Guidance on how to determine the appropriate covenant inputs needed to assess if the level of risk being run in the scheme’s funding and investment strategy is supportable by the covenant.
Published: December 2024
Introduction
In your funding and investment strategy, you need to plan how the scheme will reach its low dependency funding target from its current funding position. This is referred to as the scheme’s journey plan. When setting the journey plan, you must ensure that the level of funding and notional investment risk is set in line with the level of available covenant support and the maturity of the scheme. This is referred to as the supportability principle.
You must review and revise your journey plan at each scheme valuation. As part of this assessment, you need to review any changes to employer covenant support.
This section focuses solely on the covenant inputs required to assess supportable risk, and not scheme maturity.
The DB code distinguishes between risk-taking over and after the reliability period. Depending on which period you are considering, the covenant considerations will differ.
The assessment of employer support available for the recovery plan (available cash) differs from the assessment of employer support available for the purposes of assessing supportable risk (maximum affordable contributions):
- Available cash takes into account all cash and liquid assets available at the time of agreeing the recovery plan. This will be used to determine future DRCs and reasonable alternative uses of cash (please see the recovery plan section for more information). Once the employer has agreed to the recovery plan, they are contractually bound to make these payments.
- Maximum affordable contributions only consider the employer’s cash flows that would be available to the scheme if there was a scheme stress event, and therefore when an increased deficit would need to be rectified through cash payments to the scheme. When assessing maximum affordable contributions, you should not include any balance sheet assets that are not directly secured in favour of the scheme (unless they are being used to fund DRCs – please see the Allowing for liquid assets in maximum affordable contributions section below), or any cash flow amounts that you do not reasonably consider would be available to pay into the scheme to rectify the increased deficit from a scheme stress event.
Assessing supportable risk over the reliability period
Paragraph 13 of the journey planning section of the DB funding code states:
"We expect trustees to make an assessment of whether the scheme has access to sufficient employer cashflows and contingent asset support over the reliability period to recover both the existing deficit (if any) and any further deficit that could arise from a scheme-related stress event during this period."
When making this assessment, you must consider the following covenant inputs:
- maximum affordable contributions over the reliability period that would be available to the scheme to fund a deterioration in the funding deficit caused by a scheme stress event
- any contingent asset support that would be accessible to the scheme if a scheme stress event happened over the reliability period
Maximum affordable contributions
Paragraphs 17 and 18 state:
"Maximum affordable contributions are defined as the employer’s cash flows (as defined in assessing the employer’s current and future cash flow in the employer covenant module of this code) after the following has occurred.
- Reasonable adjustments have been made, where appropriate, for alternative uses of cash to reflect the level of cash flows that are expected to be available to the scheme to recover the additional deficit from a scheme-related stress event. For example, deducting for investment in sustainable growth over the reliability period when such payments are unlikely to be impacted in this scenario.
- Deducting deficit repair contributions (DRCs) payable to the scheme and other DB schemes the employer sponsors.
To the extent that the employer has agreed to pay some or all DRCs from its liquid assets (such as where cash generation is insufficient to cover annual DRCs), these amounts committed to support the payment of DRCs should also be factored into the calculation of maximum affordable contributions. This will prevent maximum affordable contributions being understated once DRCs are deducted."
Example 1: Calculating maximum affordable contributions
The sole participating employer has liquid assets of £15 million, and it is expecting to generate employer cash flow of £25 million per year for the next five years.
Management intends to maintain the liquid assets balance of £15 million over time, and to use the cash flow generation to fund the following:
- £12 million of shareholder returns per annum over the next few years, in line with around 50% of employer cash flow distribution policy applied over the last two years.
- £5 million per annum over the next three years on investments to expand production capacity (ie sustainable growth).
- £5 million of DRCs to the scheme, and another £1 million of DRCs to a sister scheme sponsored by the same employer.
Any unused employer cash flow generation will be used to strengthen the cash held on the balance sheet.
The scheme has a £25 million TPs deficit, and its covenant adviser has noted that the reliability period is five years. Given this, the proposal from management implies a recovery plan of five years, in line with the reliability period.
