ECPA (Employer Covenant Practitioners Association)

The “employer covenant” refers to the extent of financial support available to a pension scheme from its sponsoring employer(s) and contingent assets.

This support comprises several factors, including the extent to which the sponsor is expected to be able to pay contributions to the scheme (including deficit reduction contributions, if required), the ability of the sponsor to underwrite the funding and investment risks being run by the scheme (and in particular, the sponsor’s expected ability to pay contributions in the future should a downside event arise) and the financial resilience of the sponsor over the remaining lifetime of the scheme’s obligations.

Historically, the output of an employer covenant assessment has been a covenant rating (typically on a Strong to Weak scale) - not unlike a credit rating for traded debt, but specific to the pension scheme. The ‘stronger’ the employer covenant, the more comfort the trustees can take in the ability of the sponsor to financially support the scheme and underwrite investment risk.

In general terms, a ‘stronger’ employer covenant would typically be resilient to market risks and able to provide significant financial support relative to the needs of the scheme over the medium-to-long term, whilst a ‘weaker’ employer covenant could face challenges in meeting scheme funding requirements or provide limited longevity of support.

Under the new funding code trustees will be required to formalise a long-term funding strategy to achieve a ‘low-dependency’ level of funding by the time the scheme has reached ‘significant maturity’. The point of significant maturity is calculated by the scheme’s actuary.

In layman’s terms, pension schemes are expected to have enough money to be self-sufficient (i.e. not expected to require further financial contributions from their sponsor) by the time most of their members are retired (significant maturity). What is deemed to be a self-sufficient level of funding and associated investment strategy will vary from scheme to scheme but the Pensions Regulator has indicated that the adoption of a weighted average discount rate above gilts 0.5% and/or an investment strategy targeting a higher level of growth assets is likely to result in greater regulatory oversight and review.

The strength of the employer covenant is a key element in informing the duration of the scheme’s funding strategy and the level of investment and funding risk taken at each valuation.

As in the existing regime, the employer underwrites any gap that arises between the assets and the estimated liabilities of the scheme.

The employer covenant is a measure of the employer’s ability to underwrite any such funding gap. It considers the ability of the employer – together with any contingent assets in favour of the scheme – to pay financial contributions to the scheme as and when required to address a funding gap, and by implication, to support funding and investment risk that could create or increase such a funding gap

Accordingly, in general terms, a stronger employer covenant permits the scheme to:

1. repair any shortfall faster - through the payment of deficit reduction contributions, and
2. to seek a greater level of investment return (at a correspondingly greater level of investment volatility and risk of downside) on its financial assets.

While there is an obligation on trustees to assess the covenant supporting their scheme, there is no requirement to take external covenant advice, provided trustees have sufficient independence and experience to undertake any required analysis themselves. This is consistent with the requirements of the previous funding regime.

However, the new regime does require trustees to understand and disclose elements of employer covenant with more granularity than the previous regime, particularly where the scheme is placing greater reliance on the employer covenant – i.e. to actively pay contributions or to underwrite investment risk.

Accordingly, we would anticipate that more trustees will seek (at least some) covenant advice. Where trustees are placing significant reliance on the employer covenant, external covenant advice is recommended.

Where trustees are unsure whether to take external covenant advice, we would recommended a discussion with your other advisors, or with a member of the ECPA.

Our members are committed to providing appropriate, proportionate covenant advice and will be able to support you in agreeing a suitable approach and budget for your circumstances.

The purpose of a covenant assessment remains largely unchanged – to determine the ability of the scheme’s sponsor, supplemented by other contractual obligations such as contingent assets, to meet contributions and underwrite investment risk. Any covenant assessment would be expected to cover the following elements:

• Covenant structure, including the identification of the sponsor(s) and any contingent assets, and the extent to which each supports the covenant
• Contextual information regarding the scheme, its current funding level and expected financial needs / journey plan.
• Financial analysis covering historical and forecast financial performance (profit and loss, cash flow) and position (balance sheet, debt structure, position on insolvency) of the sponsor(s) and where appropriate, the wider group
• An assessment of the sponsor’s prospects, which may include a review of its markets and its strategic position in those markets, and its potential resilience to market shocks.

