Employer covenant

This code of practice applies to activities related to valuations with effective dates on and after 22 September 2024. For activities related to valuations with effective dates before 22 September 2024, refer to the 2014 DB funding code (PDF, 401kb, 51 pages).

1. A scheme’s journey plan is its planned progress in accordance with the funding and investment strategy as it moves towards the relevant date.
2. To determine the actuarial assumptions that would be appropriate for calculating the liabilities of a scheme during this period, trustees must take into account in a proportionate way the employer covenant. In particular, that the level of risk that can be taken should be:
   1. dependent on the trustees’ assessment of the employer covenant, where more risk can be taken where the scheme has access to sufficient employer cash flows and contingent assets to support this level of risk
   2. subject to the above, dependent on how near the scheme is to reaching the relevant date
3. This section sets out how we expect trustees to assess the employer covenant. This assessment should be proportionate to the specific circumstances of the scheme and employer. The journey planning section gives more details of this proportionality.

Covenant assessment

4. An assessment of the employer covenant must consider:
   1. the financial ability of the employer, in relation to its legal obligations to the scheme, to support the scheme
   2. the expected scheme support from any contingent assets to the extent the trustees reasonably expect these to be:
      • legally enforceable, and
      • sufficient to provide the specified level of support when required
5. Trustees must consider the following matters when assessing the employer’s financial ability to support the scheme:
   1. the employer’s current and expected future cash flow
   2. other matters that are likely to affect the employer’s future ability to support the scheme, including but not limited to the performance, future development, and resilience of the employer(s) business, and the likelihood of an employer insolvency event¹ occurring (the employer’s prospects)
6. When assessing the employer’s financial ability to support the scheme, trustees or managers of the scheme must consider:
   1. how long they can be reasonably certain that they can rely on an assessment of the employer’s cash flows and prospects, and in doing so determine the period over which they have reasonable certainty over the employer’s cash flow to fund the scheme (the reliability period)
   2. how long they can be reasonably certain that the employer will be able to continue to support the scheme (covenant longevity)
7. The nature of the trustee’s covenant assessment will depend on the circumstances of the scheme and employer, and must be considered relative to both the scheme’s:
   1. low dependency deficit
   2. solvency deficit
8. For employers where insolvency is highly unlikely over the short to medium term, the employer support relative to the low dependency deficit will help the trustees understand the support available for their journey plan. The higher the risk of insolvency, which would trigger a debt due under section 75 of the Pensions Act 1995², the more weight there should be on employer support relative to the solvency deficit.

General principles and expectations

9. 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. In general, trustees should focus on the ability of the employer to make cash contributions to the scheme to eliminate any funding deficit and address downside investment risk. Contingent assets can also be valuable where the trustees can evidence that the contingent asset is reasonably expected to be legally enforceable and will be sufficient to provide a specified level of support when required.
10. At a minimum, we expect trustees of all defined benefit (DB) schemes to assess covenant support at each valuation. However, the required depth and frequency thereafter of an assessment should be proportionate to the circumstances of the scheme and employer. The approach taken should be documented and trustees should be able to justify why it is reasonable and appropriate.
11. The covenant should be assessed in the context of, and relative to, the scheme’s funding risk. Trustees should consider the following factors:
    1. the size of the scheme’s assets and low dependency liabilities relative to the covenant support.
    2. the level of investment and funding risk, providing an indication of how the scheme’s funding requirements and reliance on covenant support could change over time with changes in market and financial conditions.
    3. the maturity and the expected cash flows of the scheme, as this will affect the timing of the scheme’s reliance on the covenant.
12. Even schemes that are fully funded on a low dependency funding basis remain exposed to covenant risk if funding levels deteriorate or if there were to be an unexpected employer insolvency event. Consequently, trustees should continue to monitor the covenant once low dependency has been reached, before and after the relevant date. In general, given the well-funded position of the scheme, we would expect any assessment to be light touch and should aim to identify any material risks that could lead to the scheme not providing promised benefits to members.
13. We expect employers (and, where relevant, third parties that have provided contingent assets) to provide trustees with the information required to assess the covenant³. If appropriate information is not provided, trustees are unlikely to be able to demonstrate how the covenant can support the risks the scheme is taking. Consequently, where appropriate, trustees should reduce their reliance on covenant when setting investment and funding strategies in their funding and investment strategy.

