In this next blog in our series looking at some of the legal issues arising from the draft DB funding code of practice and how it interacts with the draft regulations, we look at the proposals in relation to assessing employer covenant and whether independent advice will be required. TPR has stated that it will be consulting on updated covenant guidance later this year but the documents published to date give us a strong indication as to the direction of travel.

Whilst trustees already assess the strength of their employer covenant as part of a triennial valuation, the new regime imposes a statutory obligation on all trustees to undertake such an assessment and document it in Part 2 of the statement of strategy. They must also document how long it is reasonable to rely on their assessment of the strength of employer covenant and any changes in the strength of the employer covenant since the last review of the statement of strategy.

This will strengthen the importance of covenant assessment from a financial and legal perspective but does not impose a statutory requirement to take professional independent covenant advice. TPR has been keen to stress that there has been no change in its position on that.  If an employer is large in relation to the scheme, is well funded on a low dependency funding basis or on a solvency basis or is taking low investment risk in the period before the relevant date, trustees may still feel comfortable forming their own assessment. Factors which may point towards obtaining an independent assessment include:

  • where the statutory employer has a very complex covenant (e.g. intra group guarantees);
  • if the trustees do not have the experience or knowledge to assess covenant appropriately;
  • if the trustees have concerns about independence or objectivity on the board;
  • if the scheme is following the bespoke regulatory approach.

What is new in relation to covenant?

Forward looking assessment

What has changed is an increased emphasis on the need for an assessment to be primarily forward looking and specifically for trustees to determine the reliability period of their employer covenant. This represents the period where trustees have reasonable certainty over the employer’s available cash to fund the scheme. In general, trustees should focus on the ability of the employer to make cash contributions to the scheme to address downside investment risk. When assessing reliability, trustees should consider the employer’s forecasts, to the extent that these are available and deemed reasonable, and the employer’s prospects (including its capital structure and overall resilience, and the market in which it operates). The draft Code recognises that most employers will only have reliable periods over the medium term. However, some employers’ reliability period may extend to the long term.

Trustees must also consider the longevity of their employer covenant. This is the maximum period in which trustees can reasonably assume the employer will remain in existence to support the scheme. When considering the level of investment risk that is appropriate at different points of a scheme’s journey plan, the draft Code states that trustees should consider the following two periods of time separately:

  • the period during covenant reliability; and
  • the period after covenant reliability and up to the relevant date.

A scheme’s relevant date is set by the trustees – it must be no later than the end of the year in which the scheme is expected to reach relevant maturity. More risk can be taken where a scheme is a long way from reaching the relevant date and less risk where a scheme is nearing it. The draft Regulations have been criticised for being too prescriptive regarding the level of funding and investment risk that may be taken by a scheme after reaching the relevant date. In particular, the draft Regulations seem to be at odds with the amendments being made to the Pensions Act 2004 which require a scheme’s technical provisions to be calculated in a way that is consistent with the scheme’s funding and investment strategy and do not require schemes to maintain a 100% low dependency investment allocation which takes no account for the strength of the employer covenant on reaching the relevant date. The draft Code is softer than the draft Regulations on this point and it remains to be seen whether the two will be aligned. It states:

After the period of covenant reliability, trustees will need to consider what level of risk is appropriate and to what extent they need to allow for the scheme to de-risk before the relevant date. These considerations will depend on the level of risk being taken in the period of covenant reliability and include the timing and pace of any de-risking planned to be undertaken in the investment strategy.

When considering the appropriate level during this period, the trustees should consider the impact of adverse changes and the likely actions they can take to mitigate them. This will depend on the level of risk in the investment strategy and to what extent this is reflected in the TPs. This analysis of risk should also consider the extent to which the covenant is likely to be able to support risk in the future. This does not mean that we expect risk can only be taken where it is possible to forecast covenant with reasonable certainty. However, the trustees should understand the impact of a future deterioration in covenant. Where adverse changes in covenant are likely in future, we would expect the trustees to allow for those


Contingent assets

Another area of change and where additional advice may be required is in relation to contingent assets. Where contingent assets are in place to support increased risk, trustees must consider whether the contingent asset is legally enforceable and whether it will provide the promised support when required.

To determine its enforceability, legal advice may be required regarding the terms and conditions of the relevant contingent asset agreement and the applicable governing law. Secondly, in assessing whether the contingent asset does what is promised, trustees will need to identify the scenario in which it may be called upon (e.g. insolvency of the employer, failure to pay an amount due under the schedule of contributions) and an appropriate method to assess its expected realisable value in those circumstances.

With regard to one type of contingent asset, the parent company guarantee, the draft Code introduces the new concept of a “look through guarantee”, a term that is not contained in the draft Regulations and is not used by TPR in its current DB funding code or covenant monitoring guidance.  The draft Code states the following in relation to “look through guarantees”:

Some guarantees are structured in such a way that they largely replicate the obligations placed on a statutory employer. This includes providing a formal look through to the guarantor for affordability purposes. These guarantees provide an unfettered ability for trustees to claim against the guarantor in respect of all monies owed by the employer to the scheme and cannot be revoked without trustee agreement. These are referred to as 'look through' guarantees. Where trustees benefit from a look through guarantee, when assessing the strength of the employer covenant, trustees should assess the guarantor’s financial ability to support the scheme as if it was a statutory employer”.

The PPF Type A standard form guarantee defines its “Guaranteed Obligations” as “all present and future obligations and liabilities (whether actual or contingent and whether owed jointly or severally and in any capacity whatsoever) of each Company to make payments to the Scheme”. It cannot be amended or withdrawn without the agreement of all parties. Given that it appears to meet the description in the draft Code, it would perhaps, therefore, have been more helpful to refer to a guarantee in that understood and known format, as opposed to introducing new unfamiliar concepts.

Actions for trustees and employers

  • Whilst the new DB Funding regime will not be retrospective and will only apply to a scheme’s first valuation with a valuation date on and after the “in force” date (currently expected to be 1 October 2023) trustees should start their covenant work early, particularly if they envisage going down the bespoke route.
  • Identify any particular risks to the covenant and discuss with the employer. Examples include:
    • lack of visibility over covenant reliability. Trustees will need information from employers to assess the period of covenant reliability to include cash flow, profit and loss account and balance sheet projections, typically over 1 to 3 years. This will be a step change for some employers so make sure they know they will need to produce this;
    • the enforceability and likely recovery under any contingent assets;
    • covenant leakage whether through dividend payments or granting of inter-company loans that are unlikely to be repaid;
    • if the employer’s banking facility is due to be renegotiated, what commercial terms may be offered;
    • if your scheme remains open to accrual or new members, probe your sponsor as whether that is likely to remain the case during any period of covenant reliability.
  • Keep an eye on developments including the final version of the draft Regulations, draft Code and the forthcoming consultation on the revised regulatory guidance on assessing employer covenant.

We have extensive experience advising trustees and employers in relation to DB funding negotiations. Please contact Clive Pugh or your usual member of the Burges Salmon Pensions Team to discuss further.

This blog was written by Clive Pugh, Catrin Young and Emily Fox.