Guidance on how to monitor the covenant and create a framework to take proportionate action at the appropriate time.
Published: December 2024
Introduction
A robust covenant monitoring framework is an important part of the overall integrated risk management (IRM) of a DB pension scheme. This is because it should notify you of events and risks crystallising at an early stage, so that you can react before these might jeopardise the security of members’ benefits.
We expect you to monitor the covenant throughout the lifetime of a scheme, to ensure it has the resources and longevity to support the scheme, and its funding and investment risk.
Effective monitoring focuses on several key indicators combining covenant, funding and investment dynamics, and should include a clear framework to trigger pre-defined and proportionate actions.
The frequency and depth of monitoring should be proportionate to the circumstances of the employer and the scheme, but we would expect monitoring updates to be at least annual. Covenant monitoring should be an ongoing process that evolves depending on the scheme and employer circumstances, so frequency and depth are likely to change over time to ensure it remains fit for purpose. You must be able to justify the approach taken and document decisions reached. The engagement of covenant advisers for monitoring purposes should be proportionate.
Information required for effective covenant monitoring includes publicly available information, analyst reports (if available), as well as employer information such as management accounts or metrics, and forecasts. A good working relationship with management to support clear and open communications is key to any monitoring.
Information-sharing protocols and contingency plans are important parts of a robust monitoring framework and could also be used to address your key concerns in relation to specific events in a timely manner, and to create protections in favour of the scheme (eg through the use of thresholds and actions associated to them).
Where you do not have the requisite skills and knowledge to undertake robust monitoring, you should consider seeking professional advice.
Establishing a monitoring framework
There are five important steps associated with establishing a robust and proportionate monitoring framework to ensure you are informed of covenant related events and risks at an early stage.
1. Identifying key covenant support risks
The first step in setting a monitoring framework is to identify the key risks to employer covenant support.
These will naturally vary in accordance with the specific circumstances of the employer and of the industry it operates in, and may include, for example, loss of a key customer/supplier or personnel, breach of banking covenants, asset impairments, technology or market changes, or damage to reputation.
The starting point for identifying key risks is the employer covenant assessment, which should provide you with insight into:
- the elements that feed into the covenant support and prospects
- the relevant risks the covenant is exposed to
Key risks can also be identified by regularly reviewing management financial information, and regularly discussing with management. You should arrange regular updates with the employer to discuss covenant matters, including actual financial performance and variances compared to forecasts, expectations, key risks, and strategy for the business.
Monitoring should include consideration of the risks to the covenant over the short, medium and longer term. Monitoring longer-term risks should be proportionate to the level of the scheme’s reliance on employer support over the reliability period and beyond.
2. Set up of appropriate indicators to monitor key risks
A monitoring framework should include setting appropriate financial and non-financial performance indicators to monitor the key risks or any substantial changes to covenant support.
Qualitative and quantitative indicators
Indicators can be quantitative and qualitative and should be considered relative to the scheme reliance upon the covenant support provided.
Quantitative indicators should be set against the employer’s historic or forecast financial information to highlight any material improvement or deterioration in the financial performance (both profitability and cash flows) or employer prospects.
Qualitative indicators could include changes to the dividend policy, departures of key staff, or changes in the legal structure. The likely impact of the qualitative metric might be unknown until it occurs, but you should monitor the covenant for these events, which could potentially have a material impact on the employer support.
Debt is usually one of the key indicators requiring regular monitoring. You should be aware of the terms and conditions associated with employer debt and any refinancing (for example repayment terms, interest rates, banking covenants, consequences of breaking such covenants, cross guarantees, security, and restrictions on payments to the scheme). You should also monitor debt that the employer guarantees for other group entities, where applicable.
The frequency and depth of monitoring depend on the circumstances of the employer and scheme, but should be at least annual.
Contingent assets
In respect of contingent assets, you are expected to reassess their value at least at each scheme valuation. However, you should still consider the appropriateness of obtaining more frequent assessments, particularly where the security arrangement represents a material part of scheme covenant support.
You should also have processes in place to monitor other indicators that could point to a potential deterioration in the asset value. For example, where the security is a brand, you should monitor events that could indicate reputational damage.
Where the asset’s value is reliant on trading performance of a business or other external factors, at a minimum, you should be requesting written confirmation from the employer on an annual basis to confirm that there has not been, or there is not expected to be, any material deterioration in the contingent asset's value over the past and next 12 months.
