What the new DB funding code means for covenant

The day we've all been waiting for

29 July 2024 was a truly momentous day in the pensions industry. After years in the making, with a few false starts and a global pandemic along the way, the final version of The Pensions Regulator’s (TPR) new defined benefit funding code of practice (“the New Code”) was released. It was also laid in Parliament and will apply to all DB scheme valuations from 22 September 2024.

It is difficult to summarise the 100 plus page document into just a few words, but ultimately it is a vital component of the new DB pensions regime which comprises two separate, but interlinked, requirements:

1. To plan for the scheme’s long-term funding.
2. To carry out valuations assessing the scheme’s current funding position.

For the long-term planning piece, TPR requires trustees to prepare a Funding and Investment strategy, setting out the planned endgame for the scheme and the journey plan to get there. But hang on a minute – in the tradition of good integrated risk management (IRM) terminology, isn’t there a word missing?

Although TPR seems to have neglected the “c” word (covenant!) from its labelling, in actual fact the New Code is taking IRM one step further, with covenant as its cornerstone. This is because, from now on, both the pace of scheme funding and the amount of investment risk taken will need to have much stronger linkages to the strength of the sponsoring employer.

As the first of a blog series on what the New Code means for each corner of the IRM triangle, I am exploring what the key covenant aspects are. This will be followed up by my colleagues John Clements and Richard Soldan commenting on the key changes from an investment and an actuarial perspective, respectively.

Key covenant considerations in the New Code

The New Code is long and is absolutely full of references to covenant. However, two overarching points stand out for me.

Firstly, any deficits on technical provisions need to be repaid as quickly as the sponsor can reasonably afford. Whilst this terminology itself is not new, it is now written into law via the DB Funding & Investment Regulations. This raises the stakes in terms of the evidence that trustees need to provide to show how they have landed on a conclusion of what is reasonably affordable. And given the subjective judgement that will be involved here, we can see sponsors having different views to trustees in lots of cases.

Even as I am writing this, I can hear you saying “That’s all very well Jon, but aren’t schemes now much better funded following the Truss/Kwarteng fun that we all had a couple of years ago? Do schemes actually need that much cash anymore?”.

Well that may be right for many schemes, but not all, and this is actually a really nice segue into my second overarching point. In a way that is much more explicit than was the case under the old code, both the level of cash being generated by a sponsor and its prospects for the future will now be key determinants of how much investment risk a scheme can take today, the length of the scheme’s journey plan to get to full funding, and the pace of its de-risking.

To put this into TPR’s new terminology, trustees need to conclude upon, and provide evidence for, what they think the maximum supportable risk is that the sponsor can underwrite, with reference to the cash flows that it is generating, and what the covenant reliability and longevity periods are. Although covenant assessors will have been looking at these kinds of things in historic advice, they will come front and centre of future work and the outputs will need to be carefully considered and documented by trustees.

A stronger link between covenant and investment?

In my experience of working within the DB funding code for the last 18 years or so, the feedback loop between covenant advisers and scheme actuaries is tried and tested and generally operates very well. However, it is clear that there is even more scope now for covenant and investment advisers to work together more than ever before.

The New Code: advance planning will pay off

We’ve already been helping our clients, both on the trustee side and the sponsor side, to understand how the New Code will impact their approaches to covenant data collation and gathering, the assessment itself, concluding upon findings and interacting with other stakeholders.

For some schemes, in particular those with valuations over the next few months, these considerations will be quite acute. However, we have also been helping those clients not directly in sight of their next valuation to do some pre-planning given that TPR has signalled that it would be good practice for all schemes to get ahead of the curve in their thinking and take steps to align to the New Code in any case, even if only broadly.

Everything I have summarised in this blog means that there have never been so many good reasons for covenant, investment and funding matters to be considered in a truly integrated way, and for advisers to collaborate and understand each other’s ways of thinking. We expect these relationships to evolve significantly in the coming months and years, with the closer links and the adherence to the New Code ultimately benefiting trustees and pension scheme members.

Watch our on demand covenant focused webinar to find out more about how our approach to providing covenant advice is evolving given the New Code and other developments.

Further resources to help you navigate the New Code