Under the new funding code, an assessment will usually be expected to conclude on four key areas:

1. Covenant reliability, being the number of years that trustees may be reasonably certain of the sponsor’s cash flows to fund the scheme. For most schemes, this will be 3-6 years.
2. Covenant longevity, being the amount of time over which trustees can be reasonably sure that the sponsor will be able to support the scheme. For most schemes, this will be no more than 10 years.
3. Affordability of contributions, being the level of contributions that the employer might reasonably be able to afford to pay into the scheme to address a deficit. This is typically assessed by considering forecast free cash flows and liquidity, but only applies to schemes which still has a deficit.
4. Supportable risk, being a quantitative measure of the financial resources potentially available to the scheme over the reliability period, that could be used to address a downside funding event. This is typically a combination of ‘maximum affordable contributions’ or “MAC” (an aggregation of forecast free cash flows over the reliability period, less any agreed deficit reduction contributions) and contingent assets (a quantitative assessment of their potential value to the scheme during the reliability period)

Further detail on covenant reliability, covenant longevity, affordability and supportable risk can be found in the relevant section of this FAQ

Under the new funding regime, trustees will be required to consider if the employer covenant can adequately support the risks inherent in their proposed funding and investment strategy.

To be code compliant, a scheme should not take more investment risk than is supportable by their covenant; specifically the value ‘supportable risk’ (comprising MAC and contingent assets) must be greater than or equal to the estimated downside risk in the scheme’s investment strategy

The Pensions Regulator has indicated its support for the use of a downside investment risk measure based on Value at Risk, specifically a 1-in-6 Value at Risk as measured over the reliability period.

Further detail on supportable risk can be found in the relevant section of this FAQ.

As with the prior regime, covenant strength is not absolute but must be considered relative to the needs of the scheme.

In general terms, a stronger employer covenant might have significant levels of affordability combined with a long reliability period and/or valuable contingent assets, resulting in a higher value for ‘supportable risk’ relative to the needs of the scheme.

By contrast, a weaker employer covenant might have limited affordability and a short reliability period, with limited contingent asset value, resulting in a lower value for ‘supportable risk’ relative to the needs of the scheme.

There is no requirement for a covenant rating to be provided to the Pensions Regulator under the new regime.

However, trustees and sponsors may still value a covenant rating, typically to facilitate comparison with prior assessments.

Other reasons to provide a covenant rating could include, for example, the use of a previously agreed funding and investment methodology based on ratings, or the assessment of pre-agreed ‘triggers’ for the payment or release of contingent assets.

If you have previously taken covenant advice, the main change is likely to be in the conclusions of the covenant assessment, which will likely be focused on the key metrics of employer covenant - reliability, longevity, affordability and supportable risk - rather than a covenant rating (although a rating may still be provided).

All completed valuations are required to be submitted to the Pensions Regulator together with an agreed ‘statement of strategy’. Upon receipt, the Pensions Regulator will review these submissions and seek to engage with trustees over their valuation submissions where it considers appropriate.

To aid this process, the Pensions Regulator has set out a series of ‘fast track’ principles for scheme funding and investment strategy, which if met, permit a reduced level of disclosure in the statement of strategy and a reduced likelihood of regulatory engagement.

Broadly, the ‘fast track’ criteria set out a level of risk that the Pensions Regulator considers to be tolerable for an average scheme, with a correspondingly low expected likelihood of material loss to members arising through failure of the strategy.

If a scheme does not meet ‘fast track’ requirements then it is considered a ‘bespoke’ submission and faces increased disclosure requirements (including covenant information) and a greater likelihood of regulatory engagement. ‘Fast track’ schemes benefit from a lower level of disclosure (including covenant information). Furthermore, schemes that are considered ‘low-risk’ and/or those that are adopting ‘fast track’ assumptions and have fewer than 200 members require only limited covenant disclosures. Trustees should discuss with their advisors which pathway is appropriate for their scheme.

The ‘fast track’ and ‘low-risk’ criteria do not, however, override the requirements of the code. Trustees and sponsors will still be required to consider whether their proposed funding and investment strategy is compliant with the Funding code, even if it meets ‘fast track’ or ‘low-risk’ criteria.

Nevertheless, it may be reasonable to adopt a more proportionate covenant assessment where a scheme expects to submit a valuation in line with ‘fast track’ or ‘low-risk’ parameters, not least because it may be indicative of a reduced reliance on covenant.

If taking external advice, trustees should discuss their expectations and requirements with their covenant advisors to determine an appropriate and proportionate scope that is reflective of their needs yet meets the requirements of the funding code.

The extent of covenant advice required should be proportionate to the circumstances of the scheme, including the level of reliance that is being placed on covenant.

Where a high degree of reliance is being placed on covenant – and particularly if a high degree of reliance is being placed on contingent assets such as guarantees – it is possible that the cost of external advice may rise, due to increased reporting requirements and specificity of the advice required.

Conversely, where there is limited reliance on covenant, it may be possible to focus the scope of any assessment on the key areas of risk relevant to the scheme (such as covenant longevity for well-funded scheme looking to run on), with a corresponding impact on costs.

