Guidance on how to assess the employer’s reasonable affordability for recovery plan purposes.
Published: December 2024
Introduction to setting a recovery plan
Paragraph 2 of the Recovery plan section of the DB funding code states:
"In addition to complying with the matters set out below, a recovery plan must be appropriate, having regard to the nature and circumstances of the scheme. In determining whether a recovery plan is appropriate, trustees must follow the overriding principle that steps must be taken to recover deficits as soon as the employer can reasonably afford. Trustees should assess future reasonable affordability at least on a year-by-year basis, with steps taken to reduce the deficit set in line with this assessment..."
When a scheme is in a technical provisions (TPs) deficit as at the effective date of its valuation, you must put in place a recovery plan (or review/revise the existing recovery plan) to achieve full funding of the scheme on a TPs basis.
This principle, that steps must be taken to recover deficits as soon as the employer can reasonably afford, remains an overriding principle throughout this section, and further principles discussed in detail below should not take precedent over it when you are assessing affordability and setting your recovery plan.
Paragraph 2 states:
"The matters that trustees must consider are:
- the impact of the recovery plan on the sustainable growth of the employer
- the asset and liability structure of the scheme
- its risk profile
- its liquidity requirements
- the age profile of the members
- in schemes where (i) the rates of contributions payable by the employer are determined under the scheme rules in accordance with the advice of a person other than the trustees (for example, the scheme actuary), and (ii) the employer’s agreement is not required, the recommendations of that third-party must be taken into account."
In most situations, if you consider these matters in light of the principles outlined in this section, no additional actions will be required. The only exception to this is point f, which should be considered separately where applicable.
Paragraph 5 states:
"When determining the appropriateness of their recovery plan, trustees should consider:
- the employer’s reasonable affordability
- whether to allow for investment outperformance
- whether to account for post-valuation experience"
You can find further information on allowing for investment outperformance and post-valuation experience in the recovery plan section of the code.
Determining an employer’s reasonable affordability
The code of practice outlines three considerations to take into account when determining what contributions the employer can reasonably afford. We consider these in turn below.
Assessing the employer’s available cash
Paragraph 19 of the Recovery plan section of the DB funding code outlines that trustees should assess an employer’s available cash by aggregating the employer’s cash flow and its liquid assets.
Available cash comprises:
- employer cash flows, as set out in the cash flow section of this guidance
- liquid or readily recoverable balance sheet assets, after taking account of reasonable adjustments for volatility in working capital requirements
Examples of liquid or readily recoverable balance sheet assets include the following.
- Existing balance sheet cash, treasury deposits and cash equivalents.
- Intercompany balances that relate to pooled/swept cash to the extent the trustees have reasonable certainty these balances are easily and readily available to the employer to support the scheme.
- Proceeds of debt, equity raises or disposals, assuming these are not already included within balance sheet cash.
- Credit facilities (such as revolving credit facilities) when these are held to manage the employer’s liquidity requirements.
The employer raising additional debt and/or disposing of assets can potentially provide additional sources of liquidity. However, when assessing them, you must also understand their risks and benefits, in particular the following.
- When raising additional debt, you should consider any conditions and costs for accessing these facilities, the likelihood of cash being available when required, whether these are secured facilities and the employer provides any guarantees to lenders, circumstances that would trigger such guarantees, and the impact the additional debt could have on the employer’s prospects.
- For asset disposals, their impact on the covenant, reliability and therefore, the level of remaining risk supportable by the covenant.
It is important to avoid double counting available cash, for example when cash has already been included in the employer’s cash flow calculation for funding purposes and is then counted again as cash on the balance sheet or in the cash pool balance. This is only likely to apply in the short term, where you are relying on historical rather than forecast cash flows for your assessment, or where you have access to balance sheet items at different dates, or to forecast balance sheet positions.
Look-through guarantees provided by a third party
Where a scheme has a look-through guarantee from a group entity or third party, paragraph 47 of the Recovery plan section of the DB funding code states:
"Trustees should additionally assess the reasonable affordability of DRCs to the guarantor."
In this scenario, you should also consider the guarantor’s available cash for reasonable affordability purposes. When assessing this, you should be mindful of any double counting that may arise, particularly where you are using consolidated group information to form a view on the employer or guarantor’s cash flows and liquid assets.
