The Pensions Regulator continues to stress the importance of covenant assessment in evaluating the health of pension scheme. In this guide, Jenna Gadhavi examines the key elements that trustees must consider

No one can deny that covenant assessment is becoming increasingly important, especially since the launch of the Pension Regulator’s Integrated Risk Management (IRM) guidance in December 2015.


The guidance provides practical help on what a proportionate and integrated approach to risk management might look like and how trustees should go about implementing one.

In the integrated funding environment that the regulator is promoting, the strength of the covenant is one of three key considerations for scheme funding, alongside contributions and investment strategy. The theory is that the stronger the employer, the more flexibility trustees have over investment and funding decisions. In contrast the weaker the employer, the more prudent the investment strategy needs to be.

The challenge this presents is that for the companies at the weaker end of the scale, if they are unable to – in accordance with regulatory guidance – seek investment outperformance, this then puts more pressure on the employer to fund the scheme or create a longer recovery plan.

A big question for trustees is whether they can take on a covenant assessment by themselves”

The regulator has been increasing the emphasis around the covenant in its latest guidance. Expectations have become clearer and as a result, more and more trustees feel that they need to bring in some independent expertise on covenant assessment.

Despite this, Calum Cooper, partner and head of trustee defined benefit at Hymans Robertson, believes that there are some schemes out there that could successfully opt for a do-it-yourself approach. He says: “A big question for trustees is whether they are comfortable and believe that as a collective they can take on a covenant assessment by themselves.

“In some circumstances it can be appropriate, but they need to make sure there is very good governance and record keeping around why they feel they have the right skills and expertise individually and collectively, where their information will come from, and why they are confident they have access to full information.”


But if trustees do choose the independent adviser route, how do they go about finding the right one?

Gary Squires, chair of the Employer Covenant Working Group (ECWG) believes that as a starting point, trustees need to establish what advice they need – is it for a routine valuation, is it for a corporate transaction, is the sponsor in distress? They then need to take into account the risks they face and what they think they might need in the future.

If they are going through a triennial valuation, trustees must consider whether something might happen in the future that means they need to think about broader concerns than the immediate issue at hand.

Squires says: “What experience does the adviser have of the sector? Are there any special requirements that an adviser will need to understand, for example is it a regulated sector?

I’d suggest you choose someone you can work with, and be very clear about what you want”

“Do the trustees involved want to confine their advice to very specific issues, or do they vary experience wise, and therefore need a more generalist approach?”

On pricing, Squires stresses the importance of making sure the scope of the advice needed is properly defined prior to seeking an adviser, so trustees don’t pay for services they don’t need.

Cooper recommends drawing on other board members’ experience. He suggests that if a trustee has other independent trustees or advisers on the board, they’ll have experience of covenant advisers they have used previously, and may be able to give a shortlist of the best people to approach for the given situation.

Michael Chatterton, managing director at Law Debenture, believes that clarity about what a trustee wants to achieve is vital.

He explains: “Think about the complexity of the business that supports you, and therefore the types of detailed knowledge that you may require to be deployed on the covenant. Then I’d suggest you choose someone you can work with, and be very clear about what you want.”


As a bare minimum, trustees should be carrying out assessments every three years as part of their triennial valuation process.

This should include a review of two things, the first being affordability, bearing in mind that enabling the sustainable growth of the sponsor is a new regulatory objective.

Secondly, how much risk can the sponsor underwrite? As this in turn influences investment strategy. 

It’s all about being proportionate and sensible”

Darren Redmayne, managing director at Lincoln Pensions, argues that covenants need to be assessed even more regularly. He says: “Clearly you need to look at it as part of your triennial, but in the latest integrated risk management guidance, it says that even trustees with schemes in a steady state situation need to look at it annually.

“It’s all about being proportionate and sensible. If trustees have a challenging covenant, if they have problems, if there’s financial stress – then they need to be evaluating it quarterly, perhaps monthly.”

The sorts of triggers that lead to a more frequent covenant assessment are concerns over the covenant, corporate activity such as a merger or acquisition, or changes in management.

Cooper believes that in addition, although not strictly covenant assessment, regular updates from the financial director or treasurer can be really helpful to assist in maintaining a healthy working relationship.

They could give trustees forewarning of any developments with the company that they might need to evaluate whether they need an independent assessment on.


If a covenant is not regularly monitored and it declines, even if it’s gradually over a number of years, it could be that a scheme has been running too much investment risk.

Cooper says: “If [asset values] then also decline over that period, trustees could end up with that perfect storm of lack of covenant strength, funding in poor shape, and potentially the pension scheme then being the main driver behind why the sponsor goes into insolvency.”

Whereas if the covenant is effectively monitored, and action taken earlier to de-risk those assets, that may just be what the company needs to survive.

Many people may struggle to ‘put the pension on the balance sheet’”

Covenant assessment and monitoring contributions and investments to make sure they remain appropriate should be mutually beneficial and provide support to the company in the long term. This would help to avoid that perfect storm of asset loss at a time of covenant decline that Cooper describes.

Chatterton thinks trustees often forget to look at the bigger picture, and don’t always understand the business that supports them as well as they think: “Many people, even if they’ve worked in the business, may struggle to ‘put the pension on the balance sheet’. 

“Until you look at all of the rules of the scheme you may not understand what the pension fund’s position on the balance sheet is, and what other creditors or people with entitlement from that business may actually rank ahead of you.”

He explains that often those who think they know the business don’t necessarily understand how many layers of debt sit behind it. Therefore they may be attributing too much strength to the covenant because the pension fund is relatively low down the capital structure.


Covenant assessment can be a complex exercise, but it is becoming increasingly important, so should be a priority for trustees.

Redmayne says: “Unless you understand the covenant, you’ll get both your investment strategy and contribution strategy wrong. So covenant is a cornerstone to your risk management.”

Cooper sums up: “Understanding covenant is the most important aspect of delivering promised pensions in the DB space – as long as the covenant is there pensions will be paid and if it’s not, they may not, so covenant is paramount.”