As a general rule we would recommend that trustees seek training on the requirements of the new funding code from their advisory team, ahead of the commencement of any valuation.

If the trustees do not have a retained covenant advisor, we would recommend speaking to a member of the ECPA about the provision of covenant specific training.

Covenant training should be expected to cover not just the basics of the new regime but also identify any particular areas of your covenant that are likely to be impacted, for example whether a change in the trustees’ approach to considering contingent assets may be required.

In addition to requesting training, trustees may also wish to consider the following ahead of undertaking a covenant assessment, given the expected interaction with any employer covenant advice:

• Understanding the new requirement to set a Funding and Investment Strategy (FIS) targeting low dependency by significant maturity.
• Reviewing their scheme’s projected maturity date and current funding position.
• Beginning discussions with sponsors and advisers about journey planning, investment strategy and affordability
• Considering whether a bespoke or fast track valuation approach is appropriate
• Assessing the level of reliance expected to be placed on employer covenant and engage with your covenant adviser as to how the extent of this reliance, together with the valuation approach, impacts the scope of covenant work needed.
• Prepare for the new Statement of Strategy disclosure requirements.

As a general rule we would recommend that sponsors seek training on the requirements of the new funding code from their advisory team or a member of the ECPA, ahead of any valuation being commenced. A cost effective approach would be to attend any training organised for the trustees.

Covenant training should be expected to cover not just the basics of the new regime but also identify any particular areas of your covenant that are likely to be impacted, for example whether a change in approach to considering contingent assets might be required.

It will be particularly important for sponsors to understand the extent to which additional disclosures such as forecast financial information may be required, or where the new code will require assessment of different entities than may have been the case in prior valuations (for example, where trustees may have adopted a consolidated approach in prior valuations due to the existence of a guarantee, but are now required to look at sponsor entities individually)

In addition to requesting training, sponsors may also wish to consider the following ahead of any valuation commencing:

• Understanding the implications of the new code on recovery plans and investment risk.
• Engaging early with trustees to agree a proportionate approach to covenant assessment.
• Preparing an information pack for the trustees, comprising details such as group structure, financial structure and financial forecasts
• Reviewing cash flow forecasts and the affordability of contributions
• Considering management’s own views on reliability and longevity periods

Proportionality refers to the principle that the level of scrutiny, governance, and regulatory expectations should match the size, complexity, and risk profile of the pension scheme.

There are nearly 50 references to being ‘proportionate’ in the covenant guidance. The Funding Code is clear that “trustees are required to carry out an employer covenant assessment to understand the extent to which the employer can support the scheme now and in the future” and that at a minimum all schemes should assess covenant support at each valuation. Dependent on the assessment of the employer covenant, “more risk can be allowed for where the scheme has access to sufficient employer cash flows and contingent assets to support this level of risk”.

Therefore, whilst covenant must be considered by trustees in determining their funding strategy, the depth of any assessment should reflect the specifics of the scheme and sponsor’s situation, including funding level, relative size, complexity etc.

In particular, the trustees’ assessment of covenant should be proportionate to the level of reliance placed on the sponsor for contributions and to underwrite investment risk. Where a high degree of reliance is being placed on the covenant, trustees should consider undertaking a more detailed assessment; where reliance is lower, trustees may decide that a higher level approach is sufficient.

This approach focuses on efficiency – with less analysis and documentation and the main focus on the conclusions.

Less Proportionate / More Detailed Approach

Such an approach might be adopted when:

1. The scheme is underfunded or has significant investment risk.
2. The covenant is weak or uncertain, or there’s limited visibility on future support.
3. The sponsor is undergoing change, such as restructuring, refinancing, or ownership transition.
4. There are complex funding arrangements, contingent assets, or group interdependencies.
5. The scheme is large or mature, with underfunded liabilities and member exposure.

This approach involves deeper analysis, consideration of the sponsors prospects in more detail, and more robust documentation to support conclusions.

Although the funding code and covenant guidance allude to adopting a proportionate approach or seeking advice, the use of external advice can be proportionate and focused on the needs of the scheme.

Most covenant advisors will be able to adjust their scope of work to deliver an assessment that meets the needs of their client in a proportionate and cost-effective manner.

Proportionate Covenant Review

A more proportionate review would be suitable where schemes are well-funded, with limited reliance being placed on the employer covenant to meet contributions, underwrite investment risk or to support a long-term journey plan.