Example 1: Calculating available cash for recovery plan purposes
The sole participating employer to a DB scheme holds a substantial level of liquidity to support volatility in working capital requirements and other business needs. It has a £275 million cash balance, £100 million in short-term securities (eg government bonds and money market indexes), and an undrawn revolving credit facility (RCF) of £150 million to support liquidity requirements. However, management has noted that £65 million of this liquidity must be held to meet debt covenants (including a £10 million headroom over those covenants), and £100 million is required to support volatility in working capital requirements.
The employer has also confirmed with its shareholder an imminent equity injection for £300 million. Management has noted £180 million of this will be used to repay a debt maturing over the next few weeks. The remaining proceeds are not allocated against any other use and are expected to increase the available cash on the balance sheet to improve balance sheet resilience.
Management then noted that the employer is expected to generate free cash flow available for scheme funding purposes of £50 million per annum over the next three years (including the current one). The trustees’ covenant adviser considers the employer’s free cash flow of £50m to be reasonable and has assessed the employer’s reliability period to be three years.
Application of guidance
When assessing the employer’s available cash, in addition to the free cash flows expected to be generated by the employer of £50 million per annum over the next three years, the trustees include the liquid assets of the employer.
To determine which liquid assets amounts can be included in the calculation of available cash, the trustees and their covenant advisers have assessed which assets will be readily available if the scheme needs them in the future.
Based on discussions and agreement with management, the trustees’ covenant advisers have decided it is reasonable to consider the liquid assets listed in the table below.
Table 1: liquid assets calculation for recovery plan purposes
| Liquid assets | Amount (£ millions) |
|---|---|
| Cash balance | 275 |
| Short-term securities | 100 |
| Unused RCF | 150 |
| Additional equity injection not included in the above metrics | 300 |
| Total liquidity | 825 |
| Liquidity requirement for debt covenants | (65) |
| Liquidity required for volatility in working capital | (100) |
| Upcoming debt maturity | (180) |
| Liquid assets for recovery plan purposes | 480 |
If the RCF in the table of liquid assets above doesn’t support liquidity requirements but supports other more structural operations (such as acquisitions), it may not be appropriate to consider the available undrawn RCF as part of the assessment of available cash.
Assessing the reliability of the employer’s cash flow
Paragraphs 21 to 23 of the Recovery plan section of the DB funding code state:
"When determining an appropriate recovery plan, we expect trustees to consider the extent to which they have reasonable certainty over the employer’s cash flows to fund the scheme (the reliability period). The assessing of the reliability period and covenant longevity section of the employer covenant module provides details on how we expect trustees to assess the reliability period.
Where a recovery plan extends beyond the reliability period, there is an increased risk that the employer may not have sufficient available cash to meet the funding needs of the scheme.
The reliability period is therefore key in determining the reasonableness of alternative uses of cash, as discussed below, which in turn will determine an appropriate pace of funding and recovery plan length."
When determining how quickly the employer should restore the scheme to full funding on a TPs basis, we expect you to consider the extent to which you have reasonable certainty over the employer’s cash flows to fund the scheme (ie the reliability period). The reliability period should be determined through assessing the cash flows of the employer together with the relevant factors used to assess employer prospects. Read Determining the reliability period and covenant longevity period for more detail. We expect that most employers will only have a reliability period that extends over the short to medium term (three to six years).
Where the recovery plan exceeds the reliability period, there is an increased risk that the employer’s performance could deteriorate, and it may not have sufficient cash to meet the funding needs of the scheme in the later years of the recovery plan. Given this heightened risk, in general, we expect alternative uses of cash that push the recovery plan beyond the reliability period to be kept to a minimum. The exception to this is where appropriate protections (eg contingent assets) are put in place to support the extended recovery plan, or where this extension is driven by employer growth plans where there is reasonable certainty over the benefit to the employer and the scheme. This is discussed in more detail below.
While understanding the reliability period is necessary for determining the reasonableness of alternative uses of cash, and therefore can help determine an appropriate pace and recovery plan length, it should not detract from the overriding principle that a scheme’s recovery plan must be set in line with the employer’s reasonable affordability. Therefore, where the employer has sufficient affordability to pay off the scheme’s TP deficit in a period shorter than the reliability period, even after allowing for investment in sustainable growth and other alternative uses of cash, this shorter period must be used to comply with legislation.
Determining reasonable alternative uses of available cash
The recovery plans section of the code outlines four broad types of alternative uses of cash:
- investment in sustainable growth
- covenant leakage
- discretionary payments to other creditors
- making contributions to other DB schemes
These are described in more detail in the cash flow section of this guidance.
