Covenant – how to plan effectively for the long term in the face of change


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Covenant longevity is becoming a more prominent aspect of covenant advice. When considering things like the impact of climate change on the covenant it’s impossible not to think long-term. But really, defined benefit (DB) pension schemes have always been a long-term issue. Not just for trustees seeking to ensure that the scheme has sufficient assets to pay member benefits in potentially 50+ years’ time, but also for most sponsors their DB pension scheme will be by far the longest-term commitment the business will have.

With its new funding regime, The Pensions Regulator (TPR), now more than ever, is urging trustees to have a clear long term target and a plan for how to get there. But this can be challenging in a period where there have been so many short-term changes to get to grips with:

  • It could be that Covid, or maybe Brexit, has impacted covenant strength over the last couple of years.
  • Possibly more recently it’s the dramatic increase in energy prices threatening the viability of the business and prompting the sponsor to seek short term easements from its pension scheme.
  • There’s also anticipated risks for businesses that have taken on a greater debt burden due to recent challenges if interest rates should rise from their historically low levels.
  • And then there’s the raft of new Government pensions legislation, and associated regulation and guidance from TPR that trustees and sponsors need to get to grips with.
  • All this while managing the day-to-day running of the pension scheme: monitoring the sponsor covenant, investment performance and how the scheme’s funding strategy is progressing against agreed targets.

TPR published its first funding code consultation back in March 2020, before the severity of the Covid impact on the world was clear, and the second consultation seems unlikely to be published until early 2022, almost two years later. Two years is a long time between consultations in anyone’s book, but it really does feel that we’re in a different place now.

In my view, all of this makes clear just how important contingency planning is. Over the long term, it is really unlikely that all of a DB scheme’s plans are going to play out as intended and trustees (and also sponsors) need to put in place strategies to get things back on track if (when!) they don’t.

In our Chart your own course publication we talk about putting together a six-point journey plan to plan for the long-term whilst also navigating the issues facing the scheme today.

Contingency planning can also protect the scheme against unforeseen covenant related events, or those that would be regarded as outside of ‘business as usual’, such as M&A activity, which is likely to be on the rise as we explore in this blog.


In terms of covenant, the first step in contingency planning is for trustees to be undertaking regular monitoring of the covenant. Where the pension scheme has a greater level of dependence on the covenant, for example, because it has a larger deficit, then this monitoring should take place more often. Where the covenant is subject to change; this could be M&A activity, or an internal group restructuring, or a refinancing where terms are changing; bespoke assessments will also be required to establish how the covenant support will change, which will allow trustees and sponsors to consider appropriate actions to manage or mitigate any increase in risk to the scheme (if necessary). Such actions were always best practice but in light of TPR’s new powers from the Pension Schemes Act 2021, they have become essential.

Covenant monitoring is not just about trustees obtaining key financial performance indicators from the sponsor, trustees also need to consider the longer-term prospects and potential threats to the viability of their sponsors (this includes climate change but there are also other sector dependent threats such as the need to invest to keep pace with technological developments and consumer preferences). Many DB schemes have recovery plans that extend well beyond the three to five-year covenant visibility horizon TPR references in its first funding code consultation. And of course, now trustees will be thinking about how to reach long term, or low dependency, funding targets which may be many more years away.

When trustees are happy that they have a good covenant monitoring programme in place the next step is to agree on actions that will be taken if certain events do happen. Examples we have helped some of our clients put in place include:

  • If a dividend above a certain amount is paid then the scheme receives a pre-agreed proportionate payment;
  • If the sponsor group becomes a target for M&A activity, then a pre-agreed list of covenant information is provided;
  • If the covenant is weakened for some reason, then contingent security is made available, such as a letter of credit, cash in an escrow account or legal charges over property assets.

There are so many different ways that contingent funding mechanisms like these can help to support schemes for the long term and also the short term where there are covenant challenges. Contingent funding can also benefit sponsors by enabling support to be provided in a proportionate way that suits the nature of the business – so can offer a real win-win outcome. We explore many contingent funding approaches in our Contingent Funding Handbook.


What we have seen is that where trustees and sponsors have recognised the long-term nature of covenant support, and have undertaken contingency planning in advance of any issues, that these plans have helped schemes face challenges more smoothly. Now more than ever trustees should be considering the specific short and longer term risks that face their sponsors and if they have sufficient contingency plans in place to identify, monitor and respond to these risks in order to meet their scheme’s objectives.

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