Typical features of a proportionate covenant assessment:

• Desktop review principally using publicly available financial information (including equity analyst forecasts and credit rating information if available) and taking any forecasts largely at face value
• High-level financial analysis (e.g. EBITDA, net assets, cash flow trends).
• Potential focus on sponsor longevity risks rather than affordability, particularly where scheme is well funded with minimal requirement for DRCs
• Short summary report with key conclusions.

Typical uses:

• Small scheme, strong covenant, stable covenant, aiming for Fast Track compliance.

Detailed Covenant Review

A more detailed covenant review would be suitable where schemes remain materially reliant on their sponsor to meet contributions, underwrite investment risk or support a long-term journey plan. This is appropriate for higher-risk schemes, complex sponsors, or where Bespoke funding strategies are being adopted.

Typical features of a detailed covenant assessment:

• Full financial analysis including forecasts, debt schedules, and liquidity.
• Stress testing and scenario analysis (e.g. insolvency impact).
• Greater focus on prospects to support conclusions.
• Review of contingent assets or guarantees.
• Report with greater levels of analysis to support conclusions and potential follow on actions.

Typical uses:

• Large or underfunded scheme, complex covenant structure (e.g. multi-employer or high degree of reliance on contingent assets) or, sponsor undergoing change. To support Bespoke funding strategies.

The information required from trustees is largely unchanged from the previous regime, comprising documents such as the most recent scheme return, valuation, funding updates, recovery plan, statement of contributions, details of contingent assets, key correspondence with the sponsor and the Pensions Regulator etc.

However, if available, then an understanding of the following items would prove useful in terms of forming a suitable scope of work for covenant assessment:

• An understanding of the Trustees’ long-term objective for the scheme (i.e. achieving low dependency levels of funding with a view to buy-in/buy-out, run on, for surplus or otherwise or entry into a consolidator) together with the journey plan to get the scheme to this objective together with the associated funding requirements.
• An idea of whether the valuation approach will be bespoke or fast track.
• A measure of VAR on a 1-in-6 basis.

Management should continue to expect similar information requests as under the previous regime - statutory and management accounts, profit and cash-flow forecasts and balance sheet data with borrowing-covenant compliance and sensitivities, where available and proportionate.

The new Funding Code places greater emphasis on forward-looking information. Forecast quality, time horizon, and sensitivity analysis are central to assessing employer prospects and covenant reliability. Trustees may therefore request more detailed and longer-term projections where proportionate, especially where covenant reliance is material.

Free-cash-flow assessment (for affordability and MAC) requires distinguishing necessary vs. discretionary uses of cash, meaning cash-flow scrutiny will increase where proportionate to scheme risk and reliance. Trustees will be expected to understand income and expenditure flexibility, in particular the extent to which significant expenditures such as capex, debt repayment and dividends are discretionary.

Understanding the employer’s market, competitive position, structural or regulatory changes, and growth strategy remains essential. Trustees will supplement any insights from management with market intelligence and adviser research. Trustees will be expected to identify and consider future risks to the business that rise from both intrinsic (e.g. refinancing) and extrinsic (e.g. regulatory change) factors.

For sponsors within wider groups, trustees are likely to require clarity on intra-group arrangements (treasury, transfer pricing, cash-pool flexibility), given their impact on liquidity and cash-flow visibility.

For non-standard covenant e.g. not-for-profit sponsors, it will be important to understand the business’ funding model and expenditure profile

Trustees must ensure that recovery plans (used to address scheme funding shortfalls) are aligned to what is reasonably affordable by the employer. Employers should address the scheme’s deficit as quickly as they can reasonably afford while not placing undue financial stain on the employer.

An assessment of affordability should start with an employer’s forecast “free cash flow”. This is a measure of how much cash is generated by the sponsor in a given year that can be used for discretionary purposes, such as investment capex, dividends, or deficit reduction contributions. In other words, it reflects total cash inflows from operations, less non-discretionary outflows required to support continued trading, such as salaries, materials, working capital, tax, interest and maintenance capex.

In addition to forecast cashflows, an affordability assessment can also include liquid assets, such as balance sheet liquidity and headroom in borrowing facilities. To comply with the new funding code, affordability should be sufficient to fund the scheme’s TP deficit within the period of covenant reliability.

If the employer cannot reasonably afford its recovery plan within the period of covenant reliability, then the employer could provide an appropriate contingent asset that could be used to either extend the period of covenant reliability or reduce the TP deficit (but not both).

Maximum affordable contributions (or “MAC”) represent the aggregate of cash flows the employer is expected to generate over the reliability period that could be used to remedy a deficit arising from a downside funding event.

