Prospects

Guidance on how to understand the extent and duration of reliance that can be placed on employers to continue providing sufficient scheme support and highlight risks to that support deteriorating.

Published: December 2024

Introduction

The prospects of an employer provide you with an understanding of the extent and duration of reliance that can be placed on the employer to continue to provide scheme support. They also highlight the risks to that support deteriorating. An assessment of employer prospects is key in determining the reliability period and covenant longevity.

Read Determining the reliability period and longevity period for more details.

The areas below should act as a guide and starting position for your review. Understanding the scheme’s needs and the employer’s individual circumstances means you need to decide which matters are the most relevant to consider.

Generally, you should request information needed to assess prospects from employer management, but this may need to be supplemented with information from other sources such as market outlook reports and market data.

Proportionality to covenant reliance

Understanding the scheme's funding requirements and individual circumstances should assist you in taking a proportionate approach when assessing prospects and may mean that an in-depth assessment is not needed. You should be able to justify the reasoning for any proportionate approach taken to your prospects assessment.

You should focus your prospects review on the areas that pose the greatest risks to the employer covenant support available to the scheme.

The costs of obtaining information and any professional fees should be considered along with the likely impact of the assessment. For example, it may not be proportionate to incur additional costs in obtaining market outlook reports, or adviser fees, to review credit ratings for an employer or group which is substantially larger than the scheme (and could therefore comfortably fund any deficit which may arise in the scheme) or if the scheme has a surplus on a buy-out basis.

Employer prospects characteristics

Below, we set out the factors to consider when assessing prospects, using the characteristics of an employer with strong prospects as an example.

Market outlook

It operates in a strong and stable market that is forecast to grow over the long term. 

Employer market position 

It is outperforming competitors and is considered a market leader. There is minimal threat of new entrants into the market, or developments in disruptive technologies or market trends, which would affect the employer leading position. 

Strategic importance within its group (if applicable)

It is a key entity in the group and is not supporting a heavily indebted or weaker wider group. 

Diversity of employer operations 

It operates in a large market (where it is a market leader) and offers a diversified product or service range. It is not reliant on any one key customer or supplier for its prospects. 

Environmental, social and governance (ESG)

It operates in a market with limited impact from ESG risks. It has started to implement a comprehensive transition plan to manage ESG risks and take advantage of opportunities. This is credible in the context of the employer’s other covenant characteristics, track record, and its expertise and resources without requiring additional debt finance.

Resilience 

It has a strong capital structure and liquid resources at hand to withstand moderate to severe market shocks without requiring additional debt finance. It has a high investment grade credit rating.

Risk of insolvency event

There is no reasonably foreseeable risk of an insolvency event.

Other factors

Historical performance has been stable and close to forecasts. Similarly, the trustee has access to medium-term forecasts and projections which can be reviewed and monitored on a regular basis, along with regular employer updates on performance and strategic developments. 

The better the prospects, the longer you are likely to be able to place reliance on covenant. The list above is not exhaustive, and an employer does not need to have all the characteristics above to be deemed as having strong prospects. You are responsible for determining the scope of your review and to justify your conclusion of employer prospects.

The main factors to consider when assessing prospects

The sections below detail the matters, as set out in paragraph 29 of the Employer covenant section of the DB funding code, that trustees should proportionately consider when assessing the employer’s prospects.

Market outlook

The DB funding code identifies the elements relating to the employer’s market outlook as the following.

1. All material markets in which the employer operates, in terms of the relevant product or service market and the geographical market.
2. General market trends (for example whether it is a growing, stable or declining market, whether it is cyclical), the economic outlook for the countries that the employer or group operates in, and any potential risks to these markets.
3. Current regulatory requirements and expected future developments."

Employer management is well positioned to provide you with initial views on the market outlook and you should have regular communications with the employer to remain updated. You should also ensure that you challenge employer information where it is reasonable and appropriate to do so, and verify the information provided from third-party sources where it is proportionate to do so.

Use of third-party market assessments

Third-party assessments are available for most markets, and you may be able to use them to get a view of the employer’s market outlook. Employer management are likely to have access to such assessments, as well as conducting their own market review, and we recommend that you seek information from them in the first instance. When relying on management information, you will still need to form your own view on the market outlook.

As third-party assessments can be expensive, if management is unable to provide you with this information, you should assess whether it is proportionate to acquire these separately.

Employer position in the market in which it operates

The DB funding code identifies the elements relating to the employer’s position within a market as:

"The employer's current market position, the key strengths and weaknesses facing the employer and how these may impact the employer's market position in the future."

