Francesca Bailey Partner

Covenant became even more of a hot topic for pension trustees and sponsors since Covid-19 emerged last year. Now eighteen months into the pandemic, the impact on sponsors and their industries is much clearer, although this will continue to play out further as we get back to more “normal” times still.

Furthermore, as a result of the Pension Schemes Act 2021, we are seeing a significant increase in focus from both sponsors and trustees around covenant governance - formalising frameworks and protocols around financial information sharing and reporting of corporate events.

During the height of the pandemic, in last year's survey, over 45% of trustees highlighted that they had increased their frequency and intensity of covenant monitoring, and we view it as important that this trend does not reverse. Whilst some risks may have eased, there remains substantial economic uncertainty and many covenant related risks that trustees of pension schemes should be alert to - particularly following the introduction of the Pension Schemes Act 2021.





An effective covenant monitoring framework should be:

Clear and documented

Tailored to your scheme-specific circumstances



A large number of schemes now use some form of contingent funding mechanism to manage their risks. And a whole range of options are available as shown in the pie chart on the right.

Percentage of pension schemes benefiting from any form of contingent funding mechanisms

Which type of contingent funding mechanism does it benefit from?

Asset contingent funding mechanisms include charges over assets, asset backed funding arrangements and direct asset transfers. Cash contingent funding mechanisms include escrow accounts, contingent contributions and reservoir trusts. Credit contingent funding mechanisms include company guarantees, letters of credit or surety bonds. Other contingent funding mechanisms include profit or dividend sharing mechanisms, or negative pledges.

For further detail on contingent funding mechanisms see our Contingent Funding Handbook, or listen to our recent contingent funding webinar. We also bring this to life using the case studies below, setting out examples of events where covenant monitoring and clear contingency plans have helped schemes we advise to react and manage changes to their covenant, and how these events could interplay with the Pension Schemes Act 2021.

Using contingent contributions to achieve fairness across stakeholders

Leveraging letters of credit to mitigate private equity risk

Retail exposure, refinancing and negotiating protections for the scheme


The case studies above set out ways that trustees can monitor and react to risks which might arise over the shorter term. But a key question that trustees also need to consider is - over what timeframe their scheme will reach its long-term funding target?

Expected timescale to reach long-term funding target

Until the long-term funding target is reached, there is a greater degree of reliance on the sponsor covenant. And even when a long-term funding target is reached, the sponsor covenant is still required to underwrite any investment risk (or other risks such as mortality) that is being run by the scheme.

Decisions made regarding the timeframe to reach a long-term funding target are often driven by a number of factors. For example, the scheme maturity, trustees' and sponsor’s risk appetites and the strength of the sponsor's covenant.

Frequently de-risking steps are staged along the journey to reach this target and a typical glide path for a pension scheme might look like the chart opposite.

Typical strategy to reaching a long-term funding target

Designing a glide path when the sponsor covenant is declining over time

Cumulative chance of default over time

The chart shows the cumulative likelihood of default as time passes for different credit ratings.

A company rated BBB may well gain a "tending to strong" covenant rating today, but over a 15-year period there's more than a 10% chance that the sponsor fails.

However often the journey to reaching a long-term funding target doesn't necessarily factor in the risk that the sponsor may not still be in existence in substantially the same form, by the time the long-term funding target is due to be reached.

There is often an implicit assumption that covenant strength does not materially change over time. However, as time passes there is an increasing chance that a sponsor weakens, or as the chart opposite demonstrates, even enters insolvency.

The increase in the cumulative chance of default over time is why the concept of covenant longevity is important. For a sponsor where visibility is not as clear over the timeframe to the long-term funding target, it is worth trustees asking the question - is a stepped de-risking of the scheme’s investment assets over the journey plan the right approach to take?

Alternatively, should more investment risk be taken now (as shown in the chart opposite) when there is greater covenant visibility and certainty, to try to accelerate the timeframe to reaching the long-term funding target whilst the sponsor is likely more capable of underwriting the investment risk being run.

Trustees should consider convenant longevity whilst also taking into account other factors like risk appetite, investment conditions and the availability of contingent funding support.

Covenant adjusted strategy to reach long-term funding target

Designing a glide path with high visibility over covenant strength in the short term

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