Assessing covenant reliability in an increasingly unpredictable world

Central to the Pensions Regulator’s (TPR) Defined Benefit Funding Code are the concepts of the covenant reliability period (the period for which trustees have reasonable certainty of cash to fund the scheme) and covenant longevity (the maximum period that trustees can reasonably assume that the employer will exist to support the scheme).

Many have commented that this is a good idea several years too late, and with the improvement in funding levels, covenant is less important than the code would imply.

However, in an increasingly volatile economic environment, it remains important for trustees to have a good understanding of their covenant and to understand the key drivers for employer health.

This is more applicable when businesses face financial stress or are undertaking transactions, and when scheme funding levels are lower. However, it will also be important when trustees are considering requests for the release of surplus.

Case study: Thames Water

Perhaps the starkest example of a covenant that was expected to be reliable and predictable but has proved anything but is Thames Water. Infrastructure, particularly in regulated sectors, is supposed to have good visibility and predictable viability.

While Thames Water’s problems have been widely known for some time, it does appear that the chances of a solution that avoids a Special Administration are becoming increasingly slim.

The company’s accounts to 31 March 2025 included a going concern statement and highlighted the reliance on reaching an agreement with the group’s senior lenders regarding a further debt restructuring and equity transaction to avoid Special Administration.

Thames Water’s chief executive officer stated that the company was “progressing with our senior creditors’ plan to recapitalise the business”, but added that this would “come with a requirement to reset the regulatory landscape and acknowledge that it will take at least a decade to turn the business around”.

Resetting the regulatory landscape is code for forgiving the record fines levied against Thames Water and indicating more forbearance in respect of ongoing pollution while the company gets to grips with its outdated infrastructure.

The criticism of regulator Ofwat, and the likelihood that it will be replaced, makes this type of forbearance for Thames Water – and, by implication, the whole sector – very unlikely.

With funding dependent on the ongoing confidence of the senior lenders, and with only £424m available (less than half last year’s cash outflow), Thames Water’s position will need resolution very soon.

Universities challenged

Another sector long assumed to provide safe and predictable covenants, and which is now suffering more commercial pressure, is higher education.

Tuition fees for UK students have seen no increases since 2017, while inflation has increased by 40%. Fees are only rising by 3.1% for the next academic year, which looks unlikely to keep up with cost increases, particularly given the rise in national insurance contributions.

To counter these cost pressures, universities relied on rising enrolments, particularly by overseas students. However, these have plateaued since 2020.

In November, the Office for Students suggested that 72% of English universities would be in deficit by the end of the academic year if they continued as they were. Improvements in financial health for the period to 2027 were reliant on increases in income.

In comparison to the sector’s budgets, which show strong growth in students from the UK, the European Union (EU) and outside the EU, the Office for Students predicts that all three groups will be flat or mildly declining.

Financial stress across the sector is highlighted by the 93 out of 166 institutions with redundancy programmes. However, this is becoming distress for an increasing number of universities, with discussions of financially driven mergers.

Wider issues affecting employer covenant

Political forces have been having an increasingly significant and unpredictable impact on businesses across the economy.

The increase in national insurance from April 2025 is already hitting businesses, particularly in the retail and hospitality sectors. Any businesses relying on US exports have been hit by tariff turbulence.

This turbulence is having a chilling effect on trade and is particularly impacting sectors such as steel, aluminium and automotive. More generally, with much of the rest of the world, including the EU, facing high levels of tariffs on US trade, many may look to compete more aggressively in the UK to replace lost US trade.

With this level of uncertainty, planning for corporates is hard. For trustees, it has several implications.

Trustees should be focused on understanding their employer’s trading health and outlook. Constructive, open relationships with the employer and focused monitoring frameworks are key to maintaining adequate visibility of the employer’s ability to support the scheme.

For those undertaking their first valuation under the new code, assessing the covenant reliability period and covenant longevity are central to the valuation. For fully funded pension schemes, these are less demanding questions. However, for the remaining schemes, these will be more complex calculations and will require a good understanding of the fundamental drivers for the employer’s cashflow generation.

Any trustees with employers undergoing corporate transactions will need to look carefully at the impact on the future resilience of the business. Changes in debt levels or disposals of businesses with significant cash generation will need to be scrutinised to understand whether mitigation is appropriate. This also requires an open relationship with the employer and good commercial understanding by the trustees.

Meanwhile, the Pension Schemes Bill could increase the ability of those schemes that are fully funded on a low dependency basis to release some of surplus. Agreeing a secure basis on which to do this will require a clear understanding of the employer’s business to set funding and covenant triggers to allow, stop, or perhaps reverse distributions.

The regulator’s concepts of covenant reliability and longevity are important but challenging in the current, increasingly unpredictable, environment. Having trustees with commercial experience will be important for both the scheme and the employer in successfully navigating these challenges and opportunities.

Mike Birch is a client director at Vidett.