Your assessment of the employer’s position in the market in which it operates should focus upon understanding the employer’s internal strengths and weaknesses, and how these affect its position in the market.

Benchmarking against competitor firms

The employer could be benchmarked against its competitors to identify if it is in a strong position or is behind.

The employer’s position in the market should be monitored on an ongoing basis using suitable KPI measures to track its performance.

You should ensure that any benchmarking assessments are conducted in a proportionate manner, and only completed where there are material risks to covenant support associated with the employer’s position against its competitors.

Read Monitoring the covenant and taking action for further guidance.

Changing consumer demands and new entrants

You could consider changing consumer demands. For example, are competitors further ahead or in a better position to take advantage of changes in customer preferences or requirements?

You can also consider barriers that other businesses will encounter when trying to enter the market and whether any of these barriers exist for the employer. You should then consider the employer’s relative strengths and weaknesses to be able to compete with new market entrants.

Example 1: Impact of changing consumer demand

The sole participating employer has a large market share in an industry with high barriers to entry. However, demand has declined over the last three years and is expected to continue to do so. This is due to technological innovation, which has caused consumer demand to switch to a new substitute product where there are lower barriers to entry.

Application of the guidance

The employer’s traditional industry is under threat from falling demand due to technological innovation, although its competitive position within that industry appears to be secure. While the new product presents a significant opportunity, lower barriers to entry mean the employer may struggle to establish a dominant position in the new market. As such, the prospects of the employer appear to have weakened and there is significant uncertainty over its ability to support risk in the longer term. This will result in the longevity period being reduced due to the decline in demand for the employer’s product.

The trustees will need to determine whether the demand is likely to decline enough in the short to medium term to impact the ability of the scheme to reach full funding – on both the TPs and low dependency basis. If the impact is expected to create uncertainty, to the extent that reasonable certainty over employer cash flows no longer remains, this will impact upon the length of the reliability period, which the trustees can use in their covenant assessment.

Strategic importance of the employer within a group structure

The DB funding code identifies the elements relating to the strategic importance of the employer within the group as:

1. "The employer’s position within the group and its interactions with other group companies.
2. If the employer has strong operational or financial ties to the wider group, or the risks and opportunities associated with the wider group."

The level of detail required for this review should be proportionate to the extent of the interaction between the employer and the wider group, whether for trading, financing, or other purposes, as well as the overall level of covenant reliance.

How an employer may be considered strategically important to the group

The strategic importance of the employer to the overall group structure could impact its short- to medium-term prospects, even in the absence of legally binding arrangements requiring the group to provide support to the employer.

Examples of how an employer may be strategically important to the group include the following:

• the employer is a key manufacturer of products sold by several entities within the group
• the employer is a key distributor for products manufactured elsewhere in the group and accounts for a significant proportion of group sales
• the employer operates key central functions which support several group entities
• the employer holds key intellectual property and/ or trademarks
• the employer provides the group with access to markets in the UK with a favourable outlook

Where informal support is provided to the employer by the group, this does not constitute support to the scheme for the purposes of funding and investment risk in the way a formal guarantee or other contingent asset could. It should not be taken into account except in the assessment of the employer’s prospects.

You will also need to assess whether there are any legally binding arrangements in place for the group to support the employer if it is unable to financially (or otherwise) support itself. If there are legal arrangements in place for formal employer support from the group, you may be able to place greater confidence in the ability of the employer to meet the funding needs of the scheme and the prospects of the wider group to support the employer, when assessing the covenant.

Group aspects to review

Where the employer has operational or financial links to the wider group, it may be necessary for you to extend the assessment of prospects beyond the employer to fully understand the interdependencies and any associated covenant support risks. 

Examples of areas to review in respect of the wider group are as follows.

• Understanding the group’s outlook, overall strategy and how the employer(s) fit into this strategy.
• The value accessible by the scheme from the wider corporate group. This could include an assessment of the value held within subsidiaries of the employer, which should be considered to form part of the covenant.
• The extent of trading and interdependency between the wider group and the employer. This should allow trustees to understand the vulnerability of the employer to the condition of the wider group as part of assessing the covenant, or the ability of the wider group to support the employer. Common examples include cost-sharing agreements and intra-group purchasing arrangements.
• The flows of cash and capital within the group, such as intra-group financing and cash-pooling arrangements including the liquidity of intra-group debtor and creditor balances. The extent to which the employer is supporting or supported by the wider group through dividends or changes in intragroup debt can affect the extent to which the employer’s financial resources are available to support the scheme. Read Assessing cash flow for further guidance.
• The capital structure of the wider group (such as the relative weightings of equity and debt) and the extent of reliance on the employer to service debt obligations or returns to the group’s shareholders. This could also indicate the ability of group companies to provide security for the scheme.

