By Helen Abbott, Covenant Partner, LCP
What is covenant reliability?
Under the new DB funding regime, trustees are asked to determine a ‘covenant reliability period’ – which means they need to say, in years (but for some it might only be months) how long they have ‘reasonable certainty’ about how much cash the employer is expected to generate and what could be available for the scheme.
This assessment should of course be proportionate and guided by how much future support the scheme is likely to need from its employer. Many schemes are now very well funded and a light touch review is appropriate. But for those with funding deficits where making an assessment of covenant reliability is more important, doing so during a period of such economic uncertainty can be challenging.
The covenant reliability period influences deficit repair contributions, recovery plan length, and how much investment and funding risk the scheme should run. It’s also something that should be considered where schemes are thinking about running on and sharing surplus with the employer.
Covenant reliability is not about how long the employer is expected to be around (that’s ‘covenant longevity’ – more jargon!). Covenant reliability is about looking at the employer’s cash generation and its uses, reviewing its future cash flow forecasts and business plans, and establishing how reliably it is generating cash and at what level (i.e. a £ amount) it would be available to fund the scheme. That’s another key concept trustees need to conclude on – maximum affordable contributions, or “MAC”, as a total £ amount over the covenant reliability period.
The Pensions Regulator has said it expects most covenant reliability periods to be three to six years. But some may be much shorter.
If you haven’t yet navigated a valuation in the new regime this might be a bit confusing, and these new concepts are certainly more complex than having to decide on one of four covenant grades! Have a look at our guidance on preparing for the new covenant requirements for some more information on these key new concepts: New DB funding code - Preparing for the new covenant requirements.
Uncertainty is impacting most employers
It’s difficult to think of an employer that won’t be impacted by the current wave of economic uncertainty. Some will be directly impacted – for example those with energy intensive operations or supply chains that run through impacted geographies. For others there will be less direct, but still potentially material impacts. This could be from cost inflation they can’t fully pass on to customers, declining demand for their products and services due to ever increasing cost of living pressures, or difficultly obtaining financing facilities (or them becoming more expensive and with more conditions attached).
For many businesses the issues aren’t just from events this year, they’ve experienced headwinds since the Ukraine conflict impacted supply chains and energy costs, and then the imposition of US tariffs and retaliatory actions on global trade. And some businesses that were particularly hit during Covid are yet to recover fully. There’s also the impact of actions taken by the UK Government, such as increased National Insurance and minimum wage rates, and material increases to business rates hitting this year.
The impacts of this latest phase of geopolitical instability are difficult to predict. It could be that there is such uncertainty about how, when, or by how much, the employer may be impacted, that it makes assessing the outlook, and covenant reliability, a real challenge.
When economic conditions become so unpredictable, an employer’s ability to support its scheme can deteriorate quickly and sometimes without much warning.
This makes it more important than ever that the covenant is regularly monitored and advice sought to support trustee considerations.
Does covenant reliability matter for well-funded schemes?
The short answer is yes, in most cases it still does. And it’s not just about doing valuations in the new funding regime, it’s also about looking at the medium and longer term covenant for schemes that are running on.
A lot of schemes don’t have a funding deficit now, but trustees still need to take a proportionate look at the strength of covenant, including its reliability. It’s about checking that the covenant can underwrite scheme risks, making sure that if downside events materialise that the employer can afford to make them good over a reasonable period of time.
This is more important now than ever, because current geopolitical events make it more likely that downside scheme events will occur. They cause financial market volatility which can lead to a fall in the value of a scheme’s investments, potentially creating or increasing a deficit. This happening at the same time as the employer is also exposed means trustees risk having a bigger scheme funding need supported by a weaker covenant.
What does this mean for trustees?
Trustees will need to consider factoring in a level of uncertainty to their assessment of covenant reliability and consider stress testing the employer’s forecasts for the events most likely to impact them. The employer itself may have already done this and have some useful information to provide to the trustees.
This could mean it’s appropriate to conclude on a shorter time period for covenant reliability, or a lower level of cash availability (or MAC) for the scheme.
In some cases, it may mean considering mitigating actions, such as seeking contingent asset support, accelerating funding for the scheme, derisking the scheme’s investments, or revisiting whether run-on remains the best option.
The Pensions Regulator’s 2025 annual funding statement emphasises that trustees should consider trade and geopolitical uncertainty, as well as other longer term economic dynamics like the energy transition, when assessing covenant. Where these factors could materially impact the employer, trustees should ensure scheme risk remains appropriate. We expect to see more guidance on these issues in the 2026 annual funding statement due to be published in a few weeks.
Covenant reliability is not just a consideration at triennial valuations. It’s integral to managing a DB pension scheme. Recent events have shown that external shocks can arrive suddenly and have significant, lasting effects on employer finances. Regular covenant monitoring and communication with the employer is key. Trustees and employers need the right advice to ensure plans are in place for difficult periods.
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