Employer covenant assessment – the DB funding puzzle is complete

The Pensions Regulator (TPR) has published updated guidance for trustees on employer covenant assessment. The guidance represents the final piece in the new DB funding regime which came into force earlier this year. While TPR has placed increasing emphasis on the importance of covenant assessment over the last 15 years or so, the new funding regime marks the first time that the need to assess the employer covenant has been put on a legal footing.

The guidance sets out how TPR expects trustees to approach covenant assessment, and is designed to embed good practice and encourage consistency across schemes. The guidance covers the following areas:

• The role of the employer covenant and elements to consider when assessing it, including proportionality.
• Identifying scheme employers and assessing the nature and extent of their legal obligations to the scheme.
• Assessing the cash flow of employers, and non-employers, who have a legal obligation to financially support the scheme.
• Understanding the extent and duration of reliance that can be placed on employers to continue providing sufficient scheme support and the risks to that support deteriorating.
• Assessing the reliability period and covenant longevity (these are both new concepts introduced by TPR’s new DB funding code).
• Ascribing an appropriate value to a contingent asset and evidencing that it is sufficient to provide the specified level of support when required.
• Assessing the employer’s reasonable affordability for recovery plan purposes.
• Determining the appropriate covenant inputs needed to assess if the level of risk being run in the scheme’s funding and investment strategy can be supported by the covenant.
• Monitoring the covenant and creating a framework to take proportionate action at the appropriate time.

Worked examples are included in the guidance to help trustees understand how to exercise their judgement. There is also an increased focus in the guidance on proportionality of covenant assessments to ensure trustees consider the right level of detail, based on the covenant support provided and the scheme’s position.

What should trustees and employers of DB schemes be doing?

While the new funding regime applies to valuations with an effective date of 22 September 2024 or later, covenant assessment and monitoring is an ongoing process. All trustees should therefore familiarise themselves with the guidance and ensure that their covenant assessment and monitoring processes are updated appropriately, regardless of when their next valuation is. Specific funding agreements might require a review (for example payment trigger terms based on covenant-related matters).

Similarly, the guidance has implications for employers that go beyond scheme valuations – for example, the need for ongoing covenant monitoring and assessment of the impact of corporate transactions on the covenant. Employers should therefore review the guidance so they understand what requirements are being placed on trustees, what support and information they may require from the employer, and the interaction between the guidance and corporate activity.