In December 2022, the Pensions Regulator (TPR) published its 14-week consultation on the last pieces  in the defined benefit (DB) funding puzzle – drafts of the new DB funding code and fast-track regulatory regime. When the new requirements come into force and implement the changes introduced by the Pension Schemes Act 2021 (see our article on this here), it will be the biggest change in DB funding and investment strategies in nearly 20 years, with trustees and sponsoring employers of all DB schemes required to take action. The new requirements cover all aspects of funding including covenant, investment and the actuarial valuation process. 

In particular, employer covenant is a key focus point of the new funding regime, and in many cases these changes are going to result in more in-depth scrutiny of the financial strength of the employer and the support it can provide for its pension scheme. The consultation is set to close on Friday 24 March and the final regulations and new funding code are currently planned to come into force in October 2023 (and will impact all schemes with valuations on or after that date).

In our article we take a closer look at some of the factors in the draft funding code that trustees and sponsoring employers should be considering:

1. Covenant and employer prospects

What do we mean by covenant and why is it important?

TPR has made clear in its guidance that the concept of covenant is an employer’s legal obligation and financial ability to support its DB scheme now and in the future. The draft regulations build on this guidance and identify the key features that trustees should be considering when they are assessing covenant, in particular putting emphasis on an employer’s ability to support its DB scheme "in the future". This will mean consideration of the prospects for an employer going forward and how reliable its cash flows might be, as well as the risk of insolvency. The ability to support a scheme in the future should also be a consideration for the employer and is not simply a matter for which the trustees must take responsibility. Contingent assets (which we look at further below) are recognised as an important part of the covenant and should be both legally enforceable and of tangible value to the scheme. 

All schemes should already be giving consideration to the employer covenant and this is regardless of whether a fast-track valuation route is being taken. There is a misconception that covenant does not matter if the scheme can meet fast-track requirements but covenant is important even for schemes which are well funded or can meet the fast-track tests. The proposed requirements for fast-track are quite technical but broadly speaking, TPR will have regard to parameters covering funding and investment strategy. The full details can be found in appendix 1 of the consultation document. 

The fast-track valuation is not held up by TPR as a gold standard for scheme funding, but rather it is TPR fast-tracking those schemes which meet certain minimum criteria through its assessment process because they are unlikely to be high risk. TPR is not saying that covenant does not matter if the scheme is in fast-track. It is important that trustees get comfortable that: (i) their covenant can support the risks being run in their schemes; (ii) the recovery plan is not too long; and (iii) the scheme is being treated fairly (for example, when compared to payments of dividends). 

Moreover, all trustees will be required to report covenant information in their statement of strategy. The statement of strategy is a new piece of documentation that will contain information about the scheme's funding and investment strategy, its long-term target and its journey plan to get there. As part of this, trustees will need to include their assessment of covenant strength, how long that can be relied upon and whether there have been any changes since the last statement of strategy. As a result, employers should be conscious of providing sufficient information to trustees to assess the covenant. 

How is TPR saying trustees should be looking at employer prospects?

Typically, covenant assessments have often been backward looking and focused on past performance, with a short commentary on prospects and any forecasts. That is clearly quite a limited way of looking at employer strength, when really it is the future cash flows that are going to be needed to pay off the deficit. TPR has always noted the importance of forward-looking assessments, but now it is really challenging trustees and advisers to think about that in much greater detail. 

To get trustees to do this, TPR has now set out three new concepts to help inform how covenant advisers should apply these parameters going forward: 

• Visibility: this covers the period over which trustees have access to an employer’s forecasts. Typically this will range between one and three years. Trustees need to look at the historical accuracy and forecasts alongside the supporting assumptions. 
• Reliability: this represents the period of time for which trustees have reasonable certainty over an employer’s available cash to fund the pension scheme. Most employers will have reliable periods over the medium term, and our interpretation of the new funding code is that the TPR’s default position will be roughly six years.
• Longevity: this represents the maximum period in which trustees can expect an employer to exist to support that scheme. 

Recap and key action points:

• TPR has included new, more detailed, concepts in respect of covenant and these will require further analysis within covenant work. 
• A greater volume of information is likely to be required from employers. If your scheme has information sharing protocols set up, it would be advisable to revisit these to ensure they are fit for purpose and, where they are not, to provide for updates. If these are not already set up, then it would be advisable for trustees and scheme employers to put them in place in advance of the changes coming in in order to minimise delays. 
• Trustees now must formally consider and comment on the risk of employer insolvency and their view on covenant reliability. They must comment on how this period compares to the length of the current plan and document this at each valuation.

2. Reasonable affordability and recovery plans 

Affordability assessment

The concept of deficits needing to be paid off as soon as is reasonably affordable is not a new one but while this has been a principle in TPR’s guidance, it has not been previously enshrined in law. We have also seen swings in emphasis with the principle becoming less essential following the financial crisis and the introduction of the regulators sustainable growth objective. The draft regulations and the new funding code seem to be indicating a swing back to more stringent affordability assessments and potentially shorter recovery plans. 

Reasonable affordability is important because it will essentially determine how much cash is contributed to a scheme. A really key part of assessing this will be analysing forecasts provided by management, particularly focusing on cash generated and what it is being spent on. In order to determine what is reasonable and to form an appropriate recovery plan, the new code considers various principles. 

The first three relate to scheme maturity, scheme funding level and the level of prudence being used. These set the context for how much funding is required by the scheme and over what time period. In an ideal world, the recovery plan will be affordable from the employer's cash flows and will pay off the deficit by the time the scheme reaches significant maturity within the period of covenant reliability. 