The code also outlines the reasonable affordability principles that you should apply when assessing whether alternative uses of cash are reasonable. These principles are set out below and should be read in conjunction with paragraphs 29 to 43 of the Recovery plan section of the DB funding code.
Where an employer supports multiple DB schemes, you should ensure you consider the reasonableness of alternative uses of cash on a scheme-by-scheme basis. You should take into account scheme-specific factors such as funding ratio and scheme maturity, if available (see reasonable affordability principles 2 and 4 5 below).
Reasonable affordability principle 1: In general, investment in the employer’s sustainable growth may be a reasonable use of available cash where the trustees are confident of the resulting benefit to the scheme and employer.
Reviewing sustainable growth plans
Paragraph (30) of the Recovery plan section of DB funding code states:
"Where the employer is proposing to use some of its available cash to finance investment in sustainable growth, trustees should require the employer to provide clear and persuasive evidence around how the proposed investment will produce the anticipated sustainable growth and ensure they understand the risks and benefits to the employer’s business and the scheme."
It is good practice for you to ensure that you fully understand the employer’s sustainable growth plans, particularly the implications for the scheme, including the potential benefits.
When reviewing an employer’s investment plans, you should understand the following.
- What is the rationale and purpose of the investment?
- How much is needed to be invested and over what time period? How does this compare to the funding needs of the scheme over the same time period?
- What are the key risks associated with the return on the investment, and how will these be mitigated?
- How is the investment being funded?
- What benefits to the employer are expected from the investment and in what time period are these expected to be realised? How does this compare to the funding needs of the scheme over the same time period?
- What other strategic options have been considered by the employer?
- Are dividends or other discretionary payments expected to continue?
- What proposals have been made for the scheme to share in projected growth?
If an employer wants to invest in growth, but it does not have sufficient available cash to finance it after the scheme’s needs to fund a recovery plan, we expect it to be financed by lenders or shareholders. However, if ordinary lenders or shareholders are unwilling or unable to finance such sustainable growth, you should fully understand the reasons. For example, it could be because the credit worthiness of the employer or wider group is poor, and you should understand the risks and implications of this to the scheme. To the extent shareholder or external finance is unavailable, and the scheme is asked to take increased risk – as it becomes a de-facto lender – you should seek suitable protections to mitigate any increased risk in line with measures external lenders would request. Read Contingent assets for more detail.
Scheme-specific circumstances are another important consideration when determining the reasonableness of sustainable growth investment. For example, once the scheme has reached significant maturity, DRCs should be prioritised over investment in sustainable growth. This should be the case if you are not confident that this investment will result in sufficient employer growth to meet the needs of the scheme when they fall due (see reasonable affordability principle 4).
Paragraph 31 states:
"The level of information provided by the employer and the complexity of the trustees’ assessment should be proportionate to the amount of available cash to be utilised in the investment. This is particularly important where this results in the recovery plan exceeding the reliability period, where there is a higher level of risk or underfunding in the scheme."
You should ensure you have access to sufficient information to understand the investment and be able to monitor how the employer is performing against its growth targets and the implications of this for available cash.
When reviewing sustainable growth plans, you should take a proportionate approach based upon the amount of available cash that is being utilised in the investment, and the level of risk and underfunding in the scheme. For example, where an employer’s investment in sustainable growth is achievable without compromising DRCs to the scheme (ie where the recovery plan remains in line with or less than the reliability period), a lighter touch assessment may be appropriate. However, where investment in sustainable growth is favoured ahead of making required payments to the scheme, and this results in a recovery plan that extends beyond the reliability period, we expect you to perform a more detailed assessment to confirm the principles above have been upheld.
Using contingent assets to support investment in sustainable growth
Paragraph 32 states:
"Where investment in sustainable growth results in the recovery plan exceeding the reliability period, this investment will generally be reasonable provided that:
- the benefits of doing so to the employer and scheme are reasonably certain; or
- a suitable contingent asset is obtained that: meets the relevant criteria of a contingent asset as set out in the employer covenant chapter, is sufficient in value to cover at least the expected remaining deficit at the end of the reliability period generated by the sustainable investment, and the trustees are reasonably certain that they will be able to access this value during the recovery plan period should the employer not be able to meet its obligations under the recovery plan"
If you are agreeing to extend the recovery plan beyond the reliability period to support employer growth plans, and there is uncertainty over the benefits of the investment to the scheme, you should seek to obtain security or other contingent assets. This will ensure that the scheme is adequately protected in a downside event.