MAC is similar to the assessment of reasonably affordability but is calculated after allowing for ‘reasonable’ alternative uses of cash such as growth capex and/or dividends, and after deducting any agreed DRCs.

Unlike affordability, MAC typically excludes balance sheet liquidity, unless explicitly committed towards paying contributions.

In many cases – particularly those where cash inflows are relatively stable and limited to operations - an initial assessment of MAC might be simplified to an aggregation of forecast net cash flow (after DRCs) over the reliability period. This approach is both simple and prudent, as it effectively deducts all forecast cash outflows rather than making a judgement over which are ‘reasonable’. If required, more work could then be undertaken to refine the analysis by considering the reasonableness of expenditure items.

Balance sheet liquidity factors into an assessment in several areas:

• The greater the balance sheet liquidity (balance sheet cash, liquid deposits and headroom in committed borrowing facilities) the greater the financial resilience of the employer, as it has an enhanced ability to withstand financial and trading shocks. This would feed into the employer’s assessment of prospects which influences conclusions on covenant reliability and longevity periods
• Access to liquid assets might enhance an employer’s affordability of deficit repair contributions to fund the scheme’s TP deficit within the period of covenant reliability
• If an element of the liquidity is committed in favour of the scheme then this element of balance sheet liquidity may be included in the assessment of Maximum Affordable Contributions

The extent to which an employer can provide a reasonable expectation of its trading and cash flow into the future is an important factor in assessing affordability and MAC, with the latter in particular being calculated over the length of the reliability period.

Where only limited forecasts are available, this could be an indicator of limited visibility over future profits and cashflows, and consequently a reduced level of comfort over affordability and reliability.

Depending on other circumstances however, a very short forecast period – say one year - may not necessarily dictate a commensurately short period of reliance.

If there are sufficient indicators of stability in the employer’s markets and product portfolio, and evidence of historical forecasting accuracy, together with reasonable assumptions as to growth or maintenance of financial results; and absent any other major potential disruptions to trading such as a potentially difficult refinancing or contract renewal, it may be possible to gain adequate comfort over future financial results.

Although any conclusions would need to be caveated to reflect the lack of forecast information, such an may not be unreasonable when covenant reliance is relatively low.

However, where the broad assumptions adopted produce forecast cash flows which are not supported by the historical context of the employer’s recent financial performance, Trustees be cautious and apply prudence where appropriate.

Should an assessment of forecast information identify vulnerabilities in the forecast which, if they were to crystallise, could impact the assessment of reliability and consequentially MAC and/or affordability, or there is a historic of poor forecasting accuracy, it may be appropriate to request sensitised forecasts from management, or request that your covenant advisor sensitises the provided forecasts.

It may then be reasonable to curtail the period of reliability at the point where the base case and sensitised cash flow forecasts diverge materially from each other.

Alternatively, if the sensitised forecast presents results which are more justifiable in the historical context, a more prudent position could be adopted where the reliability period and projected affordability are based on the sensitised forecasts, as these forecasts are considered more reliable overall than the base case.

Where a more proportionate approach is adopted in the assessment of covenant, this would also be reflected in the assessment of MAC and affordability. In such circumstances, the assessment might reflect the following features:

• A focus on headline financial metrics (e.g. EBITDA, net cash flow).
• Reliance on historical cash flow patterns and simple forecasts or market forecasts, supported by management commentary where available
• No detailed stress testing or scenario modelling.
• Brief documentation, , with a clear rationale for the approach.

This is the amount of time over which trustees can reasonably certain of the employer’s cash flows to fund the scheme. If the scheme has a TP deficit then, ideally, it should be funded within the period of covenant reliability – i.e. any recovery plan should not be longer than the reliability period, subject to affordability.

The reliability period is inherently a forward looking assessment, representative of the confidence that may be placed in the employer’s future cash flows.

Any assessment will therefore consider a range of factors, including the stability and resilience of the employer’s business model and markets, the assumptions supporting the employers forecasts, the historical accuracy of forecasting and the employer’s financial structure.

The Pensions Regulator expects covenant reliability to typically not be more than one to two valuation cycles (i.e. 3 to 6 years)

The new Funding Code focuses heavily on forward looking information, particularly profit and cash flow forecasts. The time horizon covered, and the historical accuracy of forecasts, together with management’s view of any sensitivities to the forecast are one of the central components of assessing covenant reliability.

Any assessment will also need to consider wider factors such as the employer’s operating and financial structure, its strategy for growth and the stability and growth prospects of its markets.

A business that is able to demonstrate robust forecasting, a clear strategy that is consistent with its market and strong control over risk would generally have a longer reliability period.

