SPP: Covenant assessment under the new funding regime

Nearly eighteen months after the introduction of the new DB Funding Code, advisers and scheme employers are now operating within a more structured and evidence‑driven framework.

One of the most notable changes has been the move away from the covenant grading system towards a risk‑based approach that requires trustees to evaluate features of sponsor support, such as free cash flow, maximum affordable contributions, covenant reliability, and covenant longevity periods.

This reflects the code's core principle; scheme risk should be supportable by the employer's cash flows and contingent assets, and this must be assessed using a more detailed, methodical and evidence-based approach.

For employers, this shift has led to greater scrutiny of financial resilience, long‑term business prospects and the durability of covenant support. Trustees must now report their conclusions on covenant supportability and adequacy to The Pensions Regulator (TPR) through their statement of strategy, reinforcing the need for employers to provide structured, forward‑looking information.

The key changes under the new regime include the following:

• The new regime has raised the bar for covenant transparency: The Funding and Investment Strategy Regulations 2024 have embedded a more prescriptive covenant framework, requiring thorough assessment of forward‑looking cash flows, prospects, affordability and resilience under downside scenarios. Trustees increasingly require granular projections, operational insights and explanations of key sponsor risks to support their view of the covenant reliability period.
• Trustees increasingly expect evidence‑based discussions: Under the new code, trustees must assess how long the employer covenant can be relied upon, supporting journey planning to the scheme's long‑term objective and low‑dependency position. This means employers must articulate data‑driven links between business forecasts, capital allocation decisions and pension affordability.
• Cash flow, capital allocation and distributions are under sharper scrutiny: The requirement to repair deficits "as soon as the employer can reasonably afford" puts a spotlight on leakage through dividends, intra‑group transfers and discretionary investment activity. Trustees and their advisers, are scrutinising business plans, financing arrangements and group dependencies more closely as part of assessing covenant reliability and longevity periods.
• Early, structured engagement is proving transformational: Employers who proactively prepare covenant information well ahead of valuation cycles (often following explanatory calls with trustees' covenant advisers) are finding the process significantly more efficient. This is valuable where the business model involves cyclicality, significant investment plans or refinancing milestones that trustees must understand to assess future supportability.

Top tips for scheme employers

Here are five practical actions, based on experience to date, that employers can take to support trustee assessments of covenant reliability and covenant longevity:

1. Provide a forward‑looking financial narrative: Trustees need forward-looking information (preferably three-to-five-year forecasts), including assumptions, investment plans and downside sensitivities, to assess sponsor prospects, to consider ongoing supportability and affordability.
2. Integrate pension considerations into capital governance: Document how pension commitments are factored into internal budgeting, investment decisions, debt strategy and dividend policy. This is central to trustees' evaluation of affordability and covenant leakage.
3. Prepare structured covenant information packs: Include group structure charts, refinancing schedules, intra-group relationships and dependencies, and operational risk assessments. These, together with sector specific insights, give trustees the information needed to assess covenant resilience and longevity.
4. Engage early on corporate events with potential ‘journey plan' implications: Discuss any anticipated corporate events (investment programmes, asset disposals, funding injections or refinancing events) that have the potential to impact the employer covenant and journey plan early in the cycle. This avoids trustees making unduly cautious assumptions.
5. Consider the strategic use of contingent assets: Enforceable guarantees, security packages or escrow arrangements can strengthen trustee confidence in the covenant reliability period and enable greater investment flexibility.

The shift from historic covenant grading to a more nuanced, risk‑based covenant framework has fundamentally reshaped trustee expectations. Eighteen months on, the message is clear; trustees expect structured evidence, forward‑looking insight and transparent engagement. Scheme employers that invest in high‑quality covenant materials and proactive communication are finding the new regime more manageable, and are helping secure better long‑term outcomes for their schemes.

For further insights the SPP's recent publication – Covenant Facts, Fiction, and First Principles – may prove of interest.

Guy Jackson is a member of the Society of Pension Professionals' covenant committee and partner at RSM Pensions Covenant Advisory