Themes and trustee actions from TPR’s updated covenant guidance
Hailed by TPR as the “last piece of the jigsaw to help schemes carry out valuations under the new DB funding code”, TPR’s revamped covenant guidance sets out how trustees should evaluate employer covenant. It also includes worked examples.
Trustees will be pleased to hear that a major theme of the Code is proportionality. Trustees are encouraged “to review whether their existing covenant analysis is focused in the right areas”, particularly if a scheme’s funding position has changed significantly. This article sets out the key themes covered in the new guidance and recommended actions for trustees.
Identifying employers
The starting point for a review of covenant is to identify the correct scheme employers. Trustees need to understand the “balance of powers”, including who has the authority to amend or wind up the scheme, trigger a section 75 employer debt, and determine ongoing and Deficit Reduction Contributions (DRCs).
If an employer depends on a parent company, a larger corporate group, or other third parties, trustees should factor that into their assessments. In multi-employer schemes where it is not proportionate to assess each employer, the Guidance offers alternative approaches such as grouping employers, evaluating aggregate performance, or focusing on those with the largest share of scheme liabilities.
Key components of covenant assessment
With TPR stressing the importance of understanding that the risk being taken “on the journey plan to their low dependency target” is supportable, key areas involved in assessing covenant are:
Cash Flow
Trustees need to evaluate how much money an employer has available to support the scheme, focusing on projected cash flow rather than just past performance. “Free cash” is what remains after paying for essential business costs but before making Deficit Reduction Contributions (DRCs) or other financial commitments, like dividends or intra-group payments. The over-riding principle is that funding deficits must be recovered as soon as the employer can reasonably afford.
Prospects
Trustees need to assess how stable an employer’s financial future looks, the “extent and duration of reliance” that can be placed on the employers continuing support. This includes examining industry trends, competition, environmental and social risks, and the likelihood of insolvency. While trustees should get most of this information from the employer, they may also need external reports to validate or supplement what they’re being told.
Reliability Period and Covenant Longevity
Trustees need to determine two new key timeframes:
- Reliability period: How far into the future (typically three to six years) they can reasonably predict an employer’s ability to generate cash.
- Covenant longevity: How long the employer is expected to be able to keep supporting the scheme. This period is typically, but not always, expected to be longer than the Reliability period.
Since things can change, stress testing of “material risks” is advised to understand how these might disrupt projections. The Guidance includes examples showing how the assessment of the reliability period and covenant longevity should be undertaken.
Contingent Assets
Trustees must reassess contingent assets (like guarantees or security over property) that an employer has pledged to support the scheme at each valuation or more frequently if needed. The new Guidance details the valuation process to evidence that these assets will provide the specified level of support when required.
Maximum Affordable Contributions
The Guidance details how to assess whether the level of risk being run in the scheme’s funding and investment strategy is supportable by the covenant. It outlines how to calculate “maximum affordable contributions” over the Reliability period, where these maximum affordable contributions are assessed after allowing for outgo such as dividends, DRCs and investment in the sustainable growth of the business.
When combined with other tangible support such as contingent assets, these maximum affordable contributions must exceed the risk being run in the Scheme.1 If this test is failed, TPR expects investment risk to be reduced unless appropriate mitigation can be provided.
Monitoring covenant
TPR expects trustees to monitor the employer covenant throughout the scheme’s lifetime. A good monitoring approach should include:
- Spotting key risks (e.g. losing major clients, financial trouble, reputational damage, or industry shifts).
- Setting early warning thresholds for these risks.
- Agreeing on appropriate responses if things go wrong – this could mean increasing oversight, engaging covenant advisers, or adjusting the investment strategy.
Trustees need to document their approach and review it at each scheme valuation. Monitoring relies on up-to-date management accounts, analyst reports (if available), and public financial information. Building strong relationships with employers and setting up clear information-sharing protocols is also important.
While covenant fundamentals haven’t changed, the new approach seeks to move away from descriptive covenant ratings to a more quantified approach. Key areas such as cash flow and employer prospects are brought into sharper focus, alongside the need for regular, risk-based monitoring. Emphasising proportionality and practical application, it encourages trustees to focus their assessments where it matters most – particularly in light of a scheme’s current funding position and journey plan risk.
Ultimately, the guidance empowers trustees to take a more informed and responsive approach to covenant assessment, helping ensure that the employer’s support is not only well understood but remains adequate and reliable over time. Trustees should now take stock of their existing processes, update them where necessary, and embed this guidance into routine valuation and risk management practices.
This article features in our Quarterly Report for Q1 2025 where we cover a range of current issues in the pensions industry.
Footnotes
- Specifically, a 1-in-6 year “Value at Risk” measure over the Reliability period ↩︎
