New DB Funding Regime – covenant concepts with corporate activity 

As part of the new regime, the Pensions Regulator (TPR) has issued a new version of its DB Funding Code, which provides TPR’s practical guidance on how to comply with the scheme funding legislation under the new regime. 

The new funding regime introduces the concept of employer covenant strength into legislation for the first time, along with the concepts of covenant reliability and covenant longevity. The new Funding Code builds on the legislation and sets out TPR’s expectations for how DB pension scheme trustees should assess the strength of their employer covenant and ensure they understand how it supports the risks in their funding and investment strategies. 

Although the new funding regime only applies to actuarial valuations from 22 September 2024, all trustees should understand TPR’s expectations and ensure that they are considering the new covenant concepts when assessing the impact of corporate activity on the covenant. It is particularly important that they quickly build up a good understanding of the new concepts and guidance given expectations of increased activity during 2025 following relatively subdued levels of corporate activity during the last couple of years.

The new funding regime places significant emphasis on long-term planning and, as a result, trustees will need to consider the extent to which corporate activity could impact the appropriateness of their funding and investment strategies and their long-term objective for the scheme. Once the scheme falls under the new funding regime, trustees will also be required to assess whether the scheme’s journey plan remains suitable in the context of the post-transaction covenant.

In order to form a view on the impact of corporate activity, trustees should consider it in the context of TPR’s existing “moral hazard” powers (including the power to impose a Contribution Notice), as well as the key covenant elements outlined in the Funding Code, which include cash flows, contingent assets and prospects of the sponsor. Whilst the overall approach to the covenant assessment should be proportionate to the risks the covenant is supporting, the relevant considerations are:

When assessing the employer’s post-transaction cash flows, contingent assets and prospects, trustees will also need to understand what this means for the two new covenant concepts: 

If a transaction might have a negative impact on covenant reliability and longevity, consideration should be given to the various forms of mitigation that may be available, taking into consideration the post-transaction covenant. For example, this could include seeking to negotiate a contingent support structure to act as an underpin for the scheme’s journey towards low dependency on the sponsor and provide additional comfort over covenant longevity.

Alternatively, trustees should consider whether the corporate activity provides an opportunity to negotiate an acceleration in the scheme’s funding in the event that there is additional affordability post-transaction. As part of this process, trustees should be considering if the corporate activity changes their view on the employer’s reasonable affordability of deficit contributions and whether the scheme’s long-term strategy remains appropriate post-transaction.

If appropriate mitigation is not provided and the trustees decide to reduce the scheme’s level of investment risk as a result of the corporate activity, then funding strategies may need to be reviewed. Where the scheme has already completed its first “statement of strategy” under the new funding regime, the trustees will need to review and if necessary update the statement of strategy and send it to TPR.

In addition, for trustees currently considering the scheme’s funding and investment strategy as part of a valuation, the appropriateness of this should be revisited in the event that a corporate transaction was to occur before the strategy is finalised.

In all scenarios, as a minimum, trustees should ensure they understand the implications of any corporate activity on the scheme’s employer covenant and consider whether their technical provisions assumptions and long-term objective will remain appropriate after the transaction. Where changes are needed and the scheme has already completed a statement of strategy under the new funding regime, a revised statement of strategy will need to be completed and sent to TPR. Similarly, schemes that still fall under the old funding regime must send any revised recovery plans to TPR. 

While we are all initially in unchartered waters with the new funding regime and accompanying Funding Code, we already have significant experience in helping trustees to understand the impact of corporate activity on the strength of their employer covenant and we are ready and looking forward to supporting our clients navigate the challenges of corporate activity under the new funding regime. Additionally, to keep trustees and advisers on their toes, TPR will be issuing a revised version of its existing covenant guidance in late 2024 and we expect that will provide further detail on TPR’s expectations of trustees in the context of corporate activity.