Example 2: Impact of strategic importance within the group structure

The sole employer to the scheme is part of a global group with operations in several European countries, China, and the United States where most sales are made and recognised. The employer operates complex central functions for the wider group operations, including head-office, treasury, HR and training and development. The employer also holds group intellectual property and trademarks, and manages a number of key relationships with UK-based customers.

The employer recharges the wider group for services provided, and for use of intellectual property and trademarks based on a percentage mark-up. Consequently, its profits are restricted. The employer covenant has been assessed to support only limited funding risk by the trustees for several years due to limited cash generation relative to the size of the scheme.

Application of the guidance

The trustees need to understand group reliance on the intellectual property and trademarks, and the ability of the group to separate and move the complex central functions away from the scheme employer.

Given the nature of the central functions provided, and the likelihood that these are performed by skilled individuals (ie for training and development), the group could encounter difficulties moving all functions. The trustees will also need to understand the importance of the customer relationships managed by the employer and whether these could effectively be managed by other group entities. These factors could be indicative of the employer being strategically important to the group and would be viewed positively when reviewing the employer’s prospects.

These factors would improve the reliability and longevity assessment of the employer. However, it would need to be considered together with other factors assessed as part of the overall employer prospects.

Example 3: Impact of intra-group trading

The sole participating employer is part of a group and acts only as a local distributor for the group’s products, which are manufactured by its parent. The employer purchases the products from its parent under a transfer pricing agreement approved by His Majesty’s Revenue and Customs (HMRC). This allows it to make a small profit on the sale of the products commensurate with the low level of business risk faced by the employer.

Application of the guidance

The trustees will need to review the prospects of the employer based on the information provided. However, they should also review the financial condition of the parent as the employer is dependent upon it for its business, and the interaction between the parent and the employer will largely determine the terms of the transfer pricing agreement which affects the profitability and cash flow of the employer.

For example, if the parent was in financial distress, or experiencing structural decline, these would clearly be limiting factors for the employer’s reliability and longevity periods. The trustees should also seek to understand how scheme contributions are factored into the employers cost base, whether they are included in the mark-up, and what scope there is for additional cash flow to be made available if needed.

Trustees should consider the following:

• while such a transfer pricing agreement could ensure that the employer will be profitable, it could also prevent future increases in cash flows, and the markup could be reduced in the future if the wider group is in financial difficulties
• the approval of an intra-group agreement by HMRC does not necessarily mean that the agreement is in the best interests of the employer or the scheme, and the transfer pricing agreement may result in material covenant leakage, for example if it is not based on commercial terms
• HMRC could revoke its approval of the transfer pricing agreement

Read Contingent assets for further guidance on how to improve the covenant position of the scheme.

Diversity of employer operations

The DB funding code identifies the elements relating to the diversity of the employer’s operations as:

1. "The products or services offered by the employer, the regions and markets they operate in, and the reliance or diversity of key customers and suppliers of the employer."

If an employer has a high level of diversity in the areas outlined in the code, it is less susceptible to changes in demands or potential issues which arise in individual markets or countries.

Conversely, if the employer’s performance is reliant upon trade from one market, or sales of one product or too few key customers, if demand reduces or political or economic circumstances affect trade in that market, the employer’s prospects could be substantially impacted.

Environmental, social and governance (ESG)

The DB funding code identifies the elements relating to environmental, social and governance factors as the following.

1. "Whether the employer’s business model is resilient to a transition to a low carbon economy.
2. Other ESG-related risks and opportunities facing the employer and how these may impact on the employer’s prospects."

ESG refers to three broad groups of risk factors (environmental issues, social issues and corporate governance issues), which can impact the prospects of an employer.

ESG factors that could impact employers and the covenant supporting their scheme include, but are not limited to, the following.

Environmental

Climate 

• Climate change. 
• Greenhouse gas emissions. 
• Carbon pricing. 

Other environmental 

• Waste, contamination and pollution management. 
• Resource depletion. 
• Deforestation. 
• Ecosystem services.
• Reduction in biodiversity. 
• Water stress. 
• Sustainable land use.
• Green financing (and related covenants).