Principle of fair treatment

The principle of fair treatment has been really important in TPR's guidance for some time now, and it has to be applied to any expenditure where cash is leaving a business with no expectation of recovery. Employers and subsequently trustees should consider whether the scheme is being treated fairly, by comparing expected deficit reduction contributions and dividend payments in the sponsoring employers' budgets and cash flow forecasts. Typical areas which need to be considered for fair treatment include dividends, debt with significant interest costs or any early repayment of debt. 

Business investment is an area which previously may have been deemed as an acceptable use of cash, but now it is becoming more stringently monitored. Employers should be mindful in how they provide for business development costs and what effect, if any, it will have on pension schemes in which it is involved. It is said to be reasonable where trustees are confident of a future benefit scheme, an employer and where spending does not increase the risk of a business running into financial difficulty. The lower the scheme funding level, the less reasonable it will be for cash to be used for these purposes, as more contributions would be expected considering there is more deficit to pay off. More mature schemes mean there is a shorter time period to repay any existing deficit and so spending on this may also not be considered reasonable. 

Recap and key action points:

• The requirement for deficits to be paid off as soon as it is reasonably affordable will now be a legal requirement. This means there is likely to be more scrutiny over things like employer business plans. 
• Employers are likely to need to consider further how to justify business development costs given the increased focus on cash flow figures. 
• The concept of scheme maturity imposes new constraints that might take some getting used to by employers. As far as employers are concerned, if a scheme closed years ago and has nothing to do with the day-to-day operations of their business, it is highly likely that the idea of maturity has not crossed their minds. However. it must now be a consideration in terms of affordability and the recovery plan. 
• The principle of fair treatment could mean that employers cannot invest as freely in business development as they could previously. Difficulties may arise in relation to refinancing if they cannot commit to debt repayments and they may be prohibited from paying dividends in the way they want. It is likely to mean more interactions between trustees and employers and engagement at an earlier stage. 

3. Contingent assets

Contingent assets are nothing new. They have been around as a key aspect of covenant support for a long time now, giving protection to schemes in the case of downside events. There are many types of contingent asset being used, the most common of which is the use of a guarantee. Security over employer assets, such as cash, property or other trading assets, is also another commonly used contingent asset.

Contingent assets are really useful for both trustees and the sponsoring employers in that they provide strong, legally binding support and could help fill the covenant gap that may arise under the new code based on employer affordability and prospects. They are also flexible, so they can be implemented specifically to strengthen a certain aspect and are often not a cash-based asset, something that is really important from an employer's perspective. For example, where there is concern around over funding the scheme, diverting contributions into an escrow account delivers security to the scheme whilst enabling the potential recovery of funds to the employer, if ultimately they are not required. 

While contingent assets are clearly very useful, TPR has had concerns with the way trustees have assessed company funds, in particular around trustees placing covenant reliance on the balance sheet of employers. Whilst the balance sheet may currently be strong, the scheme's section 75 (or buy-out) deficit, which crystallises in an employer insolvency scenario, may mean that the balance sheet is likely to be much weaker at that point in time. This could mean that, in the event of a guarantee being utilised, the trustee realises that it provides a lot less value to the scheme than they had factored in previously. 

The new code introduces a new term – the “look-through” guarantee. This is effectively a full and watertight guarantee for the scheme which passes all obligations of the employer over to the guarantor in any circumstances, without expiration or restrictions, and specifically allows for affordability to be assessed at the guarantor level. Only on the basis of a look-through guarantee being in place can a scheme entirely base its covenant on the guarantor and importantly, if this is the case, then affordability must be considered at the guarantor level. Where the guarantee falls short of the criteria for a look-through guarantee, the new code means that some reliance remains on the statutory employers, and so the trustees' covenant assessment must include focus on the legal employers. 

The new code also increases the focus on the trustees to understand the expected value of the guarantee to the scheme when it is called upon. This means understanding the key terms of the guarantee, whether it is an operating company or a holding company in the group and how it is linked to the employer.

Recap and key action points:

• Where contingent assets are already in place, these should be revisited and reassessed in light of the new funding code. In particular, the scheme's legal recall to the assets and a realistic value of the asset in the event it gets called should be considered. 
• Trustees should re-evaluate if a guarantee will continue to provide the covenant reliance that is needed, and, if a high level of reliance is placed on the guarantor, consider seeking to revise that to a full look-through guarantee. 

Comment

For some trustees, the new funding regime and covenant requirements will have a significant impact on how they approach assessing covenant and will have a knock-on effect on how they manage risk in their scheme while for others, it may simply reinforce the procedures which they already have in place.

The pensions industry has broadly welcomed the draft regulations and the new funding code, and the clarity of the guidance given for both trustees and employers who find their schemes in volatile positions. There has however been some criticism of a potential lack of flexibility in the “one-size fits all” regime at a time when DB schemes are now by-and-large finding themselves in stronger funding positions than in recent times, while some advisers have expressed concern at the difficulties the regime may present to smaller schemes. 

TPR does recognise that some schemes may have to take risks that are not completely supported by the covenant or may need to have a very long recovery plan. Where this is the case, trustees will need to be able to show they have endeavoured to put the scheme in the best possible position. An in-depth covenant assessment is absolutely essential in those situations. 

It is not just trustees that should be considering covenant related checks, scheme sponsors should also be thinking about whether the new code is going to impact the manner in which they support their scheme and prepare for any changes. It can take time to organise parent company guarantees, particularly if it is an overseas parent company that might not have had a great deal of engagement on UK pensions issues before. It is also important to recognise that some contingent assets are easier for certain businesses to provide than others, and so sponsors should consider what would suit their business model. 

For more on the new DB funding regime, see our flyer here on how it could lead to an increase in pension costs for sponsoring employers and our article here on the market volatility leading up the new regime.