The financial ability of an employer to support the scheme

Identifying employers

14. Trustees should identify which entities are employers for the purposes of Part 3 of the Pensions Act 20044.
15. Entities that are not employers for these purposes (with the exception of certain non-statutory employers as described in paragraph 16 of this module below) should not be directly considered when assessing the employer covenant. However, where the employer’s financial performance is heavily dependent on a third-party or group obligation (for example under a cost-sharing agreement), or the overall performance of the wider group, trustees should consider the implications of this when assessing an employer’s cash flow forecasts and prospects.
16. Some schemes may have non-statutory employers with direct funding obligations to the scheme under their scheme rules. Trustees should assess the legal obligation of any non-statutory employer to provide support to the scheme when it may be required. This will determine whether it is appropriate to take the covenant support provided by the non-statutory employer into account when assessing affordability or overall covenant support to the scheme, or both.
17. If a group entity or other third party provides contractually-binding support directly to the scheme, this may amount to a contingent asset. This should be considered as set out in the section on contingent asset support further down in this module of the code.

Assessing the employer’s current and future cash flow

18. An assessment of the employer’s current and future cash flow will help trustees determine the following.
    1. The level of cash over the employer’s reliability period that could be paid to the scheme, if required, to remedy any deficit from a downside scenario (known as maximum affordable contributions). This should feed into trustees’ decisions around the level of risk that is supportable by the employer covenant when setting the scheme’s journey plan. The journey planning module has more details on this.
    2. What deficit repair contributions (if required) are reasonably affordable. The recovery plan module has more details on this.
19. Trustees’ assessment of the employer’s cash flow should primarily be based on management forecast cash flow information rather than historic cash flow information.
20. An employer’s cash flow means the free cash flow generated by the employer after taking account of reasonable operational and committed finance costs (for example, utility costs, essential maintenance, staff costs, committed debt service costs), but before deficit repair contributions to the scheme or other possible uses of free cash, as set out in the recovery plan section. These include:
    1. investment in the sustainable growth of the employer
    2. payments that result in covenant leakage
    3. discretionary payments to other creditors
21. The employer’s cash flow should also be considered before contributions made to other DB schemes sponsored by the employer. Although these payments may already be agreed under a schedule of contributions, if cash is not allocated fairly between DB schemes, one scheme might be favoured over another.
22. Trustees and the employer should work together to make the above adjustments.
23. When reviewing the reasonableness of employer cash flow forecasts, trustees should be mindful of the employer’s position in its wider group, its interactions with other group companies (for example through transfer pricing, intragroup trading and/or intragroup financing) and the impact this may have on cash flows.
24. Trustees should consider the appropriateness of management assumptions underpinning the employer’s cash flow forecasts (relative to the risks and opportunities identified when assessing the employer’s market and overall prospects, as discussed below) and the sensitivity of these assumptions to future events, making appropriate adjustments where necessary.
25. Where cash flow information is not produced for the employer (or it is not proportionate to produce for covenant assessment purposes), trustees should work with the employer to find a suitable proxy (for example, earnings before interest, tax, depreciation and amortisation (EBITDA), profit before tax or consolidated cash flow), adjusted as necessary to best reflect the employer’s cash flow position.
26. Where the employer’s cash flow is cyclical or subject to variance, trustees should consider using an average free cash flow over an appropriate period.
27. Trustees should consider employer cash flows beyond the forecast period, with reference to the trustee’s assessment of the employer’s prospects.

