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Introduction to assessing employer covenant

Overview of the role of the employer covenant and elements to consider when assessing it, including proportionality.

Published: December 2024

Overview

  • Assessing the covenant is about understanding the extent to which the employer and any suitable contingent assets can support the scheme, now and in the future, and the risks to this support being available when needed.
  • The covenant assessment should therefore focus on the support available from the employer in the context of the funding needs and investment risk of the scheme.
  • The assessment should focus on entities with a legal obligation to support the scheme. You should be cautious about any reliance on entities without such an obligation. No additional funding or investment risk is expected to be taken based on informal support.
  • Assessing and monitoring the covenant – including defining cash flow, reliability and longevity as outlined below – should be proportionate to the circumstances of the scheme and employer, how reliant the scheme is on the employer now and in the future, and the complexity of the employer’s operations.
  • The covenant assessment should consider the employer’s cash flow available to support the scheme, and in doing so understand management’s forecasting assumptions, and the interaction of the employer with the wider group. The focus should be on the ability of the employer to make cash contributions to the scheme to achieve and maintain full funding over an appropriate period, including addressing downside risks.
  • Assessing the employer’s prospects and insolvency risk will help you to understand the extent and duration of reliance that can be placed on the employer to support the scheme.
  • Using your assessment of employer cash flow and prospects, you should assess the reliability period, which reflects how long you have reasonable certainty of the employer’s cash flow to support the funding needs and investment risk of the scheme. You should also determine how long you expect the employer to continue to support the scheme (covenant longevity).
  • Once a scheme has reached full funding on a low dependency basis, you should focus your assessment on covenant longevity and any material risks to the scheme not providing promised benefits to members.
  • You will need to assess whether you can place reliance upon any contingent assets in place for the scheme, based on the scheme’s legal access to value as determined by the terms and conditions of the contingent asset, and the expected realisable value at the time it is likely to be called upon.
  • Where a scheme is in deficit on a technical provisions basis, a recovery plan should be put in place to recover this deficit as soon as the employer can reasonably afford. When determining reasonable affordability, you should consider the employer’s available cash (being employer cash flows and liquid assets) and the reasonableness of other alternative uses of cash, taking into account the employer’s reliability period.
  • If the employer’s plan to invest in sustainable growth restricts the funding available to the scheme, you should understand how and when the scheme will benefit from supporting this investment and whether other stakeholders are contributing appropriately.
  • Investment and funding risk should be based on the scheme’s access to employer cash flows after adjusting for certain factors (referred to as maximum affordable contributions), and contingent asset support over the reliability period to recover both the existing deficit (if any) and any further deficit that could arise in a downside scenario.
  • You should monitor the covenant regularly between valuations and have well-developed contingency plans so you can take decisive action if needed.
  • Stress testing employer forecasts can help you understand how covenant support could change and how affordability may be affected under each scenario.
  • You should consider obtaining independent external advice if the trustee board lacks the objectivity or expertise required to perform an appropriate assessment, or where the covenant is particularly complex or there are limitations in the provision of information.
  • You should work openly and collaboratively with the employer. A proportionate covenant assessment, aided by good information sharing, is in the employer’s best interests so the scheme does not pose an unnecessary risk to its future sustainability.

The role of the employer covenant

The employer covenant is the extent to which an employer has a legal obligation and financial ability to support a scheme now and in the future, as well as any expected scheme support from suitable contingent assets.

At a minimum, you should undertake an assessment of the employer covenant at each valuation. This should focus on the employer’s ability to make cash contributions to the scheme, and the scheme’s access to contingent asset support, to eliminate any existing funding deficit and to address any further deficit that could arise from a scheme-related stress event.

The outcome of this assessment will help you set an appropriate recovery plan if one is needed. It will also help you determine the level of funding and investment risk that can be supported by the employer covenant when setting the scheme’s journey plan to low dependency by the relevant date (as detailed in our defined benefit (DB) funding code).

You should ensure that the aggregated level of risk taken by the scheme is supported by the employer covenant.

As well as supporting you through your valuation process, covenant assessments are also used to respond to other scheme-related events such as scheme mergers or considering a transfer to a superfund, as well as employer-related events such as mergers and acquisitions, restructuring or periods of corporate distress. Considering how the employer covenant changes before and after these events will be a factor in determining if mitigation is required.

Areas to consider when assessing the employer covenant

As outlined in our DB funding code, an assessment of the employer covenant must consider two parts.