Social

• Employee and customer relations. 
• Diversity and inclusion (protected characteristics). 
• Employee salary and benefits (pay gaps). 
• Working conditions (including modern slavery). 
• Local community support and delivering social value.  
• Health and safety. 
• Conflict and social unrest. 
• Product safety. 
• Data safety. 
• Jurisdiction. 
• Societal driven change and product innovation.  

Governance

• Leadership and succession. 
• Board diversity and structure. 
• Executive remuneration. 
• Tax strategy. 
• Donations and political lobbying. 
• Corruption and bribery. 
• Business ethics. 
• Anti-competition/collusion. 
• Culture and staff turnover. 
• Financial and operational systems and processes. 
• Compliance, political, regulatory and policy. 
• Conflict of interest. 
• Business objectives.  
• Efficacy.
• Investor engagement.
• ESG leadership.

Identifying ESG risks and opportunities

Identifying employer-specific ESG risks and opportunities can include the following areas:

• Macro-economic.
• Supply chain.
• Operational.
• Manufacturing.
• Distribution.
• Markets.

You should discuss ESG risks and opportunities with the employer, in addition to any climate adaption and corporate social responsibility reporting, carbon management plans, and TCFD reporting analysis that management may have prepared.

Although information provided by company management can provide valuable insights, you should assess it critically and not simply accept statements at face value. Where ESG risks/opportunities are complex and material to the employer’s prospects, you should consider obtaining professional advice.

Climate change risks and opportunities

You should consider the following risks that specifically relate to climate change.

Transition risks: These risks will arise as countries seek to realign their economic systems towards low-carbon, climate-resilient solutions. Changes are expected in industry regulation, consumer preferences and technology, and will likely impact upon current and future employer investments. Where there is a commitment to alignment with changing regulation, you should consider the employer’s progress with the development of a transition plan.

Physical risks: This refers to physical impacts that occur as the global average temperature rises. For example, the rise in sea levels could have impacts such as flooding and mass migration. Extreme weather events could become more frequent and severe, and these incidents could threaten physical assets and disrupt supply chains.

Litigation risks: This refers to climate-related litigation risk, which could arise as a result of a claim being initiated against the employer (in relation to ESG matters) with the aim of changing the employer’s behaviour or seeking compensation for consumers/investors.

To assess the impact of ESG-related risks and opportunities, you should engage with management’s plans to address these risks and opportunities and/or the expected impact of not addressing them. Examples of ESG related plans might include climate change related transition plans and plans to achieve net zero targets.

Example 4: Fast fashion retailer

The employer is a traditional retailer in the fast fashion space with a rapidly growing online presence.  

Historic performance has led to confidence in the current employer covenant and its short-term prospects, but the employer is proposing for large dividends to be paid in the near future. The trustees want to gain a better understanding of the medium- to longer-term prospects of the employer, in particular the ESG-related risks to its business and its supply chain.   

The trustees consequently engage with the employer and the scheme’s covenant adviser to better understand the employer’s operations and supply chain, which highlights the following material ESG risks based on each supply chain area: 

Production materials

Principally oil and cotton; these are subject to potentially significant price movements based on environmental factors

ESG factor: E

Social pressure for the use of sustainable materials

ESG factor: S

Garment manufacture

Human rights risks, in particular the use of sub-contractors creating oversight challenges and the use of sustainable manufacturing practices

ESG factors: E, S and G

Logistics

Reliance on sea freight and lorry freight; both markets are subject to disruption from environmental factors and geopolitical tensions.

ESG factor: E and G

Staff shortages

ESG factor: E and G

Physical retail

Societal changes to shopping habits.

ESG factor: S and G

Legislative risk (eg health and safety)

ESG factor: S

Online retail

Cybersecurity risk and data protection

ESG factor: G

Logistics (ie home deliveries)

ESG factor: E, S and G

Marketing campaigns

Risks to reputation, eg arising from diversity and inclusion, legislative requirements.

ESG factor: S and G

Diversity and inclusion

A lack of female and minority representation in leadership roles and risks highlighted over the gender pay gap.

ESG factor: S and G

Consumer preferences

Changing consumer preferences towards higher quality, sustainable garments.

ESG factor: E and S

Application of the guidance 

The trustees discuss these risks with the employer to understand the employer’s contingency plans, and the employer’s ability to address the risks if they materialise. The trustees understand the employer’s limited ability to fully mitigate these risks and that this is due to the business operating model in fast fashion with high volume, and low price and margin. 