After discussions with management and the scheme’s advisers, the trustees conclude that a scheme-related stress event is unlikely to halt the employer’s sustainable growth plans, even if this leads to an increase in the scheme’s funding deficit by the amount estimated by the advisers.
Management also formally communicated to the trustees that there is flexibility in the employer cash flow distribution policy, which can be reduced by up to 60% in the event of a scheme-related stress event arising, until any resulting increase in scheme deficit has been repaired.
Application of the guidance
After carefully considering the information and input from advisers, the trustees make the following observations in relation to the maximum affordable contributions:
- Given a scheme stress event will be funded through employer cash flow after reducing forecast shareholder returns by 60%, but without impacting investments in sustainable growth, the employer cash flows should be reduced by these amounts when determining maximum affordable contributions.
- As the maximum affordable contributions are after agreed DRCs, these should be removed in full, including the DRCs due to be paid to other schemes.
- The employer is not expected to use the balance sheet liquid assets to fund DRCs, so there is no requirement to add these to the employer cash flow (please see the Allowing for liquid assets in maximum affordable contributions section below).
- As the employer supports another scheme and, based on the information available, its potential funding and investment risk (including any additional deficit which could arise from a scheme stress scenario) is likely to be approximately one-fifth of the combined exposure to both schemes, maximum affordable contributions available to this scheme should be reduced by one-fifth (please see the Where an employer sponsors more than one DB scheme section below).
Based on the above, the trustees decide that it is reasonable to consider the maximum affordable contributions for the next five years as outlined in Table 1 below.
Table 1: Calculation of maximum affordable contributions
| Maximum affordable contributions calculation | Forecast year (£ millions) | ||||
|---|---|---|---|---|---|
| 1 | 2 | 3 | 4 | 5 | |
| Employer cash flow | 25 | 25 | 25 | 25 | 25 |
| Sustainable growth investments | (5) | (5) | (5) | 0 | 0 |
| Shareholder return (at 40% of intended allocation) | (12)*0.4=(4.8) | (4.8) | (4.8) | (4.8) | (4.8) |
| DRCs | (6) | (6) | (6) | (6) | (6) |
| Total maximum affordable contributions pre-adjustment for sister scheme | 9.2 | 9.2 | 9.2 | 14.2 | 14.2 |
| Share of maximum affordable contribution assumed for sister scheme | (9.2)*0.2= (1.8) | (1.8) | (1.8) | (1.8) | (1.8) |
| Total maximum affordable contributions | 7.4 | 7.4 | 7.4 | 12.4 | 12.4 |
Allowing for liquid assets in maximum affordable contributions
When setting the recovery plan, you need to assess the total available cash of the employer (please see the recovery plans section for more detail). As a result, where liquid asset balances held by the employer are high, but cash flows are limited, you may agree to set a recovery plan that utilises the employer’s liquid assets to meet the payments due.
In this scenario, you should include this in the maximum affordable contributions figure, as liquid assets are to be used to supplement the DRC payments due under the recovery plan.
Only the liquid assets balance, which is expected to pay the DRCs, above and beyond the amounts that will be paid from employer cash flows in each year of the reliability period should be added into the maximum affordable contribution figure. No amounts should be included that are to be used after the reliability period or amounts that exceed those that will be used to pay DRCs.
Where employer cash flows are sufficient to cover DRCs over the reliability period without needing to utilise liquid assets, no adjustment should be made to the maximum affordable contributions figure.
Payments to other DB schemes
Maximum affordable contributions are calculated by deducting DRCs paid to other DB schemes that are also funded by the employer. This is because these payments are contractually agreed by the employer to be paid to those other DB schemes, and the cash will not be available to fund the impact of a scheme stress event.
Therefore, where DRCs to other DB schemes are to be funded partly or fully through liquid assets of the employer, these amounts should also be added into the calculation of maximum affordable contributions. These should be added in the same way as they would be for the scheme being assessed, as detailed above.