A business with more limited forecasts or in a more volatile industry would be expected to have a shorter reliability period, with reliability potentially also shortened by known structural, operational or market factors in short to medium term; examples could include a significant refinancing, expiry of a major contract or regulatory changes.

The shorter the forecast period, the shorter one might expect the period of covenant reliability to be, especially where management itself is not willing or is unable to provide a view as to what its future profits and cash flow might be.

Any known factors might limit covenant reliability – e.g. a potentially problematic refinancing and/or significant market or regulatory change, or the end of a significant contract with limited evidence to support renewal.

The covenant reliability period can arguably be longer than 6 years if the employer has stable, predictable cash flows (e.g. through long term contracts) and strong financial resilience. However, the Pensions Regulator has said it would expect any reliability period of more than 6 years, or longevity periods of more than 10 years to be supported by evidence and analysis of commensurate depth.

The reliability period defines the timeframe over which trustees can assume employer support for additional investment risk in excess of that inherent in the trustees’ low dependency investment strategy.

It reflects the period over which Trustees can assess the Maximum Affordable Contributions, with longer reliability periods generally resulting in higher MAC and consequently the ability to support more downside risk.

Longevity is the amount of time over which trustees can be reasonably sure that the employer will be able to continue to support the scheme. In other words, while you might not have reasonable certainty over employer cash flows outside of the reliability period, you can be reasonably certain that the covenant will continue to exist for the longevity period.

Ideally the longevity will extend to, or beyond the date of the scheme’s significant maturity, at which point it should be funded to a low dependency level.

The factors to consider are similar to the reliability period but reflect more material risks to the employer’s viability (e.g. material regulatory change, end of a franchise, ability to withstand shocks in the market/economy).

An assessment of longevity is likely to reflect information from a range of sources, including a sponsor’s or group parent accounts, other sponsor disclosures such as TCFD reports or regulatory filings, industry reports, analyst reports, credit ratings and the in-house knowledge and expertise of the assessor.

For particularly complex covenants, a covenant assessment may be supplemented by bespoke analysis from economic or sector experts, or input from an industry expert.

A number of analysis tools may also be used to consider longevity, including well known approaches such as SWOT, PEST and Porter’s five-forces, alongside proprietary approaches considering a range of risk factors.

The Regulator doesn’t expect longevity to, generally, be more than 10 years.

Covenant longevity would be expected to be at least as long as covenant reliability.

Shorter longevity periods might typically be seen in a declining industry, where the market is highly competitive or where there is material future uncertainty for the business, for example due to changing regulations, the expiry of a large contract or a challenging refinancing requirement etc. Longer longevity periods are more likely to be seen in a stable business with low disruption risk and long-term contracts with high barriers to entry.

The Pensions Regulator has stated that it would expect longevity periods of more than 10 years (and reliability periods of more than six years) to be supported by market and financial analysis of commensurate depth.

It is inherently judgment-based, so trustees should apply prudence and document their conclusions and rationale for them.

The Pensions Regulator acknowledges that assessing longevity is not a precise science. Trustees are expected to:

• Use reasonable assumptions based on available evidence.
• Document their rationale clearly.
• Review longevity assessments regularly (typically every three years or at each valuation).

A contingent asset is a commitment due to the scheme that only crystallizes in certain circumstances, for example on the insolvency of the sponsor.

Contingent assets may take many forms such as guarantees, asset security, money held in trust or even just an agreement to pay additional funding contributions in the event of certain criteria being met.

Contingent assets form part of the employer covenant. They are in addition to the commitments of the sponsor set out in statute and the scheme’s trust deed and rules.

When considering the level of investment risk that is supportable by the employer covenant (the ‘supportable risk’), the value of contingent assets in the scenario in which they may be called can be considered in addition to the value of the sponsor’s available cash flows (‘maximum affordable contributions’)

A typical scope for covenant advice would be expected to consider both sponsor cash flows and potential contingent assets.

However, a detailed assessment of the value of contingent assets that might be used to underwrite investment risk could represent a significant additional cost, particularly where their value (or the circumstances under which such value may be realised) is potentially uncertain.

Accordingly trustees may wish to take a proportionate, phased approach to the assessment of contingent assets, with a detailed valuation only commissioned if it is expected that the value of contingent assets will be critical to the agreement of the schemes’ funding and investment strategy.

Specialist advice may be required to value some contingent assets, for example the underlying value of property or other assets over which the trustees have security.

Legal advice may also be required in considering the circumstances in which content assets may crystallize and/or their enforceability. Where the value of a contingent asset is subject to factors such as funding level or investment risk, input from your actuarial and/or investment advisers may also be needed.