  1. The financial ability of the employer to support the scheme in relation to its legal obligations.

    This includes the following:
    1. Identifying employers and assessing the nature and extent of their legal obligations to the scheme

      Read Identifying employers and assessing their legal obligations.

    2. Assessing the employer’s current and future cash flow based on forward-looking management information, where available. This assessment forms the starting point for:
      • setting an appropriate recovery plan where required, based on an employer’s cash flows and liquid assets (known as available cash) and applying the principles of reasonable affordability
      • setting an appropriate journey plan, based on the level of risk that is supported by the employer covenant, with reference to the cash flows of the employer and any suitable contingent asset support

      Read Assessing cash flow.

    3. Assessing an employer’s prospects to understand the extent and duration of reliance that can be placed on the employer to continue providing scheme support.

      Read Assessing an employer’s prospects.

    4. Assessing the reliability period and covenant longevity based on an assessment of (b) and (c) above. You must consider how long you can be reasonably certain over employer cash flows (the reliability period) and the employer’s ability to continue to support the scheme (covenant longevity). This will feed into your decisions around:
      • setting an appropriate recovery plan, with reference to the length of the recovery plan and the principles around reasonable alternative uses of cash
      • setting an appropriate journey plan, based on the level of risk that is supportable by the employer covenant during and after the reliability period
      • for open schemes, the actuarial assumptions used for future accrual and new entrants

      Read Assessing the reliability period and covenant longevity

  2. The expected scheme support from any contingent assets to the extent the trustees reasonably expect these to be legally enforceable and sufficient to provide the specified level of support when required.

If both conditions are met, contingent assets can be used to support decisions when setting the recovery plan and journey plan.

Drawing on the covenant analysis performed above, this guidance will help you:

While scheme- and employer-specific factors may vary, the key areas to consider in this guidance will be broadly consistent across most employers. You should use your judgement to assess how all the relevant factors taken together determine the overall support provided by the employer in the context of the scheme and risks faced.

Read what the DB funding code says in relation to areas to consider.

Not-for-profit covenant assessments

Paragraph 52 of the Employer covenant section of the DB funding code states:

"Not-for-profit organisations are organisations:

where some (or all) of their activities are of a non-commercial nature that rely on donations (or other discretionary income or subscriptions) to fund their activities by nature or where an organisation relies on donations or other discretion."

Not-for-profit organisations include (but are not limited to) charities, higher education institutions such as universities, museums, churches, unions, social housing associations and other entities reliant on government funding.

Where a not-for-profit organisation has material commercial operations, these operations should be assessed in line with the principles set out in this guidance. However, where a not-for-profit organisation is reliant on non-commercial operations, modifications and additional considerations may be required when assessing your employer covenant.

This guidance highlights these modifications and additional considerations in the relevant sections.

Proportionality

Paragraph 10 of the funding regime of the Employer covenant section of the code says:

"At a minimum, we expect trustees of all defined benefit (DB) schemes to assess covenant support at each valuation. However, the required depth, and frequency thereafter, of an assessment should be proportionate to the circumstances of the scheme and employer. The approach taken should be documented and trustees should be able to justify why it is reasonable and appropriate."

Factors affecting whether a detailed covenant assessment or more frequent reviews between valuations are needed include, but are not limited to, the following. The factors below are interrelated.

  • The size of the scheme, both in absolute terms and relative to the size and level of covenant support provided by the employer.

    For example, a light touch covenant assessment may be more proportionate where the employer is very large relative to the size of the scheme, and where the employer has ample cash flow to meet the funding needs of the scheme (now and in the future) even after factoring in alternative uses of cash.

  • The funding level of the scheme.

    For example, a light touch covenant assessment may be more proportionate where the scheme is already well funded on a low dependency funding basis, solvency basis or both. In this scenario, the assessment should focus more on employer prospects to identify any material risks that could prevent the scheme from providing promised benefits to members, rather than carrying out detailed analysis on the employer’s cash flow generation. The period over which to consider these risks should be consistent with the scheme’s long-term strategy (for example running on or buying out).

  • The level of funding and investment risk within the scheme journey plan.

    For example, a light touch covenant assessment may be more proportionate where the scheme’s journey plan relies on only a small amount of risk being taken before the relevant date. This approach will also require the scheme to be either well-funded or the employer to have sufficient cash flows to make good any existing deficit over a reasonable period.

  • The maturity and expected cash flows of the scheme.