Other considerations when assessing maximum affordable contributions
Look-through guarantee
Where a look-through guarantee is in place to support the scheme (please see the contingent asset section for more detail), you should consider the reliability period and the cash flows of the guarantor, in addition to those of the employer, in your assessment of maximum affordable contributions. However, you should avoid any double counting, which could be the case when the employer is a subsidiary of the guarantor.
Payment of DRCs by an entity other than the employer
Some schemes may receive DRC payments from other entities in the employer’s group, for example from the parent company of the employer.
If the other group entity is legally obliged to pay the DRCs for the recovery plan period but does not provide the scheme with a guarantee with look-through to its affordability, DRCs should not be deducted from the maximum affordable contributions figure of the employer as these are not expected to be paid through employer cash flows. As there is no formal look through to the entity’s affordability, the cash flows of the entity paying the DRCs under the recovery plan should not be factored either into the maximum affordable contributions figure.
There may be schemes whose DRCs are paid by another group entity in practice, but whose recovery plan and schedule of contributions state that the employer will pay the DRCs. In this scenario, the other group entity is not legally obliged to continue to pay the DRCs and the obligation remains with the employer. To reflect this, the employer’s maximum affordable contributions should be based on the employer’s cash flows only, with DRCs deducted from this figure as if they were paid by the employer.
Where an employer sponsors more than one DB scheme
Where the scheme employer sponsors more than one DB scheme, you should seek to understand the funding requirements and funding and investment risk of the other scheme(s). We expect employers to provide the information needed for you to be able to make this assessment.
You should consider the impact a scheme stress event could have on employer cash flows, if this was to occur for the other scheme, or across both schemes simultaneously.
In general, we would not expect you to consider the employer’s cash flows in full when the employer supports multiple schemes, as this is likely to overstate the level of maximum supportable risk.
To ensure that each scheme is treated fairly, you may consider it proportionate to divide the employer’s cash flows after reasonable adjustments among the DB schemes based on, for example, scheme liabilities (on a low dependency basis), and only consider your scheme’s share when assessing the level of maximum supportable risk.
Contingent asset support
Paragraphs 19 and 20 of the journey planning section of the DB funding code state:
"If trustees are relying on contingent asset support to provide additional funding to the scheme following a scheme-related stress event, they should ensure it satisfies the relevant criteria outlined in the contingent asset support section of the employer covenant module. This should be accessible to the scheme if a scheme-related stress event arises over the reliability period. Examples include, but are not limited to, a third-party contingent funding mechanism that underpins the scheme’s investment risk, or cash in escrow that is accessible if a downside investment scenario arises.
There may be limited circumstances where trustees are able to take additional risk based on contingent asset support that is only likely to be accessible after the reliability period, including those that provide an underpin in insolvency. For this to be the case, trustees need to evidence why they are reasonably confident of the value this support would provide when called upon. When deciding whether to take additional risk on this basis, trustees should consider the circumstances in which they can access this value and the likelihood of these circumstances arising. The more remote the circumstances in which the value can be accessed, and the lower the confidence in the value it would provide when called upon, the less reasonable it will be to take additional risk."
Read the contingent assets chapter for more detail on what qualifies as a contingent asset and how to attribute an appropriate value to it.
You should ensure that the value from a contingent asset is not double counted or relied upon for more than one purpose. For example, where a contingent asset is used to support a recovery plan that extends beyond the reliability period, the proportion of the value of the contingent asset used for this purpose cannot also be used to support risk-taking in the funding and investment strategy.
Example 2: Using a contingent asset to support taking more funding and investment risk
Continues from example 1 above.
Following the initial discussion on maximum affordable contributions and the level of supportable funding and investment risk that the trustees are able to run, management notes that it would like the scheme to target higher asset returns over the reliability period and suggests a new investment strategy.
After reviewing the proposal, the trustees note that this would likely increase the deficit in a scheme stress event to a level where they would be uncomfortable, based on the covenant support currently available. This is because this level would exceed the estimate of maximum affordable contributions.
To overcome this, management offers to enhance the original proposal with a contingent asset, with the aim of covering the additional risk.
Scenario 1: Contingent funding mechanism
In this scenario, management offers the trustees a contingent funding mechanism from the employer, to provide additional cash to the scheme in case the investment risk crystallises.