Assessing an employer’s prospects

28. An assessment of the employer’s prospects will help trustees determine the extent and duration of reliance that can be placed on the employer to continue providing scheme support and will highlight the risks to that support deteriorating. This will feed into trustees’ assessment of the reliability period and covenant longevity, as outlined below, and will ultimately feed into trustees’ decision making around journey planning.
29. The matters the trustees should proportionately consider when assessing the employer’s prospects are as follows.
    1. The employer’s market outlook
       1. All material markets in which the employer operates, in terms of the relevant product or service market and the geographical market.
       2. General market trends (for example whether it is a growing, stable or declining market, whether it is cyclical), the economic outlook for the countries that the employer or group operates in, and any potential risks to these markets.
       3. Current regulatory requirements and expected future developments.
    2. The employer’s position within its market
       1. The employer’s current market position, the key strengths and weaknesses facing the employer, and how these may impact the employer’s market position in the future.
    3. The strategic importance of the employer within its group (if applicable)
       1. The employer’s position within the group and its interactions with other group companies.
       2. If the employer has strong operational or financial ties to the wider group, or the risks and opportunities associated with the wider group.
    4. The diversity of the employer’s operations
       1. The products or services offered by the employer, the regions and markets they operate in, and the reliance or diversity of key customers and suppliers of the employer.
    5. Environmental, social and governance (ESG) factors
       1. Whether the employer’s business model is resilient to a transition to a low carbon economy.
       2. Other ESG-related risks and opportunities facing the employer and how these may impact on the employer’s prospects.
    6. The resilience of the employer and the wider group (where applicable)
       1. The ability of the employer (and where applicable the group) to withstand market shocks or unanticipated events based on:
          1. the employer’s balance sheet, capital structure and other financial information
          2. the group’s financial resources to the extent that these are available to support the employer
          3. other non-financial indicators of resilience
    7. The risk of an employer insolvency event
       1. The employer’s insolvency risk and the likely flow of value to the scheme at the time of an insolvency event.
       2. We expect trustees to take into consideration the matters, as set out above, in determining the likelihood of an employer insolvency event.
       3. The level of detail should be proportionate to the risk of insolvency, and the reliance placed by trustees on realising value from assets to fund the scheme and support risk.
       4. Where insolvency is deemed highly unlikely over the short to medium term, less scrutiny and weighting should be placed on the outcome to the scheme in such a scenario. Conversely, the higher the risk of insolvency, or where trustees place significant reliance on realising value from assets to fund the scheme and support risk, trustees should undergo a more extensive exercise to demonstrate with reasonable certainty what value would flow to the scheme.
    8. Any other relevant factors
       1. Other factors (including more general macroeconomic and geopolitical factors) that may be relevant to the circumstances of the employer’s business or market that may impact on the employer’s prospects.
30. Trustees should consider how these matters might affect the reasonableness of the employer’s forecasts, and the employer’s profitability, cash flow generation and balance sheet strength (including financing arrangements) beyond the forecast period.

Assessing the reliability period and covenant longevity

31. An assessment of the employer’s financial ability to support the scheme is primarily forward-looking and should consider the following:
    1. The period over which trustees can be reasonably certain of the employer’s cash flow to fund the scheme (the reliability period)
       • When assessing the reliability period, trustees should consider the employer’s current and forecast cash flows, to the extent that these are available and deemed reasonable, and the employer’s prospects. This includes (but is not limited to) assessing the stability of the employer’s market and its position within that market, its capital structure and overall resilience, and any foreseeable events that may reduce the level of certainty over future cash flows, either on a standalone basis or cumulatively. Such events may include a material refinancing or a potential change in regulations that could negatively impact the employer’s market.
       • Most employers will only have reliability over the short to medium term (three to six years). However, some employers’ reliability periods may extend to the longer term based on employer-specific circumstances.
       • Trustees should take a proportionate approach to assessing the reliability period. For example, a high-level assessment may be sufficient when the scheme has a short recovery plan and is running a lower level of risk relative to the level of covenant support. A more detailed assessment will be needed where the scheme is relying on a longer reliability period for recovery plan purposes, or to enable the scheme to take higher levels of supportable risk.
    2. How long the trustee can be reasonably certain (based on information available at the time) that the employer will be able to continue to support the scheme (covenant longevity)
       • For the purposes of this assessment, support refers to the longer-term ability of the employer to support the scheme along its journey plan to low dependency and beyond, even when that level of support may be uncertain or fluctuate over time.
       • Covenant longevity will end when trustees do not have reasonable certainty that the employer, or its market will continue. Covenant longevity would also cease where uncertainty over the viability of the employer exists, which could lead to an insolvency or other event that could trigger the crystallisation of the scheme’s solvency deficit.
       • For some schemes, covenant longevity may be finite, making it easier for trustees to pinpoint an exact timeframe for this period. For example, if an employer provides a single product or service that will no longer be required due to legislative changes in eight years and there are limited plans for the employer to diversify, the maximum longevity period would be eight years. For most employers, reasonable certainty over covenant longevity will not exceed ten years. However, some employers may be able to demonstrate a longer period. Trustees should be proportionate when assessing covenant longevity, particularly when this period is expected to exceed the relevant date.
32. Trustees should reassess these periods at each triennial valuation, as a minimum, and adjust the scheme’s journey plan accordingly, where appropriate.