Where a suitable contingent asset is put in place to mitigate reduced available cash for the scheme due to the sustainable growth investment, as long as the contingent asset meets the criteria in the code (as above), it is reasonable to take a more proportionate approach to justify your conclusions that the sustainable growth investment is a reasonable alternative use of the employer’s available cash.
Example 2: Impact of capital investment on affordability and recovery plan
The sole participating employer does not have material liquid assets, but it is forecasting an operating cash flow of £15 million per annum over the next five years.
Management intends to use this cash flow generation to fund:
- £4 million per annum to replace obsolete fixed assets.
- £8 million per annum over the next five years to develop a new product line.
There is limited evidence of how the employer’s customers will receive the new product and in quantifying its financial return. However, management expects these investments to provide the employer with a competitive advantage and improve its future profitability.
The employer is currently paying DRCs of £5 million per year over a six-year recovery plan for total committed contributions of £30 million. However, given the intended investments above, management has asked the trustees to reduce this level of DRCs to £3 million and extend the recovery plan to 10 years.
The scheme is relatively well-funded, and the reliability period has been assessed as six years by the trustees’ covenant adviser.
Application of the guidance
After carefully considering the information above, the trustees make the following observations.
- Employer cash flows for funding purposes should be £15 million of operating cash flow, less £4 million of maintenance capital expenditures = £11 million.
- The £4 million expenditure on replacing obsolete assets represent maintenance capital expenditures as it is required to allow the employer to operate at its current level.
- The £8 million per annum over the next five years represents a sustainable growth investment as it is in a new product line and is expected to improve profitability. This should, therefore, be excluded from the employer cash flows (see the cash flow section for more detail).
Management’s proposal would extend the recovery plan beyond the reliability period, so the trustees need to fully understand the sustainable growth investment, in particular risks and other implications for the scheme.
The trustees, with the assistance of their covenant advisers, undertake an assessment of the employer’s growth investment plans. This assessment concludes the following:
- Management does not intend/ is not able to fund the investment through external funds as it is trying to minimise financial risks from external debt, and shareholders have already communicated that they will not be willing to provide additional capital.
- There is a high level of uncertainty as to whether the growth investment will deliver a return and higher future cash flow.
- Despite the lack of evidence around the expected return, management is motivated to undertake the growth investment, as it is concerned the employer would otherwise lose its competitiveness in the long term.
Given the above, the trustees inform management that, in order to accept its proposal and extend the recovery plan to 10 years, it would require a contingent asset from the employer to cover the DRCs payments which extend beyond the reliability period (ie £3 million for years 7, 8, 9 and 10 of the recovery plan, for a minimum expected asset value of £12 million).
After thorough discussions and negotiations, the trustees and management agree a security in favour of the scheme over an unencumbered, non-core office building in London valued at £15 million (providing some level of headroom to the potential claim of £12 million). See the Contingent assets section on relevant criteria for security and contingent assets.
Reasonable affordability principle 2: The lower the funding ratio and the more funding risk, the less reasonable it will be to use available cash for discretionary payments or to effect covenant leakage.
You must consider the scheme’s funding position and level of funding risk when considering how reasonable the employer has been when effecting discretionary payments or covenant leakage.
Where a scheme has a lower funding ratio or chooses to take more funding risk, the overall risk to the scheme will be higher. Given this higher level of risk, we expect the scheme to receive a greater share of the available cash by way of DRCs, with discretionary payments and covenant leakage becoming less reasonable.
Where affordability is already constrained before making such payments, or where alternative uses of cash result in a materially longer recovery plan (particularly where it leads to the recovery plan exceeding the reliability period), we would expect covenant leakage and discretionary payments to be kept at a minimum. This is discussed in more detail under the reasonable affordability principle 3 below.
In addition to considering the reasonability of the covenant leakage or discretionary payments from a recovery plan perspective, you should also assess the overall impact to the covenant, including the impact on balance sheet resilience, and employer cash flows to the extent that these are required to support risk within the scheme’s funding and investment strategy. Read Determining the covenant inputs required to assess supportable risk for more information on this.