The trustees rank the risks in order of potential impact on the prospects of the employer and assess the extent to which risks can be mitigated. The risks are factored into the prospects assessment as a poorer aspect of the employer’s overall prospects.

The employer agrees to share appropriate information with the trustees to enable them to incorporate these specific ESG factors into covenant monitoring. They agree to provide the information biannually, and any material inter-period changes will be shared with the trustees earlier.

Following the assessment, the trustees conclude that the uncertainties on ESG risks will be a limiting factor when assessing the longevity of the employer covenant. However, the impacts are likely to be manageable in the short term and more severe downsides are only likely to be felt in the longer term (ie eight years and beyond).

Resilience of the employer and the wider group

The DB funding code identifies the elements relating to the resilience of the employer and the wider group as the following:

1. "The ability of the employer (and where applicable the group) to withstand market shocks or unanticipated events based on:
   1. the employer’s balance sheet, capital structure and other financial information
   2. the group’s financial resources to the extent that these are available to support the employer
   3. other non-financial indicators of resilience."

Employer and wider group financial position

You should understand the nature and value of the assets and liabilities of the employer, and wider group, to form an opinion on the overall level of balance sheet support. This will allow you to understand the immediate availability of financial resources and how this may affect future financial performance.

We also expect you to understand the group’s financial resources when assessing scheme support from the wider group (see the strategic importance of the employer within a group structure above in this section). Understanding this will enable you to negotiate with the employer to obtain contingent asset support or group guarantees for the scheme (please refer to the section on contingent assets and improving scheme security for further information on this area).

Typical sources of information to use when assessing the employer’s current financial resources include the following.

• The balance sheet and supporting notes set out in the latest financial statements, including:
  • Statements and associated terms of any drawn or undrawn financing facilities (including debt covenants).
  • A schedule of intercompany balances showing the counterparties, the terms on which these can be recalled, and the likely ability of the counterparties to repay these balances (either immediately or over a longer period).
  • Registered charges at Companies House.
  • A summary of contingent liabilities (eg guarantees, performance bonds, ongoing legal claims, or disputes).
• Credit rating information and analyst reports to understand market perception, and as an indicator of how likely it may be for the employer to raise funds in the future.

Areas to consider when assessing the financial resources and obligations of the employer may include the following.

• The liquid financial resources available to the employer, including cash on hand, liquid investments, committed undrawn borrowing arrangements (such as overdraft facilities or revolving credit facilities) and the terms and conditions attached to them, including banking covenant tests. You should be mindful not to include any liquid assets in your assessment that have already been committed to pay other creditors or the scheme, for example through future DRCs, or secured to support investment risk.
• The capital structure of the employer, including any cross guarantees to other parts of the business, ie the relative proportions of finance from debt and equity. You should seek to understand the terms and conditions attached to any debt financing, including date for refinancing (and the expected timeframe required to agree the refinancing arrangements), interest rate, security/insolvency priority, cross guarantees and debt covenants attached to any facilities. If loans cannot be refinanced or there is substantial doubt over the ability of the employer to be granted new loan facilities which they require to continue trading, you will need to establish whether the group is able and likely to assist with the employer’s funding.
• The capital intensity of the business. Highly capital intense businesses such as heavy industry production lines are likely to need substantial investment in maintaining capital equipment, and may require significant investment expenditure to grow. This will be a prominent factor in static or declining markets where investment in up-to-date machinery and production facilities will be vital to obtain a competitive advantage.
• The level of working capital (defined as the cost required to finance day-to-day trading operations such as stock purchases, creditor payments and credit offered to customers) relative to historical levels and how this may be expected to change in future. You will have considered the impact this has on current forecast cash flows as part of the cash section. See Example [5] for details on how working capital may impact the covenant.
• The origin, size, counterparty, and (for debtors) recoverability of significant intercompany balances and group cash pooling arrangements. Where relevant, understanding these balances and arrangements can be crucial to understanding the ability of an employer to quickly raise cash in periods of stress. It may also be necessary for you to perform a high-level review of the counterparty.
• Financial commitments including lease obligations and contracted capital expenditure.
• Any contingent liabilities of the employer or group, including those that may not be stated in the financial statements. Examples include performance bonds, cross-guarantees and ongoing legal disputes which could constrain the affordability of contributions to the scheme in certain circumstances. Additionally, you need to establish whether there is any threatened or ongoing litigation risk or regulatory investigation, at either the employer or group level, which may cast doubt upon the employer’s ability to continue.
• The ability of the employer to raise additional finance if required, for example due to unexpected market shocks, is a further indicator of the resilience of the employer. If there are adequate tangible fixed assets available on the balance sheet, which are uncharged (ie have not been pledged as security already), and are good quality assets which have value, these may allow the employer to raise additional finance. Examples of how these assets can be used to raise further funds include the following:
  • Outright sale: this option could be available for saleable intangible assets as well as tangible fixed assets. For intellectual property assets, you should understand the implications of selling the asset, such as the impact on its use by the business and any royalty payments the employer is currently in receipt of for its use by others.
  • Sale and leaseback of assets required for business operations.
  • Pledging of assets as security to raise additional debt.
• Contingent assets supporting the scheme which have not been used to support risk-taking. There may be situations where the scheme benefits from a contingent asset that has not been utilised to support risk-taking in the scheme’s funding and investment strategy. For example, a scheme may benefit from a section 75 guarantee from a parent entity, but you have not attributed a value to the guarantee to be able to input this into your assessment of supportable risk. In such circumstances, you may consider the additional support this provides when assessing prospects. Read Contingent Assets.