Contingent asset support

33. A contingent asset contributes to the covenant support to the extent that these are reasonably expected to be:
    1. legally enforceable
    2. sufficient to provide the specified level of support when required
34. A contingent asset’s legal enforceability is determined by the terms and conditions of the relevant agreement and the applicable law. Trustees should be satisfied that they have sufficient legal advice in relation to the enforceability of proposed contingent assets for both the UK jurisdiction and any relevant overseas jurisdictions. They should then consider whether, on balance, taking into account any qualifications in the legal advice, if this supports taking additional risk.
35. Common types of contingent asset are:
    1. charges over cash, real estate and securities
    2. letters of credit and bank guarantees
    3. guarantees from related and third parties, such as parent and group companies
    4. contingent funding mechanisms from related and third parties, such as parent and group companies
36. Typically, asset backed contributions (ABCs) should not be used to take additional funding or investment risk, as they already enable a scheme to increase its asset position and therefore reduce or eliminate the scheme’s technical provisions (TPs) deficit.
37. To understand whether a contingent asset will provide a particular level of support when required, trustees should identify the following.
    1. The scenario in which the contingent asset is likely (or able) to be called upon (for example in the event of insolvency of the employer).
    2. An appropriate method to assess the expected realisable value of the contingent asset. This will primarily be driven by the type of contingent asset, such as whether it’s a security arrangement (for example security over an asset, cash in escrow, letter of credit) or a group or parental guarantee.

Valuing security arrangements

38. Some assets have clear, demonstrable, readily recoverable value (for example cash in escrow or a letter of credit or surety bond provided by a recognised financial institution), allowing trustees to recognise this value in full, subject to any limitations in the scheme’s legal access.
39. Other assets have less certain value. For example, the value that would be returned to the scheme from security over a tangible asset such as a building or machinery will depend on the market value for that asset and its condition at the time it is called upon. Trustees must determine the most appropriate valuation methodology, considering the scenario and the timing in which any asset value is likely to be realised (for example insolvency). They must also consider how the relevant market is likely to develop for that asset in the future.
40. Where the contingent asset is provided by the employer (rather than a third-party), trustees must be mindful of the impact enforcing the security may have on the employer’s continued performance and financial ability to support the scheme. Where enforcement will have a material negative impact on the employer’s financial ability to support the scheme, trustees must also factor that cost into its valuation.
41. Trustees should reassess the value of a security arrangement at each valuation as a minimum.

Valuing guarantees

42. Some guarantees are structured in such a way that they largely replicate the obligations placed on a statutory employer. This includes providing a formal look through to the guarantor for affordability purposes. These guarantees provide an ability for trustees to claim against the guarantor in respect of all monies owed by the employer to the scheme without restrictions or qualifications once a trigger event has taken place. They cannot be revoked without trustee agreement. These are referred to as ‘look through’ guarantees.
43. Where trustees benefit from a look through guarantee, when assessing the employer covenant, they should assess the guarantor’s financial ability to support the scheme as if it was a statutory employer.
44. However, if a guarantee doesn’t meet the criteria of a look through guarantee, trustees should determine the level of support a guarantee can provide by considering the following factors.
    1. The guaranteed amount (including whether the amount is capped and, where the amount is calculated by reference to the scheme’s funding position on a particular basis, how that funding position may develop over time).
    2. The duration of the guarantee and any termination clauses.
    3. The circumstances in which a claim can be made under the guarantee (or, where the guarantee provides for a variety of triggers, the most likely scenario in which the guarantee would be called upon).
    4. The guarantor’s financial ability to provide that support at the time it may be required.
45. Generally, we expect the level of reliance trustees place on a guarantee that can only be triggered by an unexpected future event, such as employer insolvency, to reduce the more unlikely the event is, unless trustees can demonstrate with reasonable certainty what value would flow to the scheme.

Valuing a related or third-party contingent funding mechanism

46. A related or third-party contingent funding mechanism comprises a legally binding arrangement where a related party, such as a parent or group company or third party will commit to make a payment into the scheme under certain pre-defined triggers. This might be, for example, where the scheme’s funding position falls below a set threshold.
47. When determining the level of support a related or third-party contingent funding mechanism can provide, trustees should consider the following factors:
    1. the quantum of the agreed payments
    2. the circumstances in which the scheme will have access to these payments (we would expect a trigger event to provide access to value in advance of an employer insolvency)
    3. the likelihood of the additional payments being triggered
    4. the third-party’s financial ability to make the payments when required
48. Trustees should ensure that they do not double count the support provided by a contingent funding mechanism, particularly where the arrangement is with the
    employer or another party (such as a look through guarantor) whose cash position is already factored into the trustees’ covenant assessment or supporting the value of another contingent asset.

