Covenant in the New Funding Regime – Four Numbers you Need to Know

The new DB funding regime, effective for valuations from September 2024, brings a new focus on how covenant relates to the pension scheme's funding and investment strategy. Trustees and sponsors will need to think differently about covenant for valuations under the new code.

Historically, covenant assessments have focussed on grading the covenant as strong, weak or something in between, and assessing what the sponsor can reasonably afford to pay in deficit recovery contributions, where required. These have then been used to inform the choice of funding assumptions and the recovery plan.

The new regime expands the role of covenant to assess, in a much more quantitative way, the level of funding and investment risk that the sponsor can underwrite during the journey plan to 'low dependency' (i.e. a position where there is very little reliance on the covenant of the sponsor). The effect is to put integrated risk management on a statutory footing.

For this purpose, covenant boils down to four key numbers that most schemes will need to report in the statement of strategy:

• The maximum affordable contributions over and above any recovery plan, that would be available to the pension scheme if there were a scheme stress event
• The number of years for which that assessment can be relied upon (the reliability period)
• The number of years that trustees can be reasonably certain the sponsor will be in existence to support the scheme (the longevity period)
• The value of any contingent asset support realisable in the event of the funding and investment risk crystallising

This applies whether the scheme is following a Bespoke or Fast Track approach. A scheme could be fully funded on Fast Track assumptions that are independent of traditional covenant grading, but if it is taking investment risk in the journey plan — whether to get to buy-out, funding for surplus, or for another reason — then trustees must report their assessment of maximum affordable contributions and be confident that it supports the funding and investment risk they are taking. Bespoke schemes will also have to report further detail. Only small schemes and schemes meeting a 'low risk' definition will be exempt.

In some cases, it will be obvious at the outset that the sponsor's maximum affordable contributions will be more than sufficient to cover the scheme's investment risk, either because the sponsor is large relative to the scheme or because the investment risk is low. In these circumstances a light touch approach may be proportionate. On the other hand, where the scheme is material to the sponsor, detailed analysis of cash flow forecasts and business risks will be needed.

All this means that trustees and sponsors will need to think carefully when planning the first valuation under the new regime. They will need to consider whether the scheme is likely to be Bespoke or Fast Track, whether it meets the 'small' or 'low risk' definitions, and what is the desired risk profile on the journey plan - all of which will determine the scope of the covenant assessment. It may be that covenant assessment becomes a multi-stage process, with an early qualitative assessment of whether anything has materially changed and a more detailed analysis of maximum affordable contributions later in the valuation process.

One thing is clear - if you are asking your covenant adviser what the fee is for a standard covenant assessment — unfortunately, you are asking the wrong question.