance if they are not going to obtain professional advice, document the assessment and be able to justify the results. It is likely that most trustees will feel the need to obtain professional advice.
What are the TPR covenant reporting requirements?
Certain schemes (based on size and/ or funding) will have to provide information to TPR on covenant in the statement of strategy.
Identifying employers with a legal obligation to support the scheme and the extent and nature of that obligation
TPR has long emphasised the importance of trustees identifying those employers with a legal obligation to support the scheme and determining the extent and nature of those obligations. Whether an employer has a legal obligation will depend on if it is a statutory employer or has other legal obligations to the scheme.
TPR notes that a careful approach must be taken to relying on those organisations which do not have a legal obligation to support the scheme – additional funding and investment risk should not be adopted based on informal backing.
Reference is made to the importance of trustees understanding the balance of powers in the scheme – for example, which parties have the power to amend, wind up and trigger a section 75 employer debt.
The structure of the scheme is also important, and there is guidance for those schemes with more than one employer.
Assessment element 1: assessing cash flow
The covenant assessment will need to consider current and future cash flow to determine:
- maximum affordable contributions which are used to assess the levels of funding and investment risk in the journey plan that can be supported by the employer; and
- where required, the level of deficit repair contributions (DRCs) that an employer can reasonably afford (recovery plans under the new regime must follow the overriding principle that the deficit should be recovered as soon as the employer can reasonably afford).
The cash flow assessment should concentrate on future forecast management information which will typically reasonably cover a one-to-three-year period. Historical data can be used to assist in determining whether the forward-looking information is accurate and reliable.
The employer’s cash flow is what remains as ‘free cash’ after reasonable operational and committed finance costs are taken into account but before DRCs, alternative uses of cash and contributions to other DB schemes.
Alternative uses of cash include investment in the sustainable growth of the employer, covenant leakage when cash is distributed with no ‘clear return of monetary value’, and discretionary payments to creditors when payment is not due.
Assessment element 2: employer prospects
Trustees need to assess an employer’s prospects to understand the degree to which the covenant can be relied upon and how it might weaken. It is a key part of assessing the reliability period and covenant longevity. The level of detail required and areas to focus upon will depend on funding needs and specifics.
Trustees will first need to ask the employer for relevant information and, with appropriate assistance, reach their own view after assessing employer-provided information for reasonableness and accuracy. They may also need to use other sources such as market outlook reports and data being mindful of the fact that third-party assessments can be expensive and whether these are required will need to be assessed.
Relevant factors to consider include market outlook and position, strategic importance of the employer in the group, operational diversity, ESG matters, financial and non-financial resilience to market shock or unanticipated events, and insolvency risk. The guidance draws out from the Funding Code the applicable elements for each factor and then sets out additional TPR commentary.
Assessment element 3: reliability period and covenant longevity
The cash flow and prospects assessment can be used to determine the employer’s reliability and covenant longevity:
- The reliability period: how long the trustees can with reasonable certainty rely on cash flow to fund the scheme – typically using a short to medium term of 3-6 years but, for some, the period will be shorter or longer. The trustees will need to consider the availability and reasonableness of cash flow forecasts, profit and loss account and balance sheet forecasts (if available), employer prospects and reasonably foreseeable events that might mean certainty over cash flows needs to be adjusted.
- Covenant longevity: how long with reasonable certainty it can be said that the employer will continue to support the scheme “along its journey plan to low dependency and beyond” – usually this will not go over 10 years.
It will cease when there is no reasonable certainty that the employer or its market will continue or there is uncertainty over the employer’s viability such that an insolvency or other deficit crystallisation event might occur. It will be determined through consideration of prospects of the employer and wider group in the event of interdependencies with key factors being the employer’s industry, its position and operational diversity.
These are new concepts but a lot of what stands behind them will already be covered in current assessments. The guidance outlines how the reliability period and covenant longevity should be assessed with case studies.
Assessment element 4: contingent assets
Contingent assets used for covenant purposes must reasonably be expected to be legally enforceable and “sufficient to provide the specified level of support when required” (the relevant criteria).
Understanding whether a contingent asset will provide a specific level of support requires the trustees to identify the circumstances when the contingent asset will be called upon (e.g. employer insolvency) and to use a suitable method to assess the asset’s realisable value which will depend on its type.