Multi-employer schemes

49. Schemes frequently have more than one employer. The Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2024⁵ do not make any special provision for multi-employer schemes, but we recognise that it may be unnecessary for many multi-employer schemes to carry out a full assessment for each employer to comply with the legislation. Trustees must consider the extent to which it is appropriate to analyse the financial ability of every employer to support the scheme and how to reach an overall view on the covenant provided by the pool of employers as a whole.
50. Where trustees determine it is not proportionate to review all employers, they should consider if alternative approaches are appropriate. For example, this could include pooling employers into sub-groups with varying levels of review for each.
51. In considering which employers to assess in detail and the weight to be given to each, trustees should consider the following factors.
    1. The number of members of the scheme attributable to each employer, and an estimate of the size of each employer’s liability to the scheme. This should be based on an understanding of each employer’s share of the scheme’s liabilities, including orphan liabilities (such as those that are not attributable to any specific employer).
    2. Whether the scheme is classed as an associated multi-employer scheme or non- associated multi-employer scheme.
    3. The position of the scheme in the event of an insolvency or withdrawal of an employer, for example whether the scheme has segregation provisions or ‘last man standing’ arrangements.
    4. The trustees’ powers under the trust deed and rules to impose contributions.
    5. The likelihood of employer withdrawal and its impact and the treatment of any orphan liabilities.
    6. Any restrictions that might apply under the trust deed and rules to the allocation or payment of contributions due to the scheme, for example where member contribution rates constrain the level of overall contributions to the scheme.

Not-for-profit covenant assessments

52. Not-for-profit organisations are organisations:
    1. where some (or all) of their activities are of a non-commercial nature
    2. that rely on donations (or other discretionary income or subscriptions) to fund their activities
53. Where not-for profit organisations have material commercial operations, these operations should be analysed in accordance with the general principles set out above in determining employer covenant support. The non-commercial operations of a not- for-profit should be assessed in accordance with the modifications below.

Assessing cash flow

54. Where a not-for-profit organisation’s cash flow is generated largely from donations, when assessing the reliability over the employer’s cash flow and covenant longevity, trustees should recognise that the cash flow may be volatile and subject to reputational risk.
55. Trustees should ascertain the extent and nature of any restrictions on the use of the employer’s cash flow (restricted funds) and consider the extent to which restricted funds are permitted to be used as contributions to the scheme.
56. To the extent that an employer’s restricted funds are not permitted to be used as contributions to the scheme, those funds should be disregarded when assessing the financial ability of the employer to support the scheme.

Assessing prospects

57. When assessing the outlook for the sector and the position of the employer within the sector, trustees should, in addition to considering the factors set out in paragraph 29 above, specifically consider:
    1. the reputation and public profile of the employer and the impact of any changes to that on future donations
    2. the quality of governance of the organisation including its efficiency, management of reputational risks, and contingency plans for potential shocks to income (for example reputational damage), or demand for services
    3. the competition for income from other organisations
    4. the demand for the services it offers, including the impact of government policy and social factors (for example demographic assumptions) on potential revenue, or both
    5. the macroeconomic environment

Contingent assets

58. Where a contingent asset is provided by a not-for-profit organisation, trustees should consider whether the entity is subject to any restrictions that would prevent the trustees realising value in relation to the asset.

Legal references

¹ Section 121 of the Pensions Act 2004 [Article 105 of The Pensions (Northern Ireland) Order 2005]

² Article 75 of The Pensions (Northern Ireland) Order 1995

³ Regulation 6 of The Occupational Pension Schemes (Scheme Administration) Regulations 1996 (SI 1996/1715) [Regulation 6 of The Occupational Pension Schemes (Scheme Administration) Regulations (Northern Ireland) 1997 (SR 1997/94)]

⁴ Part IV of The Pensions (Northern Ireland) Order 2005

⁵ The Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2024 (SI 2024/462) [The Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations (Northern Ireland) 2024 (SR 2024/90)]

Related content

• Assessing and monitoring the employer covenant: guidance