Reasonable affordability principle 3: Available cash should not be used for discretionary payments or to effect covenant leakage where this would require DRCs to be paid after the reliability period
Where covenant leakage or discretionary payments result in a recovery plan that extends beyond the reliability period, there is a greater risk that the employer’s cash flow generation could deteriorate and it will not have sufficient cash to be able to pay DRCs towards the end of the recovery plan. Given this increase in risk, such payments will become less reasonable unless supported by a suitable contingent asset that covers the value of the DRCs due to be paid beyond the reliability period. This is outlined in paragraph 39 of the Recovery Plan section in the DB funding code.
In case of discretionary debt repayments, you should understand what impact (eg early repayment charges or lower ongoing interest payments) the proposed repayment would have on the future covenant support available to the scheme. This would include any impacts on future cash generation and both reliability and longevity periods. If there are improvements, this could support greater risk capacity.
Where the employer’s debt is unsecured, meaning the debt ranks alongside the scheme in terms of creditor status, any discretionary debt repayments might be inequitable. You should not agree to the proposal without appropriate protections for the increased risk, if it is not offset through improvements in covenant support available through the debt repayment.
Example 3: Impact of discretionary payments and shareholder return on recovery plan
The sole participating employer does not have material liquid assets, but it generated free cash flow before dividends of £15 million in the previous year, £20 million in the current year, and it is expecting to generate £18 million per year for the next five years.
Management intends to use this cash flow generation to fund:
- £13 million of shareholder returns (comprising dividends and share buy-backs) per annum over the next few years, in line with the employer dividend policy applied over the last two years
- £5 million of DRCs
The scheme is relatively mature, 60% funded on TPs and has a £50 million TPs deficit. The scheme’s actuarial adviser, along with the scheme’s covenant adviser, has concluded that the level of risk in the funding and investment strategy is supportable by the employer covenant. However, it is at the higher end of the level of risk that is supportable. The reliability period has been assessed as five years by the covenant adviser.
Given the cash flow allocation proposed by management, the length of the recovery plan would be 10 years.
Application of the guidance
After carefully considering the information above and reviewing the rationale for management’s intended discretionary payments, with the assistance of their covenant advisers the trustees make the following observations:
- Given the low funding ratio (and therefore long period of covenant reliance) of the scheme and the fact that it is taking a high level of funding and investment risk, the shareholder returns suggested are viewed as inequitable compared to the DRCs (this is not consistent with principle 2 of the code).
- The length of the proposed recovery plan (10 years), resulting from the discretionary payments outlined by management, is longer than the reliability period (five years) (this breaches principle 3 of the code).
- In line with their discretionary nature, there are no clear business needs for such shareholder returns and it would not be unreasonable to ask management to reduce them.
In light of the above, the trustees conclude that the proposed uses of free cash flow and longer recovery plan is not acceptable. They propose the allocation below with higher DRCs to maintain the recovery plan within the reliability period and ensure fair treatment of the scheme:
- £10 million per year for five years to cover the scheme’s TPs deficit.
- Reduced shareholder returns of up to £10 million each year.
If the above allocation is not acceptable to the employer (for example, if they claim that a reduction in dividends or scaling back of the share buy-back programme outside of market expectations would not be well received), the trustees should seek appropriate mitigation for the scheme. This may include appropriate contingent assets to cover the DRC payments due after the reliability period.
Reasonable affordability principle 4: The more mature the scheme, the greater the need for available cash to be paid to the scheme in the near term.
Covenant leakage and discretionary payments will become less reasonable the closer the scheme is to reaching significant maturity. This will particularly be the case if these payments lead to DRCs that don’t enable the scheme to reach full funding on a low dependency basis at the relevant date.
Post-significant maturity, DRCs should be prioritised over other alternative uses of cash, except for investment in sustainable growth. However, you must be confident that the scheme will be able to benefit from this investment and that the needs of the scheme will be met when they fall due (read principle 1 above for more detail).
Reasonable affordability principle 5: Allocation of available cash between DB schemes sponsored by the employer should be fair, considering the position of those schemes.
While payments to other DB schemes the employer sponsors are not discretionary and will be required to be paid, available cash should be allocated fairly between competing DB schemes of the employer, depending on their circumstances (eg funding level). This aims to ensure schemes are treated equitably.
You should ensure you are provided with the necessary information in respect of the other DB schemes, such as the funding level of the scheme and its requirement for DRCs.