Non-financial indicators of employer resilience

Employer management generally assesses resilience against financial and non-financial factors, and you should discuss these factors with the employer to identify the most relevant areas to include in a proportionate review. You should review any indicators provided with independence and objectivity.

Examples of non-financial indicators of resilience could include the following:

• inclusive and positive workplace culture
• positive image in media publications
• clear and well-defined business strategy
• comprehensive risk management practices in place such as efficiency in operations (eg just-in-time and zero waste policies)
• sustainable operations
• government support

Example 5: Impact of working capital balances

The sole participating employer operates in a seasonal industry. Purchase of goods for resale is concentrated during December, with most revenues being generated between April and September each year. This results in substantial increases in working capital requirements for stock and creditors in December and January. Stock reduces substantially from April (to almost nil in September), with debtor balances increasing over this same period.

Application of the guidance

When assessing the employer’s available resources, the trustee should consider the date of the balance sheet and how seasonal fluctuations in balances which occur each year may affect these. Where seasonal fluctuations occur, it may be necessary to assess the employer’s available resources throughout the financial year. This is because assessing the balance sheet in September, when stock is nil and cash or debtors is high, is likely to overstate the employer resources. Similarly, reviewing the balance sheet in April, when stock is highest and cash and debtors is low, is likely to understate the employer’s resources.

Trustees should be mindful of business cyclicality and should seek to understand any variations to expected working capital balances. Trustees are expected to work with the employer to understand how their working capital fluctuates and assess how this may affect their resilience. For example, periods of high working capital may coincide with the timing of contractual cash outflows, which could place a strain on employer finances and insolvency risk.

Example 6: Impact of contingent liabilities

The sole participating employer is subject to an ongoing legal claim in relation to a historic contract. Its legal advisers believe they have a strong case and expect that no compensation payment will be required, and, therefore, no provision has been recorded in the employer’s financial statements. However, the potential compensation payable if the employer loses the case could be material. There will also likely be a reputational impact for the employer following the claim, which could further weaken the covenant position. The potential claim is disclosed in the notes to the employer’s financial statements under 'contingent liabilities'.

Application of the guidance

The trustees would need to consider the conclusions by the employer’s legal advisers that the case is likely to be won by the employer, and ensure they are comfortable in relying upon this assessment. This may involve the trustees seeking their own advice on the merits of the case. Where the trustees conclude that it is reasonable to rely upon this assessment, it is likely that this would not have an impact upon the reliability or longevity assessment of the employer. This is because there is reasonable certainty that the case will not have an impact upon the employer covenant position.

However, the trustees should be aware of the potential impact on covenant support if the case is lost (for example, by sensitising forecasts) and should seek regular updates from the employer. Given the trustees are not directly involved in the claim, it may be acceptable for them to rely on the employer’s updates and views of the case, unless there is a good reason not to. If the case is lost and employer covenant support is weakened, reliability and longevity would need to be reassessed. The trustees should also be aware of the potential legal costs that could be incurred in defending the claim and ensure these are factored into their assessment of the covenant support available.

Use of business valuations in forming a view on employer prospects

Comparing equity value (a measure of a business's value, excluding debt obligations, ie all ownership interests) or similar valuations of the employer relative to the scheme obligations may be useful when assessing covenant position. For example, market capitalisation premium above book value of net assets could be indicative of market confidence and reflect positive prospects.

