The new world of employer covenant and defined benefit pensions: The Pensions Regulator’s new covenant guidance

The way employer covenant should be considered as part of funding, investment and journey planning for defined benefit (DB) pension schemes has changed with The Pensions Regulator (TPR)’s recent publication of its new employer covenant guidance. Sponsoring employers and trustees need to understand the implications of the guidance for their scheme.

In December 2024, TPR published updated covenant guidance, Assessing covenant: detailed guidance, for trustees of defined benefit (DB) pension schemes, aligned with its new DB funding code.

The new guidance provides the industry with greater certainty over how TPR expects scheme trustees to assess their employer covenant. It embeds good practice and encourages consistency across schemes.

This overview of the revised guidance will help scheme trustees and sponsoring employers understand the new key covenant concepts and some of the covenant challenges and opportunities.

Headlines for scheme trustees and sponsoring employers

Cash flow is king. Trustees need to assess the employer’s ‘reasonably certain’ cash generation. This assessment will then be the foundation for justifying the scheme’s strategy for deficit repair, agreeing recovery plans and the appropriate level of supportable scheme investment and funding risk. The prescriptive approach in the revised guidance sets a higher expectation of how this is assessed and documented. Where there’s volatility or uncertainty in the forecasts or a lack of forecasts to rely upon, TPR expects an increased focus on eliminating deficits, reducing risk, and obtaining contingent asset support.

Covenant ratings are out, covenant reliability and longevity are in. These two metrics will underpin journey planning and supportable risk negotiations. These judgemental assessments will create a limitation for the scheme’s strategy. They’re likely to be a key area of employer/trustee debate, so justifying assumptions used will be critical.

TPR has been prescriptive on how the employer covenant is assessed. The specific terms and details in agreements between the sponsoring employer and the scheme trustees will change the recognition and impact on strategy of:

•    Contingent assets
•    Employer investment in growth
•    An employer’s ‘available liquid assets’

Equitability and fairness remain key concepts through evaluation of “reasonableness of alternative uses of cash”. This will include consideration of investments in sustainable growth, dividends, discretionary creditor payments and contributions to other DB schemes.

Stress testing and sensitising employer cash flows is necessary to assess supportable risk. This requires a robust commercial understanding of the business, contingent asset values and the risk profiles of both the employer and scheme. Employer input is critical to form a balanced view.

Contingent assets are TPR’s default mitigation for covenant or funding risk where cash is constrained. There will be a commercial balance to strike in negotiating proportionate, commercial arrangements under the revised guidance.

Covenant monitoring is expected at least annually – and not just a verbal update from management. TPR expects trustees to conduct regular reviews of the employer covenant and contingent asset values.

Key concepts you need to know

Reliability and longevity periods

These are new terms and regulatory concepts but not new principles for many schemes. Visibility of cash flow forecasts and subjective, informed judgements will underpin the determination of these periods. They’ll then need to be reported to TPR. The assessment of employer prospects will be a key driver, with relevant factors different for individual schemes, but likely including consideration of some or all of:

1.    Market outlook
2.    Employer’s market position
3.    Resilience of the employer
4.    Diversity of operations
5.    Future development of the employer’s business, including environmental, social and governance considerations
6.    Risk of employer insolvency

Supportability principle

The level of funding and notional investment risk should be set in line with the level of available covenant support and the maturity of the scheme.

Available cash

Available cash is all cash and liquid assets available at the time of agreeing the recovery plan. This is used to determine Deficit Repair Contributions (DRCs) and fairness through consideration of reasonable alternative uses of cash.

Reasonable affordability

TPR prescribes the following approach to determining reasonable affordability of deficit repair contributions.

•    Consideration 1 – the employer’s available cash flow
Cash flow and liquid assets.

•    Consideration 2 – reliability of the employer’s cash flow
Trading and working capital cycles, certainty of cash flow, stress testing and sensitivities.

•    Consideration 3 – reasonable alternative uses
Investment in sustainable growth, covenant leakage, and discretionary payments to other creditors.

Where a third party has provided a ‘look-through’ guarantee, trustees should additionally assess reasonably affordability of DRCs from the guarantor. ‘Look-through’ is a new concept and technical term under the guidance, and TPR has detailed several conditions which need to be met for the guarantee to qualify.

Maximum affordable contributions

The employer’s cash flows that could and would be available to the scheme if there was a scheme stress event.

Recovery plan

A technical provisions deficit must be repaired as soon as the employer can reasonably afford. In determining DRCs under a recovery plan, the trustees must consider an employer’s sustainable growth investment and may consider:

•    Post valuation experience
•    Reasonable affordability
•    Investment outperformance

Supportable risk

Supportable risk should be considered separately for both during, and after the reliability period of the employer covenant. During the reliability period, the key determinants of supportable risk are the maximum affordable contributions over the reliability period, and contingent asset support which would be accessible. After the reliability period, there is increased uncertainty over cash flows, so becomes a more qualitative assessment. The revised guidance states that risk after this point would need additional support, with a focus on contingent assets. This again highlights the importance of the assessment of the covenant reliability period.

The new guidance has implications for triennial valuations and corporate transactions moving forward. DB scheme stakeholders should familiarise themselves with the new regulatory requirements and seek specialist covenant advice where further clarification or support where necessary. 

About the author: Matt Cooper CA is Head of Employer Covenant Solutions at ISIO