Many have suggested covenant is now less important than what The Pension Regulator’s Defined Benefit (DB) Funding Code would imply. But in an increasingly volatile economic environment, it remains important for trustees to understand their covenant and the key drivers for employer health.
Central to the Funding Code are the concepts of Covenant Reliability Period and Covenant Longevity:
- 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.
Understanding these terms and everything that surrounds them, increases when businesses face financial stress or distress, undertake transactions or where funding levels are lower. It’s also important where trustees are considering requests for release of surplus.
A recent example – Thames Water
Perhaps the starkest example of a covenant which was expected to be reliable and predictable but has proved anything but is Thames Water. Infrastructure, particularly in regulated sectors, should have good visibility and predictable viability. But it now appears that the chances of a solution that avoids a Special Administration for Thames are becoming increasingly thin.
The accounts to 31st March 2025 included a going concern statement and highlighted the reliance on reaching agreement with the group’s senior lenders to a further debt restructuring and equity transaction to avoid Special Administration.
Christopher Weston, the Thames Water CEO stated:
“We are progressing with our senior creditors’ plan to recapitalise the business” but “this will 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’ means forgiving the record fines levied against Thames and a greater tolerance for ongoing pollution as Thames improves its outdated infrastructure. The criticism of Ofwat, and the likelihood that they will be replaced by a tougher regulator following Sir John Cunliffe’s report into the sector, makes this type of forbearance for Thames and the wider sector very unlikely. With funding dependant on the ongoing confidence of the senior lenders, and with only £424m available (less than half last year’s cash outflow), Thames’ position will need resolution, one way or another, very soon.
Covenant issues in other sectors
Another traditionally ‘safe’ industry, which is now suffering more commercial pressure, is the university sector. Like water, it has suffered from political headwinds. Tuition fees for UK students have seen no increases since 2017, in which time RPI has increased 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 NI costs.
To counter these cost pressures, universities relied on rising enrolments, particularly by overseas students. However, enrolments have plateaued since 2020. Last November the Office for Students suggested that 72% of English universities would be in deficit by the end of the 2024/25 academic year if they continued as they are. They also highlighted that improvements in financial health in budgets for the sector for the period to 2027 are reliant on increases in income which in aggregate are unrealistic. In comparison to the sector’s budgets, which show strong growth across UK, EU and Non-EU overseas students, the OfS predicts all will be flat or mildly declining. 93 universities currently have redundancy programmes (out of 166). However, this is becoming distress for an increasing number of universities with discussions of financially driven mergers. Distress is predominantly among the post-1992 institutions but pre-92 universities are not immune.
Economic considerations
Political forces have had an increasing impact on businesses too, like the increase in National Insurance from April 2025 which has disproportionally affected the retail and hospitality sectors. Any businesses with significant reliance on exporting to America have been impacted by the tariff turbulence. Whilst the UK’s trade agreement gives some more clarity, it incorporates a significant increase in tariffs on exports and key parts remain to be negotiated. Very few nations have agreed trade deals with the US ahead of the 1st August deadline for reimposition of ‘Liberation Day’ tariffs, but this ‘hard deadline’ may still have some ‘flexibility’. This makes planning for the wider competitive environment very difficult, particularly with our major trading partner, the EU having agreed a 15% tariff on exports to the US.
This turbulence is having a chilling effect on trade, impacting sectors which are particularly targeted – steel, aluminium and automotive. For steel and aluminium the position remains unclear – with a 25% tariff in place but a UK expectation that this will be negotiated down to 0. For automotive and all other sectors the tariff is 10% – better than the ‘Liberation Day’ level but still far higher than before. 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.
What actions can be taken by trustees?
With this level of uncertainty, planning for corporates is hard. For trustees it has several implications. Generally, in a faster changing environment, trustees should be more focussed on understanding their employer’s trading health and outlook. Constructive, open relationships with the employer and focussed monitoring frameworks are key to maintaining visibility over the ability of the employer to support their scheme. For those schemes that are undertaking their first valuation under the DB Code, assessing the Covenant Reliability Period and the Covenant Longevity are central to the valuation. For the 54% of schemes funded above buy-out, or the 76% fully funded on a low dependency basis, these are less demanding questions as assuming a limited period to use on the basis of “at least x years” will not impact the valuation and no Recovery Plan will be required. However, for the remaining 24%, these will be more complex calculations and will require a good understanding of the drivers for the employer’s cashflow generation.
Trustees of schemes with employers undergoing corporate transactions will need to look carefully at the impact of those transactions on the future resilience of the business. Changes in debt levels or disposals of businesses with significant cash generation will need to be looked at to understand whether mitigation is appropriate. This requires an open relationship with the employer and good commercial understanding by the trustees.
Looking ahead
The Pension Schemes Bill will increase the ability of the 76% of schemes funded to more than 100% on a low dependency basis to return some of that surplus to their employer. Agreeing a secure basis on which to return (and potentially share) surpluses, will require a clear understanding of the employer’s business to set funding and covenant triggers to allow, stop or perhaps reverse surplus distributions. The more open the relationship and the better the understanding of the business is, the more likely the trustees are to be able to agree an appropriate arrangement to share surpluses.
There are many ways in which the regulator’s concepts of Covenant Reliability and Longevity remain important but challenging in the current, unpredictable environment. Having trustees with the commercial experience to navigate this will be important for both the scheme and the employer in successfully navigating these challenges and opportunities.
At Vidett we have a highly experienced and skilled team ready to deal with all forms of corporate transactions and proposed restructurings. To learn more about the above, or how we can help – please contact the author Mike Birch from our Corporate Transactions and Restructuring team.