However, you should bear in mind that the ability to pay contributions to the scheme when required is the key determinant of covenant strength, not the proceeds, after any debt, from the sale of the employer. Equity value comparisons (or similar valuations) should be considered with caution as they can over-simplify the covenant. They should not replace more detailed analysis conducted to assess the resilience of the covenant on an ongoing basis or assessing the covenant in the round.

Use of credit ratings in forming a view of employer prospects

Employer credit ratings are generally available from employer management and should be shared with you to assist in the assessment of the current position, likely prospects of the employer and wider group. Credit ratings are a useful source of information and can provide an independent and impartial view on the employer’s prospects, which considers both quantitative and qualitative factors of the employer. There are three principal credit agencies that provide ratings – Moody’s, Standard and Poor’s and Fitch.

While it may be informative to review the credit rating of the employer as an indicator of financial performance, this should not be seen as a substitute for a covenant review. Similarly, a movement in credit ratings should not be considered as a proxy for a movement in covenant on a standalone basis. The basis of the credit rating is a short- to medium-term measure of credit worthiness, which is not consistent with the long-term nature of scheme liabilities and their inherent volatility. You should also be careful not to rely too heavily on a group-wide credit rating, particularly when the scheme only has direct access to its employer(s), ie in the absence of a parental guarantee.

Risk of an employer insolvency event

In relation to the risk of an employer insolvency event, the DB funding code identifies the following matters which the trustees should consider.

1. "The employer’s insolvency risk and the likely flow of value to the scheme at the time of an insolvency event.
2. We expect trustees to take into consideration the matters, as set out above, in determining the likelihood of an employer insolvency event.
3. The level of detail should be proportionate to the risk of insolvency, and the reliance placed by trustees on realising value from assets to fund the scheme and support risk.
4. Where insolvency is deemed highly unlikely over the short to medium term, less scrutiny and weighting should be placed on the outcome to the scheme in such a scenario. Conversely, the higher the risk of insolvency, or where trustees place significant reliance on realising value from assets to fund the scheme and support risk, trustees should undergo a more extensive exercise to demonstrate with reasonable certainty what value would flow to the scheme."

The financial health of employers can change significantly over the lifetime of a pension scheme. It is not possible to establish with any certainty the continued existence of any employer over the medium to long term.

Where an employer is part of a wider group, you should understand how it fits in, and how contagion from elsewhere in the group (such as an employer cross-guaranteeing debt of another group entity) could cause financial stress and possibly insolvency. (See further considerations in the ‘strategic importance of the employer within a group structure’ above in this section).

You should understand the potential outcome for the scheme in insolvency. The level of detail of any insolvency review should be proportionate to the risk of insolvency and the level of reliance placed on this analysis, particularly as insolvency analysis can be complex, and may require professional advice.

Where insolvency is considered unlikely over the short to medium term, a lighter touch insolvency review may be considered more proportionate, with less weighting placed on this area when assessing the employer’s overall prospects. This may take the form of a more qualitative understanding of how insolvency could be triggered and the resulting impact on the scheme, including how asset values could be impacted and who the competing creditors are. Where you are unsure of the most useful way to assess the employer’s insolvency in the context of assessing the insolvency risk to the scheme, you should consider seeking professional advice.

Where the risk of insolvency is higher or where greater reliance is being placed on realising value from balance sheet assets to fund the scheme or support funding and investment risk, you should undergo a more extensive insolvency review to demonstrate with reasonable certainty what value would flow to the scheme.

Areas to consider as part of an insolvency review may include the following.

• The likely cause of insolvency (eg whether it relates only to the employer or to events in the wider group).
• The entities against which the scheme would have a legal claim in insolvency (employers and providers of contingent support) and the size of those claims. Depending upon the scheme structure, this may be impacted by the nature of the insolvency and sequence of insolvencies throughout a group.
• Whether there would be claims from other material creditors against those entities (such as debt holders), which could compete with the claim of the scheme, and the relative priority of those claims in insolvency. This could include the impact of fixed and floating charges and the structural subordination of creditors in parent companies to those in subsidiaries.
• Whether the book value of the assets shown on the balance sheet of the employer reflects the value that could be recovered from them in distress, and the net of the costs of realising that value. You should note that some assets may need to be sold at a discount (such as stock) and the recoverability of others may be uncertain depending on the nature of the event (intercompany balances and investment in subsidiaries).
• What material contingent liabilities could crystallise in insolvency (such as cross-guarantees of the obligations of other entities or performance bonds) that could reduce the recovery by the scheme.

