Covenant turns 21! What’s changed, the here and now, and what does the future hold? 

Last year we commemorated covenant turning 20 by looking back at how and why the Pensions Act 2004 first planted the seeds of the covenant industry and reflecting on what we had learned in the two decades since then.

It has been a busy year, so we have built further on this topic, weaving in the latest covenant developments and what we are seeing in the market.

High profile insolvencies are often the catalyst for change. The Pensions Act 1995 introduced the minimum funding requirement (MFR) and Employer Related Investment rules following the Robert Maxwell scandal. The Pensions Act 2004 raised the bar further, introducing the Scheme Specific Funding regime, Section 75 instead of MFR as the price for employers to exit a defined benefit (DB) pension scheme and the Pensions Regulator’s (TPR’s) moral hazard powers. Covenant was the common thread running through the new concepts introduced by the Pensions Act 2004, and the covenant industry was born.

By the time the new DB Funding Code landed last year, most schemes had already achieved much of what TPR was mandating and the Government had shifted focused onto productive finance and surplus release.

We now also have a new Pension Schemes Bill working its way through Parliament, as well as new guidance and consultation responses. 

Covenant has always been about the security of members benefits. That hasn’t changed. 

But we’ve seen a real shift towards a collaborative strategic role for the covenant advisor: being part of a suite of joined up advisors, helping clients meet the increased regulatory requirements robustly but proportionately in a way that leaves trustees and sponsors with sufficient headspace and budget to think about the bigger picture. 

There are still times where the covenant advisor needs to play “bad cop” but more often than not, it’s about finding joined up solutions that balance the complex needs of multiple stakeholders. The idiosyncratic nature of covenant has always made it difficult to quantify but strategy, risk management and balancing stakeholder objectives is also much more than a numbers game.

DB Funding Code: the new DB Funding Code has scrapped covenant ratings and replaced them with a series of new metrics that must be compared to a scheme’s funding and investment risk to determine whether the covenant is “adequate” to support the scheme. Traditional Pension Protection Fund (PPF)-style guarantees get very little credit, and emphasis is on cash flow forecasts. Successfully navigating the new DB Funding Code requires trustees, sponsors and advisors to work closely together in a much more collaborative way than the combative negotiations of old.

Technology: as scheme funding improves and regulatory requirements become more demanding and more prescriptive, technology has a greater role in driving efficiency to allow trustees to meet regulatory requirements while still having the headspace and budget to think about the bigger picture. This is particularly relevant for smaller schemes that might not otherwise be able to afford robust covenant advice, or simple well-funded cases where detailed covenant work is not proportionate. Technology can also help with training, and covenant monitoring. Learn more in our article ‘How AI agents can revolutionise the DB and DC pension markets’.

Transactions: the Pensions Schemes Act 2021 added protections for schemes by adding clarity around TPR’s moral hazard powers and notification requirements; this is balanced with the fact that schemes are better funded so cash mitigation is less often needed. Covenant remains important: in a world of continued macroeconomic uncertainty, sponsors may struggle to refinance debt piles built up during the COVID years, and M&A activity may lead to material changes to a sponsor’s structure, strategy and risk profile.

Insurance: with new insurers entering the market, increased awareness of risks around re-insurance, the robustness of insurers and the protections available is a key part of managing the security of members’ benefits. Understanding covenant (and tail risks) is particularly important for schemes weighing up the pros and cons of run-on versus insurance.

Surplus: run-on and surplus release is a topic that has been gaining traction. The new Pension Schemes Bill, and associated announcements from the Department for Work and Pensions (DWP) and TPR have drawn attention to opportunities for sponsors and members. Covenant is critical in any decision to release surplus (for example, release based purely on a funding threshold will not factor in unmodelled risks or the need for a solvent sponsor), as well as a key factor in calibrating what is appropriate. Thoughtful covenant support structures provide opportunities for mutually beneficial outcomes. 

Alternative endgame options: the new Pension Schemes Bill marks a big step forward for the fast-developing superfund market, bringing a clear legal framework, backed by new authorisation and supervision powers for TPR and potential criminal penalties for those who don’t follow the rules. We expect this to give more confidence to members, trustees, employers and providers in considering superfunds as a solution to provide members’ benefits – where appropriate. We have a good understanding of the gateway tests having directly advised on their application.