3. Setting of tolerance thresholds for each key risk identified
You should identify thresholds that could indicate or lead to a weakening of covenant support, meaning potential changes to scheme funding and investment assumptions may be required.
Such thresholds can be based on financial indicators. For example, a fall in cash flow below a certain level, or an increase in leverage above X times EBITDA would mean a refinancing is likely to be more difficult at maturity, impacting your view on reliability.
Each indicator could have more than one threshold, for example ’soft‘ or ’hard’ thresholds reflecting the severity of the breach and the level of strength of the action to be taken. These dynamics could be shown using a visual rating system like RAG (red, amber, green). For example, an amber rating would result in a watch position and red would result in action being required.
Thresholds should be proportionate, but set at a level that would allow you to respond to risks at an early stage to protect members’ benefits.
4. Agree actions to be taken if thresholds are breached
Once tolerance thresholds have been set, you should work with management to put in place proportionate actions if a threshold is breached.
For example, if a metric breaches a ’soft‘ threshold, you may consider doing the following.
- Start discussions with management and obtain additional and more frequent information.
- Engage covenant advisers.
- Put in place a contingency plan to help you react quickly if the position worsens.
- Seek to improve the covenant position through increased cash contributions or contingent asset support.
If the breach is more severe and meets the ’hard’ threshold, this may warrant you to consider additional actions to those above, including the following.
- De-risking the investment strategy.
- Calling an out of cycle valuation.
- Reconsidering the long-term objective.
- Using your powers.
Triggers and actions should be discussed, agreed, and legally formalised with management, where possible, so that both parties understand the position, and are ready to respond as soon as a threshold is breached.
5. Continually review appropriateness of established indicators and thresholds
It is good practice to ensure indicators continue to measure the relevant key risks over time, and to adjust them accordingly if appropriate.
For example, if a risk is no longer relevant – because it has been fully mitigated (eg an onerous contract has been settled), or there is a change in the macroeconomic conditions (eg high inflation impacting margin has stabilised) – the relevant indicator could be removed from the monitoring framework. You should also ensure that new risks are identified and added to the monitoring framework where appropriate to do so.
At a minimum, a full review of the monitoring framework should be completed as part of the scheme valuation process, after you have undertaken a holistic assessment of the covenant and identified any changes in key risks.
Information sharing protocol
When setting up a monitoring framework, you should supplement this with a robust information-sharing protocol agreed with management. This should ensure that you are notified of potentially detrimental events at an early stage, so that you can react quickly.
Elements of a robust information-sharing protocol
A robust information-sharing protocol should include the following.
- Ongoing information provision in relation to pre-defined metrics.
- Notification at an early stage of corporate events, for example transactions, restructuring or refinancing.
- A proportionate framework to define when additional action is needed (eg triggers or thresholds).
- Pre-defined actions associated with any threshold considerations.
A robust information-sharing protocol should also set out the following.
- The format for the information to be shared.
- Documentation to be shared.
- How frequently the information and documentation should be shared, taking account of other stakeholders who may be provided with the same information, such as lenders.
The benefits of an information-sharing protocol
A properly drafted and agreed information-sharing protocol should provide you with a seat at the negotiating table in the event the covenant deteriorates materially, but before reaching a level of distress that might jeopardise the security of members’ benefits.
An information-sharing protocol agreement will usually have other benefits for you, including the following.
- The employer will be clear on the information you require, and when you need it, for effective covenant monitoring.
- Management will have committed to provide this information, so you will have greater certainty over having the information you need at the right time.
- The protocol and information provision will continue regardless of any personnel changes, including a change of control, reducing reliance on existing relationships with key personnel at the employer.
An information-sharing protocol is most effective in delivering the benefits above when it is legally binding.
You should ensure that any confidentiality agreements you enter into with the employer or the wider group in respect of information provided does not prohibit you from sharing that information with us.
The information-sharing protocol should be frequently reviewed to ensure it remains appropriate. At a minimum, we expect you to revisit it at each scheme valuation or sooner if significant changes arise.
Contingency planning
Contingency plans are another important component of any monitoring framework to ensure the covenant continues to have the resources to support the scheme, if and when required. Contingency plans should consider covenant, funding and investment risks holistically, in line with an integrated risk management approach. Please read the general code on risk management for more detail.
We may revise the covenant guidance when needed and include industry feedback. Send comments or queries about the new guidance to covenantguidance@tpr.gov.uk.