You should be aware that intangible assets may retain little (if any) value in an insolvency scenario. This is because their value may be highly correlated with the financial performance of the employer (eg intellectual property).

You may find it helpful to develop an estimate of the value that would likely be payable to the scheme on insolvency of the employer (such as preparing an estimated outcome analysis). It could help you develop appropriate monitoring triggers by identifying key balances to monitor, and contingency plans.

Insolvency usually follows a period of decline where assets may reduce and creditors competing with the pension scheme may improve their priority ranking, such as banks. This could cause the insolvency outcome to be significantly less than originally estimated.

Generally, a higher risk of insolvency would be indicative of poor prospects and vice versa. If an insolvency of the employer or a group insolvency involving the employer is likely, the employer’s prospects should be considered as poor regardless of how you view the other factors.

Structural subordination

Structural subordination describes a creditor’s (including a pension scheme’s) position and priority compared to other creditors in a group, because of where it’s located in the organisational structure.

For example, if a scheme’s employer is a parent company whose subsidiaries trade and create value to support the scheme, on insolvency, the scheme will not be able to access the value in the subsidiaries until after all the subsidiary’s creditors have been paid, and any excess value distributed up to the parent. In this scenario, the scheme is structurally subordinated to the creditors of the parent company’s subsidiaries. They will get paid first, and before any residual value is distributed to the parent, the scheme’s employer.  

Where a scheme has recourse to a company or companies within a group, you should consider whether it is appropriate to look at the employer and subsidiaries on a consolidated or an individual company basis.

Reviewing the group on a consolidated basis can conceal restrictions on cash flow into the employer/guarantor from cash generating subsidiaries. It may also hide the potential impact of structural subordination on the outcome to the scheme if the employer enters insolvency.

Where there is greater reliance on the cash flows from subsidiaries or on the potential outcome from insolvency, you should obtain professional advice which is not only on a consolidated basis.

Example 7: Impact of structural subordination on the returns to the scheme in an insolvency

The XYZ Group has a holding company with three operating subsidiaries. The group has £135 million of assets (book value), an unsecured bank debt, and the pension scheme deficit. All assets sit in the subsidiary companies, evenly spread across each. The pension deficit on a section 75 basis is £105 million and the only employer is the holding company. Unsecured bank debt is £75 million and is lent directly to the three operating subsidiaries, £25 million to each.

Application of the guidance

On a consolidated basis, a simplified and high-level review of the likely outcome in insolvency of the group would show the following:

Table 1: return to the scheme on a consolidated basis

Assets and liabilities	Value
Assets	£135m (book value)
Realisable value in insolvency	£90m
Liability: Bank debt	£75m
Liability: s.75 deficit	£105m
Total liabilities	£180m
Return to creditors (bank and scheme)	£90m/£180m = 50p in the £1
Return to the pension scheme	50p x £105m = £52.5m

However, based on where assets and liabilities sit in the group, the value realised would be apportioned as follows:

Table 2: return to the scheme on an individual company basis

Assets and liabilities	Value
Assets in each subsidiary	£45m (book value)
Realisable value in insolvency for each subsidiary	£30m
Bank debt in each subsidiary	£25m
Surplus value available to the holding company from each subsidiary	£5m
Total surplus to the holding company from all subsidiaries	£15m
Return to the pension scheme	£15m

This simplified example demonstrates why trustees should assess the insolvency return to the scheme based on the value flow to the individual employer(s) as, in effect, the pension scheme is structurally subordinated to the bank creditor. This example seeks to illustrate how structural subordination can impact a scheme and should not be viewed as guidance on how to prepare an insolvency analysis.

Considerations for not-for-profit employers

If your scheme has a not-for-profit (NFP) employer supporting the covenant, you will still need to perform a proportionate assessment of the prospects of the employer. This will help you determine the overall covenant support, as well as assist you in determining the appropriate reliability period and covenant longevity.

Whilst most of the factors listed under this guidance will remain relevant for NFP employer prospects assessments, you will also likely need to consider the following additional factors.

• The reputation of the NFP and the impact the uses of available cash may have upon donor or grant funding received.
• Trends in demand for the activities undertaken.
• Where material income is derived from government bodies, the strategic importance of the services to the government’s aims.
• The scale of operations undertaken – either local, national or international and the available funding streams as a result.
• When considering the resilience in the balance sheet, whether restrictions on the assets improve or limit the resilience.
• When considering longevity, the likelihood of the NFP merging with other organisations which fulfil the same purpose in a downside scenario as opposed to being wound down. This could be considered in reference to industry trends.

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.

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