Outcome
The trustees note that the suggested mechanism does not support additional risk as it does not add additional covenant support. The employer cash flow generation has already been considered in the previous calculations of the maximum affordable contributions, and liquid assets cannot be considered in the maximum affordable contributions unless secured in favour of the scheme, in line with the code.
The trustees, with the support from their covenant adviser, added that, to consider a contingent funding mechanism to support increased investment risk, this would need to be enhanced, for example via the following:
- holding cash in an escrow account in favour of the scheme, therefore securing an amount of cash on the balance sheet equal to the potential additional funding that might be required under the mechanism
- changing the counterparty of the contingent funding mechanism from the employer to the parent of the wider group – a large, profitable and diversified corporate, with robust balance sheet resilience and no foreseeable material risks impacting its prospects
Scenario 2: Guarantee
In this case, management offers the trustees a section 75 guarantee, triggering upon the insolvency of the employer from a service company not connected to the employer.
Outcome
The trustees commission advice to assess the contingent asset offered. The advice notes that it is unlikely that the scheme will obtain access to the guarantee in the short to medium term, given that the employer is unlikely to go insolvent over that period. In addition, the proposed guarantor, a service entity, does not currently appear to have sufficient profitability, cash flow generation, or balance sheet resilience to be able to meet a claim under the guarantee, without additional support from the wider group.
Based on the above analysis, the trustees conclude that they cannot rely on the proposed guarantee to support the additional risk proposed by management.
The trustees then note that, to be able to factor the guarantee into the supportable risk calculations, and to increase the investment risk requested by management, the proposed guarantee would need to be enhanced, for example by:
- being provided by the parent of the wider group, a large, profitable and diversified corporate, with good prospects as noted above; and
- being triggered not only in case of insolvency of the employer, but also in case of a scheme investment downside event where the employer is not able to rectify the increased deficit
Example 3: Using a contingent asset to support taking more funding and investment risk and extending the scheme’ recovery plan
Continues from example 1 above – therefore please ignore example 2 when reading this.
Following the initial discussion on maximum affordable contributions and the level of supportable funding and investment risk that the trustees are able to run, management notes that it would like the scheme to do the following.
- Target higher asset returns and suggests a new investment strategy.
- Extend the recovery plan to six years, ie beyond the reliability period, which means that instead of £5 million per annum over the next five years, the recovery plan would be £4.2 million per annum over the next six years. The request to do this is driven by the employer looking to invest in additional sustainable growth projects, which will also absorb any excess employer cash flows and the employer’s liquid asset balances held on the balance sheet.
To mitigate for the higher risks arising from the above, management suggests a contingent funding mechanism from the parent of the wider group. This would provide £4.2 million of cash to be paid into the scheme if the employer can’t pay the DRCs in the sixth year (ie the last year of the recovery plan, which is beyond the reliability period). The trustees are comfortable that the parent company has a reliability period of at least six years and would therefore be able to support this contingent funding mechanism.
Separately, the trustees’ actuarial and investment adviser notes that the management’s proposal would increase the scheme’s funding and investment risks.
Application of the guidance
After carefully considering management’s proposal with their advisers, the trustees note that the contingent asset proposed, given the amount and events covered, is effectively only covering the increased risks from the extension of the recovery plan beyond the reliability period.
The trustees cannot rely on the same contingent assets to also cover the higher risks from the proposed investment strategy. This would double count the value of the mechanism, which would also not be directly accessible to the scheme in case a downside investment event was to arise. They would therefore be open to considering the extension in the recovery plan supported by the contingent asset but not in addition to the increased investment risk.
Example 4 - Assessing the need for reliance upon a contingent asset to support risk
The trustees of a large scheme with a single employer have asked their covenant adviser to undertake an assessment of the covenant support provided to the scheme.
This assessment concluded that the reliability period is seven years, and that cash flows adjusted for sustainable growth, dividends and DRCs determine maximum affordable contributions to be £8.7 million.
Separately, the scheme actuary and investment adviser have informed the trustees that the increase in deficit that could be expected in an appropriate stress scenario is £7.2 million. This would need to be supportable by the employer covenant, to be compliant with our code.
