The Pensions Regulator (TPR) released its updated Covenant Guidance[1] in December 2024 as part of the evolving defined benefit funding regime flowing from TPR’s new defined benefit funding code.[2] The Covenant Guidance operates alongside the funding code, marking a significant step forward in helping trustees of defined benefit occupational pension schemes assess and manage employer covenant risks. However, while the guidance provides a robust framework, trustees of smaller schemes may find it particularly challenging due to assumed baseline knowledge and increased reliance on external advisers. This could lead to higher costs and operational burdens, potentially nudging more schemes towards consolidation.
The role of the proportionality principle
One of the key elements in the guidance is the proportionality principle, which suggests that the depth of employer risk assessments should be aligned with scheme size and complexity. However, there is little practical detail for covenant assessment simplifications for small schemes, leaving trustees to interpret and apply proportionality in practice. Whilst there is no strict definition for a small scheme, the PPF views schemes with assets under management of less than £10 million as “small”. Similarly, schemes with fewer than 100 members are often characterised as small.
This article considers what practical steps smaller schemes can take to align with the proportionality principle while managing costs and resource limitations. We set out four potential simplifications which could be considered:
Streamlined covenant assessment templates
Smaller schemes can benefit from front-loading work in the first year to develop standardised templates for ongoing assessments. These could include:
- covenant monitoring templates to track key financial metrics and employer updates regularly;
- documentation templates to record proportionality decisions to ensure alignment with TPR expectations; and
- simplified risk checklists to focus on high-level risks such as employer insolvency likelihood and stress test outcomes.
Simplified stress testing
Instead of engaging in full-scale stress testing, trustees of small schemes can adopt a more focused approach:
- model a limited number of adverse scenarios, such as a 10% revenue drop or a 20% cost increase, to assess the employer’s ability to continue pension contributions; and
- use historical data and industry benchmarks to estimate potential impacts rather than conducting extensive financial modelling.
Using simplified financial metrics
Rather than complex financial analyses, trustees of small schemes can rely on key financial proxies to gauge employer strength:
- EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) to assess profitability;
- Current Ratio (current assets divided by current liabilities) as a measure of liquidity; and/or
- Debt-to-Equity Ratio to understand financial leverage without in-depth analysis.
Leveraging tiered advisory services
Given the resource constraints of smaller schemes, professional advisers are increasingly offering tiered advisory services, allowing trustees to access proportional levels of support at reduced costs. Trustees should explore such options to optimise their approach without excessive financial strain.
Industry adaptation to proportionality
While the guidance does not prescribe exact solutions, it provides room for innovative and pragmatic approaches to applying the proportionality principle. The industry is expected to respond quickly with solutions that help trustees of small schemes meet regulatory expectations without overextending their resources.
For trustees, the key takeaway is to be strategic and selective in their approach to covenant assessments. By leveraging simplified processes, proportionate stress-testing and cost-effective advisory services, they can maintain compliance while ensuring operational efficiency.
[1] Covenant guidance | The Pensions Regulator
[2] Dentons – Discretions for trustees in defined benefit schemes: Navigating flexibility beyond the funding and investment strategy; Dentons – New defined benefit funding code – what does it mean for trustees and sponsoring employers?