Your covenant advisor will be able to inform you when such advice may be necessary.

The regime proposes different treatment for two main types of guarantee.

Where a guarantee includes “look through” provisions, which allows for the affordability of the guarantor to be taken into account for the setting of contributions to a scheme, the guarantor is effectively treated as an additional sponsor. Any covenant assessment would therefore consider the guarantor’s cash flows and prospects as if it were a sponsor. The guarantors cash flows over its reliability period would therefore be included in the assessment of ‘MAC’ for the purposes of assessing the level of risk supportable by the employer covenant.

Where a guarantee does not include look through provisions and only crystallizes in the event of non-payment or sponsor insolvency – known as an “underpin” guarantee – it does not permit the cash flows of the guarantor to be assessed as part of MAC. The value attributable to the guarantee should instead reflect the likelihood and timing of it being called and the quantum that might be expected to be realised at that point in time. For employers where the likelihood of insolvency is remote, it may not be appropriate to place material value on such guarantees.

We would anticipate that the Pensions Regulator is likely to ask trustees and sponsors to justify any decision to place significant reliance on guarantees in reaching funding and investment decisions.

The treatment of guarantees was not prescriptively set out under the previous regime, however the practice of equating covenant strength to that of the guarantor was widely adopted for underpin guarantees that covered both non-payment and insolvency protection up to the full s75 debt (e.g. PPF compliant s75 guarantee).

Under the new regime, such an approach would only be permitted where the guarantee also benefits from a ‘look-through’ provision.

The extent of any assessment should be proportionate to its requirement. If the trustees and sponsor expect to rely heavily on the valuation of a contingent asset in supporting their choice of funding and investment strategy, a more comprehensive assessment may be necessary.

Conversely, if the trustee’s strategy can be supported by the sponsor alone, without recourse to relying on contingent assets, it may not be necessary to undertake more than an initial, high-level assessment.

As a minimum, all trustees will need to confirm whether they consider their employer covenant to be ‘adequate’ to support the agreed funding and investment strategy. Whilst trustees have agency to consider how they interpret ‘adequate’, a key principle under the code is that the level of investment risk being run by the scheme (VAR on a 1-in-6 basis over the reliability period) is supportable by the employer covenant (as measured by reference to ‘maximum affordable contributions’ and contingent assets).

Where a scheme is both small (<200 members) AND adopting a fast track approach or classed as “low-risk”, no further covenant information will need to be provided in the statement of strategy beyond this confirmation. Nevertheless, the trustees will need to be satisfied that they have undertaken – and can evidence - sufficient work to support this conclusion. ”Low-risk” schemes are defined as schemes following a Fast Track approach that have either secured full benefits with an insurer or have a surplus on a low dependency funding basis after an immediate Fast Track stress test, or those following a Bespoke approach which have reached their relevant date and have a surplus on a low dependency funding basis after an immediate Fast Track stress test.

For all other schemes, trustees will be required to disclose further information including their assessment of the covenant reliability and longevity periods, maximum affordable contributions and the value of any contingent assets (to the extent relied upon).

For a bespoke valuation (that is not classed as “low-risk”) the disclosure requirements in the statement of strategy covering actuarial, investment and covenant are extensive, and trustees will be required to provide more detailed evidence of their covenant analysis, including a minimum of three years of cash flow analysis to support their assessment of maximum affordable contributions.

A small scheme (<200 members) adopting a fast track approach is still required to confirm whether the employer covenant is ‘adequate’ to support their funding and investment strategy.

In particular, while the adoption of ‘fast track’ parameters may indicate that the scheme has a lower reliance on covenant, the sponsor may still be required to underwrite deficit reduction contributions for up to six years and some level of investment risk for the remainder of the scheme’s journey plan.

Accordingly, despite the reduced disclosure requirements for such schemes, the trustees are still expected to have assessed the covenant in line with the requirements of the Funding Code and documented their conclusions, for example to ensure:

• that an employer is expected to have sufficient MAC to support the Scheme’s risk if the scheme hasn’t yet fully adopted its low risk dependency investment strategy and funding basis;
• the covenant reliability is sufficiently long for the scheme to achieve full funding on its low dependency basis;
• the employer has sufficient affordability to meet the contributions required over the period of reliability
• the covenant longevity is sufficient for the scheme to achieve full funding on its low dependency basis.

If the Trustees do not have sufficient experience or independence to make this assessment themselves, they should consider taking proportionate external advice.

No, neither the Funding Code nor the related covenant guidance explicitly cover transactions.

Trustees and sponsors should continue to assess the impact of corporate events on the employer independently of funding negotiations, with a view to agreeing appropriate mitigation where necessary.