Contingent assets that meet the relevant criteria can be used to support additional risk-taking in the journey plan and a longer recovery plan provided certain conditions in the Funding Code are met.
The guidance contains separate detailed sections on how to value the three main types of contingent assets – securities, guarantees and contingent funding mechanisms. There is also a section on other arrangements that can be used to improve scheme security.
The guidance talks about guarantees in terms of whether it is set up on a look through basis, that is the guarantor effectively replicating the employer’s obligations – the trustees can treat such guarantors as a scheme employer and include the entity within the cash flow and prospects assessment.
- Reassessing the contingent asset value: Minimum – at each valuation, more frequently if needed e.g. if it accounts for significant part of scheme support.
- Monitoring: The scheme should have monitoring processes to identify any possible deterioration in the value of the asset between valuations or assessments.
Recovery plans and reasonable affordability
“In determining whether a recovery plan is appropriate, trustees must follow the overriding principle that steps must be taken to recover deficits as soon as the employer can reasonably afford. Trustees should assess future reasonable affordability at least on a year-by-year basis, with steps taken to reduce the deficit set in line with this assessment...” (the Reasonable Affordability Principle) [Source: The Funding Code]
The Reasonable Affordability Principle takes precedence over other matters that must be considered when setting a recovery plan for a scheme in technical provisions deficit and the recovery plan section should be read with this in mind.
The guidance considers the three assessments that the Funding Code notes should be considered when determining reasonable affordability:
- Assessment 1: the employer’s available cash (aggregate cash flow and liquid or readily recoverable balance sheet assets after taking account of working capital adjustments).
- Assessment 2: reliability of the employer’s cash flow by reference to the reliability period (cash flow and prospects).
- Assessment 3: alternative uses of cash (investment in sustainable growth, covenant leakage, discretionary payments to other creditors, other DB scheme contributions and others). The Funding Code sets out five Reasonable Affordability Principles that should be used when determining if alternative uses of cash are reasonable – the guidance expands upon these.
The Funding Code says that future reasonable affordability should be assessed on “at least a year-by-year basis”. Back-end loading recovery plans are only suitable if the Reasonable Affordability Principle is met and the employer cannot reasonably take earlier action to make up the deficit. Trustees must also be reasonably certain that higher DRCs in later years can be met.
Covenant inputs required to assess supportable risk (maximum affordable contributions and contingent assets)
The guidance sets out how to determine the appropriate covenant inputs required to decide if risk levels in the funding and investment strategy can be supported by the employer’s covenant. The evaluation of employer support available for assessing supportable risk looks at maximum affordable contributions. This differs from the employer support analysis used for the recovery plan as this considers available cash whilst maximum affordable contributions only look at available cash in the event of a scheme stress.
There are two covenant inputs for assessing supportable risk over the reliability period: (1) maximum affordable contributions available for any increased deficit caused by a scheme stress event; and (2) contingent assets that could be accessed following a scheme stress event over the reliability period if they meet the relevant criteria.
Maximum affordable contributions are the employer’s cash flows after reasonable adjustments for alternative uses of cash and deduction of DRCs payable to the scheme and other employer-sponsored DB schemes. DRCs paid from liquid assets should also be factored in but should only be included if they are to be used during the reliability period.
Assessing supportable risk after the reliability period involves looking at future employer support levels, risk taken during the reliability period, contingent asset support post-reliability period and how soon the relevant date is.
Monitoring
Monitoring the covenant throughout the existence of a scheme (so even after there is low dependency on the employer) remains an important part of an effective IRM framework. The guidance discusses the five key steps involved in the framework as well as the need for a ‘robust’ information-sharing protocol with management and adequate contingency plans.
The frequency and depth of monitoring should be proportionate to scheme and employer specifics, but TPR expects annual monitoring updates and notes that frequency and depth is probably going to change over time. As a minimum a “full review of the monitoring framework” should be carried out during the valuation process.
Next steps
Schemes now have the full suite of documents required to conduct their first valuation under the new framework and should prepare well in advance for completion given the lead-in time that will be needed.
The updated guidance has replaced TPR’s earlier covenant guidance and applies to all covenant assessments so will need to be used by trustees when carrying out future covenant analysis (for example, because of corporate activity or covenant deterioration) even if the effective date of the scheme’s first valuation under the new regime has not yet passed. As TPR notes, it should be used to determine if any current covenant assessment considers the correct matters and is proportionate.