Ten years ago, the trustees secured a contingent asset in favour of the scheme – security over an investment property owned by the employer - which was valued at £12 million. A full valuation has not been completed on the property by the employer or the trustees for the past six years.
The trustees have obtained a quote for the re-valuation of the investment property but are concerned that the cost is high and are unsure if it will benefit the scheme.
The employer does not support any other DB pension schemes.
Application of the guidance
The trustees’ assessment of maximum affordable contributions shows that they have £8.7 million of support available from the adjusted employer cash flows. This is sufficient to cover the £7.2 million of risk from their preferred investment strategy over the reliability period.
On this basis, the trustees conclude that they do not need to rely upon the value of the contingent asset in place. Therefore, it is not necessary to have a new valuation completed to determine the current value of the investment property.
Assessing supportable risk post the reliability period
Paragraph 21 of the journey planning section of the DB funding code states:
"After the reliability period, trustees will need to consider what level of risk is appropriate, and the timing and pace at which the scheme should transition to low dependency by the relevant date. To do this, they should consider the following factors
- The extent to which the employer will be able to continue to support the scheme in the future.
- The level of risk being taken during the reliability period.
- The extent to which the scheme can rely on contingent asset support in the post-reliability period.
- How close the scheme is to the relevant date."
After the reliability period, there is increased uncertainty over cash flows, which makes it difficult to place a quantitative value on the covenant support available to the scheme, or to give a value to the level of risk that is supportable by the covenant in this period. Given this, the assessment of supportable risk becomes focused towards a qualitative assessment.
Our code provides clear principles that you should consider when assessing the level of appropriate risk to run after the reliability period, and to inform your strategy and timing for de-risking after the reliability period.
Example 5 – assessing supportable risk post reliability period
Continues from example 1 above - therefore please ignore example 2 and 3 when reading this.
Following the initial discussion on the level of funding and investment risk that the trustees are able to run, management notes that it would like the scheme to maintain the current investment strategy for the next ten years. This compares with the trustees’ intention to start a gradual, linear de-risking of the investment strategy from year five, to reach the low dependency investment allocation at the relevant date of the scheme in nine years, in line with expectations outlined in the code.
The trustees note that, while the current and proposed revised investment risk is covered by the maximum affordable contributions over the reliability of the employer of five years, the period suggested by management would extend beyond reliability and the scheme’s relevant date. Therefore, it is difficult to consider management’s proposal, given that predicting the covenant support available in the future becomes more challenging, and the proposal would breach legislative requirements.
Application of the guidance
The trustees commission advice to assess the proposal above. The covenant adviser concludes that, while the reliability is confirmed to be five years, the employer is profitable, and it is strategically important to the wider group as it provides access to the UK (the second largest market of the group). These factors are viewed positively when reviewing the covenant longevity of the employer, as the group is a large, profitable and diversified corporate, with no particular concerns around ceasing operations. Given this, coupled with the maturity of the scheme, the trustees undertake a proportionate assessment of covenant longevity and conclude that this is at least nine years.
The trustees note that, to consider the management’s proposal, given the higher uncertainty beyond the reliability period, they would need additional support to justify the additional risk compared to the de-risked investment path they would otherwise undertake.
The trustees then notify management that, in order to accept the proposed higher investment risk beyond the reliability period, the following would be required.
- The proposal would need to be changed so that the scheme’s journey plan reaches the low dependency investment allocation by the relevant date in nine years, to be compliant with regulations.
- They would need a suitable contingent asset to be granted at the time of setting the revised journey plan which provides access to additional cash, when needed (during the reliability period and up to the relevant date). The contingent asset would need to cover the difference in TPs liabilities that results from the revised journey plan and the increased deficit which could arise from a scheme stress event occurring after the five-year reliability period. An example of a suitable contingent asset in this case could be security over an investment property with clear, demonstrable and readily recoverable value, subject to revaluation.
We may revise the covenant guidance when needed and include industry feedback. Send comments or queries about the new guidance to covenantguidance@tpr.gov.uk.