Nevertheless, a strong understanding of the funding code is likely to be beneficial during such discussions – particularly in connection with mitigation – to ensure that the potential impact of the transaction and any associated mitigation on future valuations is understood.

For example, whilst the trustees and sponsor may agree that the provision of a parent guarantee adequately addresses any detriment arising from a transaction, a negative impact on sponsor cashflows could still result in the trustees adopting a more prudent funding and investment strategy at the next valuation in order to remain compliant with the Funding Code.

In this case, a strong understanding of the Funding Code would ensure both trustees and sponsor had clarity over the value of any mitigation agreed, not just in connection with the transaction, but also the forthcoming valuation.

Just because a scheme meets fast track criteria does not mean it no longer relies upon the employer covenant – indeed it may rely heavily on the employer, with a recovery plan of up to six years and many further years beyond that where the employer would be expected to support downside funding risk. Furthermore, regulatory tests for material detriment reference Section 75 debt positions and can capture a broad range of corporate activity. Corporate activity can also drive a change in covenant which may require Trustee consent, such as the release of a guarantee or Flexible Apportionment Arrangements.

The extent of any assessment trustees take in connection with corporate events should continue to be actively considered by reference to the specific circumstances of the scheme and situation.

The Funding Code is primarily focused on the end-game position for schemes, aiming for schemes to be fully funded to a low dependency level by the time they are significantly mature. One of the features of a low dependency basis acceptable to the Pensions Regulator is that there should be low funding volatility and a high probability of the scheme not requiring further contributions from the employer. The inference being that, once low dependency funding is achieved, investment returns alone over time can be expected to achieve the trustees’ long term objectives for the scheme, be that run on, buy-in followed by buy-out or an alternative risk transfer solution (e.g. a superfund). Nevertheless, employer covenant still remains important, as employer insolvency prior to securing members benefits can result in a shortfall to members.

As was the case under the previous funding code, trustees should consider the strength of their existing employer covenant in considering the relative merits of various end-game options.

The pursuit of a run-on strategy, whether in the short term whilst preparing for a risk-transfer, or as a longer term objective, is effectively simply a continuation of the status quo. Accordingly, the strength of the employer covenant should be a key factor to consider in taking any decision to run-on, whether to the point that the last member dies or as a bridge to an eventual risk-transfer.

Under the new funding code, a scheme that has reached significant maturity is expected to maintain a strong funding level, in line with a low dependency funding target. Whilst this would typically be associated with a lower risk investment strategy, a scheme supported by a strong covenant could theoretically choose to pursue a higher return strategy with a view to generating surplus that could enhance member benefits and/or be returned to the employer on the eventual wind-up of the scheme.

Provided the employer covenant could support the downside risk, and appropriate protections are put in place, such a strategy would appear justifiable under the requirements of the code, subject to broader considerations such as trustee and sponsor risk appetite, scheme maturity etc.

Under the draft Pension Schemes Bill, trustees will be granted the power to distribute a surplus from the scheme pre-wind up, provided that the scheme meets certain funding requirements. In considering whether to exercise such power, the Regulator’s June 2026 statement makes it clear that assessment of employer covenant is likely be a critical factor in any decision, with a strong and robust covenant necessary to underwrite the risk of a subsequent shortfall arising. Trustees will need to consider this developing legislation alongside the requirements of the new funding code.

Disclaimer

Any reference to ‘ECPA’ or the ‘Employer Covenant Practitioners Association’ in this Guidance paper refers to The Employer Covenant Practitioners Association Limited, a Company Limited by Guarantee Number 9915768. The information contained on this page (the 'Information') reflects the views and opinions of the ECPA at August 2026. The information is intended as guidance only and nothing contained within this document is to be taken, or relied upon, as advice. Every effort has been made to ensure that the information is accurate, but the ECPA makes no warranties, representations or undertakings about any of the Information (including, without limitation, any as to its quality, accuracy, completeness or fitness for any particular purpose). This document is not a full and authoritative statement of the distressed situations that could impact on defined benefit pension schemes and you should not rely on it as such. The ECPA cannot and does not accept any responsibility, liability or duty or care (whether in contract, tort (including negligence) or otherwise) to any party for any action or omission taken by you or any party in relation to the Information. Any reliance you place on the Information is solely at your own risk.

The ECPA is comprised of member representatives of firms that provide covenant advisory work in the UK and its membership may change from time to time. A list of current members is available on the ECPA’s website, www .ECPA.org.uk. The ECPA does not purport to represent, and should not be taken as representing, the views of individual members or their firms.

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