Pension schemes: Understanding of covenant still critical

It's widely recognised that the shift in market conditions precipitated in large part by the UK Government’s September 2022 ‘mini-Budget’ resulted in a significant improvement to the aggregate funding level of many UK pension schemes, with potentially more than half now estimating a surplus on a solvency basis.

This improvement in scheme funding has altered the focus for covenant advice. Where previously trustee concerns have centered around the short-term affordability of contributions required to address current funding deficits, attention is now being turned – quite rightly – towards the long term support required to ensure the respective options and timeframes to secure members’ benefits can be delivered.

This is particularly true for well-funded schemes – those close to their long-term funding targets with largely de-risked investment strategies – where the focus of covenant advice is now firmly on sponsor longevity over the remainder of the scheme’s journey. Meanwhile, the traditional ‘covenant rating’ has become less valuable as a tool to inform scheme funding and investment strategy, with many schemes having already adopted a de-risked approach under which the covenant rating is largely irrelevant when establishing the required target discount rate.  

TPR still expects an understanding of covenant

While the changing nature of covenant assessment is reflected throughout TPR’s new Funding Code, it's clear that an appreciation of the underlying covenant components (being the reliability and longevity of the employer’s business and the maximum level of contribution affordability) remains a fundamental element of the funding regime for all schemes, even those meeting ‘fast track’ criteria or already at low-dependency funding. This is reinforced in TPR’s recent consultation/guidance on the SoS, which sets out a clear requirement for trustees of all but the smallest and/or lowest risk schemes to provide information on the employer covenant as part of their valuation submission, under both the ‘bespoke’ and ‘fast track’ approaches.

It's equally clear that TPR is looking for a proportionate and risk-based approach to be applied, where the level of information and analysis expected reduces as schemes become less reliant on their sponsor to pay contributions or underwrite a return seeking investment strategy.     

What might a ‘more proportionate’ assessment look like?

It's evident from the Funding Code and the SoS that trustees of all schemes will need to consider covenant to some degree, with those of all but the smallest and most well-funded schemes also required  – as a minimum, assuming ‘fast track’ compliance – to document and evidence to TPR their assessment of: 

• The sponsor’s expected corporate longevity
• the period over which the scheme may need to rely on support from the sponsor’s covenant (the reliability period)
• the maximum level of funding that the sponsor could potentially provide over the reliability period if needed
• details of any contingent asset support provided to the scheme, including an estimate of the value of this support to the scheme

While the Funding Code helpfully gives some guidance over typical periods expected for longevity (10 years) and reliability (three-six years), even a proportionate assessment will require at least some diligence to ensure that these typical time periods are appropriate and relevant for the specific sponsor. By way of example, it's unlikely that a funding strategy based on an assumed three to six year reliability period would be appropriate where a sponsor is facing financial stress and at risk of breaching banking covenants, or relies upon a major contract that is about to expire, with limited expectation of renewal.

Similarly, while it's clear that detailed cash-flow information and an assessment of alternative uses of cash won't be required for all schemes, some analysis of future financial performance will still be required to form a view on the maximum level of funding that an employer could have available to support a scheme’s future funding requirements. Likewise, the underlying nature, structure, and value of any contingent assets will also require some consideration.  

In conclusion, while the trustees of schemes that are less reliant upon the employer covenant will – quite reasonably – be able to adopt a more proportionate approach to covenant assessment, they'll still need to consider and evidence a range of covenant factors, including a forward looking analysis of financial performance and risks.

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How we can help

In recognition of the evolving needs of trustees and the growing emphasis on advice that's proportionate to risk, we have developed a tiered range of covenant assessment services, comprising: 

• A high-level covenant summary, designed for lower complexity situations, including fast-track
• a concise covenant report, our core offering suitable for most pension schemes
• a detailed bespoke covenant assessment, suitable for the largest and most complicated situations 

In all cases, we pride ourselves on delivering solutions designed around our client’s needs, led by experienced covenant professionals and incorporating relevant insights from experts around our firm.      

For more insight and guidance, get in touch with Luke Hartley.