    Maturity should not be considered in isolation, but in the context of the scheme’s funding level and level of risk-taking. The more mature the scheme, the less time an underfunded scheme has to get cash in from the employer and achieve sufficient investment return to ensure that the scheme can pay member benefits when they fall due. A more detailed covenant assessment is usually likely to be required where a scheme is reaching significant maturity and is underfunded, or running moderate to high levels of risk in its journey plan.

Once an approach has been decided, you should document this and be able to demonstrate why it is reasonable and appropriate.  

Providing information

Paragraph 13 of the funding regime of the Employer covenant section of the code says:

"We expect employers (and, where relevant, third parties that have provided contingent assets) to provide trustees with the information required to assess the covenant. If appropriate information is not provided, trustees are unlikely to be able to demonstrate how the covenant can support the risks the scheme is taking. Consequently, where appropriate, trustees should reduce their reliance on covenant when setting investment and funding strategies in their funding and investment strategy."

It is important that you work with the scheme employer in an open and transparent way to strike the right balance between the needs of the scheme and those of the employer.

You should engage with the employer at an early stage in the covenant assessment process, and the employer should provide you with the information reasonably required to allow you or your professional advisers to perform your respective duties. This may include providing management accounts, business plans and forecasts, and banking and treasury arrangements. You and the scheme employer should overcome confidentiality or disclosure issues (including in relation to unpublished price-sensitive information), for example through confidentiality agreements or the use of sub-committees (these are particularly relevant for non-segregated non-associated multi-employer (NAME) schemes, see more below).  Information provided by management can provide valuable insights and you should assess it critically and not simply accept statements at face value.

Where management information is not provided, you may rely on publicly available information (eg market analyst forecasts), where appropriate. However, where this information is lacking in detail, or is not sufficiently robust to enable you to demonstrate how the covenant can support the risks the scheme is taking, you should take steps to reduce the reliance on the covenant when setting the funding and investment strategy.

You should consider agreeing an information sharing protocol (ISP) which places a contractual obligation on the employer to provide information and will survive a change of control of the employer or key personnel [Link to ISP section of monitoring]. 

In relation to NAME schemes, you should be mindful that the employers may be competitors, and may have reservations about providing you with sensitive commercial information. However, you should mitigate the concerns through measures to ensure that you are still provided with the information required to be able to complete your covenant assessment. These measures include: 

  • using confidentiality agreements
  • delegating to a covenant sub-committee whose membership is tailored to restrict the view of sensitive information by an industry rival 
  • redacting covenant assessments to remove sensitive information before they are provided to certain members of the trustee board  

When to commission a professional covenant assessment

Deciding when to commission a professional covenant assessment, in full or in part, will depend on a range of specific scheme and employer risk factors. One of these factors in isolation may not necessarily require professional advice. The decision should include considering the overall impact of these risk factors taken together and weighted appropriately based on the scheme’s circumstances. 

Relevant factors include the following.

  • You do not have the necessary expertise and experience to assess or challenge fellow trustees or the employer on the legal, financial and prospects aspects of the covenant.
  • The trustee board is not fully able to take an objective view, for instance if an influential trustee holds an important role in the employer such as finance director.
  • The scheme is highly reliant on the covenant, for example the scheme is large relative to the employer, is under-funded or has a higher risk investment strategy.
  • The covenant is complex, for example there is a complex legal or operating group structure, or an asset-backed contribution structure is being used.
  • The covenant is undergoing significant changes, for example the employer is restructuring or is in financial distress.
  • The employer and trustees do not have a good relationship, or the employer has been unwilling to provide requested information on a timely basis.

You should periodically reassess whether to commission professional covenant advice, as changing circumstances for the scheme or the employer may lead to situations where it can add greater value. 

If you decide not to obtain professional advice and to perform your own assessment, or obtain targeted professional advice to supplement your assessment, you should be comfortable that you can adequately perform all the relevant steps set out in this guidance, and fully document and be prepared to explain your analysis and conclusions.

Covenant reporting requirements

Certain schemes (depending on their size and/or funding level) will be required under the statement of strategy to provide information on the key components of covenant support (eg cash flows, including alternative uses of cash where applicable and maximum affordable contributions, and contingent assets) and the relevant covenant periods (ie reliability and covenant longevity) to demonstrate that the scheme’s level of funding and investment risk is supported by the employer covenant.

Information on how to assess these can be found in this guidance, along with our supporting guidance provided as part of the statement of strategy.

We may revise the covenant guidance when needed and include industry feedback. Send comments or queries about the new guidance to covenantguidance@tpr.gov.uk.