Changing market for covenant assessment: trends that shaped 2025

Proportionate advice for smaller schemes 

The New Funding Code has now been in place for over a year, over which time many schemes’ funding levels have continued to improve due to rising gilt yields and generally strong investment performance. By 31 December 2024, The Pensions Regulator (TPR) reported that 80%1 of schemes qualified for the Fast Track valuation route and by 31 December 2025, 82%2 were fully funded on a technical provisions basis. 

Despite the strong funding levels of many schemes reducing reliance on the sponsor to meet contributions, trustees of all schemes are required to assess covenant and confirm – as a minimum – in their Statement of Strategy whether the employer covenant is ‘adequate’ to support the scheme’s funding and investment strategy.  Nevertheless, as emphasised by the Funding Code and associated guidance, the assessment should be ‘proportionate’ to the reliance placed on the covenant.   To meet this demand for leaner, risk-aligned assessments, we have developed a range of short, modular and lower intensity assessments, suitable for small or well-funded schemes, combining a high-level assessment of sponsor performance, prospects and the market, but with more limited commentary on affordability, particularly where schemes are unlikely to require further sponsor contributions. 

Valuation of contingent assets 

The updated covenant guidance offers expanded direction on how and when contingent assets may be used, either to support scheme risk, thereby reducing a deficit, or by underwriting a recovery plan that extends beyond the reliability period. While a single contingent asset may in theory fulfil both purposes, the guidance makes it clear that a contingent asset’s value cannot be double counted. Any contingent asset included for covenant support must be quantified and disclosed in the Statement of Strategy, alongside confirmation of how it underwrites risk.  

Trustees must be satisfied that a contingent asset is enforceable and that its value can be accessed when needed. Contingent assets such as escrow accounts or charged property can be valued with relative ease, whereas instruments like parent company guarantees present more complex and scenario dependent valuation challenges. TPR has attempted to address this through the introduction of “look through” guarantees, which allow the guarantor’s covenant to be substituted for that of the sponsor. To qualify, the guarantee must, among other things, provide trustees with meaningful recourse to the guarantor when assessing contribution affordability—effectively treating the guarantor as a de facto sponsor. These guarantees are valuable to have but potentially onerous to give and so are still relatively rare.   

Contingent assets are an extremely versatile form of covenant support and we have worked with a number of trustee and corporate sponsor clients to design contingent arrangements that provide access to value when needed—for example, in support of “corridor funding” structures, under which contingent contributions are underpinned by a guarantee. While such structures may not meet all the criteria for “look through” status, they can still deliver quantifiable value that is accessible when needed and can be reliably assessed for the purposes of supporting scheme risk. We have also found a willingness on the part of some employers to consider conversion of existing guarantees to “look through” guarantees where it preserves material covenant support and facilitates the continuation of a “top down” approach, based on a perceived consolidated Group obligation. We generally find that a frank and open dialogue between the corporate sponsor and the trustees is the quickest route to a solution, balancing scheme requirements with the commercial needs of the sponsor. 

Transactions and schemes as a source of value 

Historically, defined benefit schemes have often hindered corporate transactions due to their funding risks, volatility and buyout costs. The Pensions Act 2021 heightened scrutiny by introducing the potential for significant civil fines and criminal sanctions for improper stewardship, supported by expanded notification requirements and strengthened powers of investigation for TPR. 

However, recent shifts in funding, policy reform and emerging endgame options have started to change this dynamic. Stronger funding levels and more cost-effective liability settlement routes, such as capital backed consolidation vehicles, mean defined benefit schemes may now be neutral or even accretive to deal value in certain circumstances. The 2025 Pensions Bill, when it becomes law, will likely enhance this by enabling well-funded schemes to release surplus to sponsors, provided they remain above a low-dependency funding level. With more than 75% of schemes now in surplus on a low dependency basis3, the potential for long-term scheme run-on as a genuine alternative to buyout has become a key topic of conversation, particularly if benefits can be enhanced.   

When assessing a target with a potential DB scheme surplus, buyers are increasingly focused on the scheme’s low dependency funding basis and the rules governing surplus usage (subject to any statutory override under the Pensions Bill). Buyers may also look to engage with the trustees of a scheme to understand their appetite for end-game options that might facilitate surplus release. Where a buyer sees potential upside in a DB scheme, this may be reflected in its assessment of equity value – but not always in the purchase price!  In practice, buyers can be expected to apply a significant discount to a surplus’s face value, depending on extraction horizon, trustee stance, funding stability and member expectations for benefit uplifts. 

Summary 

The covenant assessment landscape in 2025 has been shaped by the New Funding Code and continued strong funding improvements across defined benefit schemes. With over 80% of schemes meeting fast-track criteria and many now fully funded, trustees are increasingly expecting proportionate covenant analysis, tailored to their reduced reliance on sponsor support. As advisors, we have responded by scaling our work appropriately - focusing on high level reviews, light touch affordability assessments and streamlined evaluations of covenant reliability and longevity for smaller or well-funded schemes. Alongside this, the Code’s enhanced guidance on contingent assets has driven our thinking about when such assets can support risk, how they should be valued, and how instruments such as “look through” guarantees or alternative contingent funding arrangements might be structured to deliver dependable, quantifiable support. 

Stronger scheme funding levels and policy reform have also shifted the narrative on defined benefit schemes in corporate transactions: instead of being purely obstacles, schemes with a stable long-term surplus may now be viewed as potential sources of value. The Pensions Bill will open the door for surplus distribution (subject to conditions), prompting corporate vendors and potential buyers to assess what value can be obtained from well-funded defined benefit schemes in terms of pricing adjustments or medium to longer term deal funding.