Other alternative uses of cash
Paragraph 27 of the Recovery plan section of the DB funding code states:
"Employers may identify other alternative uses of cash beyond what is set out above. We would expect employers to fully evidence and justify why the alternative uses are reasonable and should be preferred to repaying the scheme’s deficit. When assessing the reasonableness of these alternative uses, trustees should apply the same principles as discussed below and ensure that their approach is well documented."
Examples of other alternative uses of cash may include the following:
- investment for transformative growth
- a partnership reserving cash to buy out a retiring partner
- a business planning to purchase the freehold title on leasehold property
- ring-fencing cash to buy a strategic stake in another business
- reserving cash for ongoing and expected lawsuits
- building cash to improve overall balance sheet resilience
You need to understand the rationale and make an assessment based upon the principles outlined above to understand whether the alternative use of cash is reasonable in the context of the scheme and its employer.
Example 4: Impact of other alternative uses of cash
The sole participating employer has £10 million of liquid assets available for recovery plan purposes (ie after cash reserved for volatility in working capital), and it is expected to generate free cash flow of £15 million per year for the next six years.
Management intends to use this available cash to fund:
- £17 million in year 1, and £7 million in year 2, to purchase the building and yard currently rented to run the employer’s main production mill, whose aggregate fair value has been estimated by a third-party valuer at £24 million. This would allow the employer to save material rental costs from year 3 of £1.25 million per annum which is proposed to then increase DRCs. Management have confirmed that they do not intend to use the property to secure any debt.
- £3 million in each of year 1 and 2, increasing to £10 million in each of the following years, to provide for an ongoing lawsuit, which may result in claims in the range of £30 to £35 million based on formal, independent legal advice obtained by the company. There is currently no clear date for the resolution of the claims, however management expect that it will be resolved within the next 4 years. The cash will be reserved to manage the downside risk from this lawsuit, and will not be used for any other purpose while the claim is outstanding. If the claim falls away, management have confirmed that this cash would be available to fund future DRCs if required.
- £5 million of DRCs, per annum, from year 1 to 2, then increasing to £6.25 million per annum from year 3 to 6.
The scheme is relatively well funded and has a £35 million TPs deficit. The reliability period has been assessed as five years by the scheme’s covenant adviser.
Given the cash flow allocation proposed by management, the length of the recovery plan would be six years.
Application of the guidance
After reviewing the available information, the trustees, with the assistance of their covenant advisers make the following observations:
- The acquisition of the building is positive for the employer’s future cash flow, prospects, and resilience:
- It will lead to a material reduction in rental payments, with this saving then funding higher DRCs in future years.
- It removes the risk of future rental increases, and the risk of having to move premises.
- At fair value, it is relatively neutral from an ongoing balance sheet perspective given that it would essentially represent a swap of an asset (cash) for another (building and yard).
- As the property will not be used to secure any debts, this transaction will not result in other creditors ranking ahead of the scheme.
- The intent to reserve cash to manage any downside risk related to the ongoing lawsuit is also viewed as prudent as it is required to protect the employer’s prospects. Assuming the cash is reserved in line with management’s proposal as outlined above, if the claim were to crystallise at the full amount (ie £35 million), based on the information available at the time of the analysis, the trustee’s covenant adviser considers the risk of an employer insolvency to be remote. Reserving this cash protects against more extreme actions that may be required if the cash was not on the balance sheet (eg sale of assets).
- Given the trustees have reasonable certainty over the benefits to purchasing the building and yard, and consider reserving cash to protect the employer’s prospects if the legal claim crystalises to be prudent, they believe it is reasonable to agree to a six-year recovery plan as suggested by management. This is despite the recovery plan exceeding the reliability period by one year, as they consider it to be in line with the employer’s reasonable affordability. The trustees also take comfort from the upside from reduced rental payments, and from any upside from the legal claim should this fall away (or crystallise at a lower amount) that will be available to fund future DRCs if required.
Dealing with short-term employer affordability constraints
Paragraphs 44 to 46 of the Recovery plan section of the code state
"Trustees should assess future reasonable affordability on at least a year-by-year basis, with DRCs set in line with this assessment, even if this leads to an unusual recovery plan structure.
Back-end loaded recovery plans are therefore only acceptable where:
- trustees can evidence that annual DRCs are set in line with the reasonable affordability principles and
- trustees consider with reasonable certainty that the higher level of DRCs factored into the recovery plan will be affordable in the later years and that no more is reasonably affordable in earlier years
Where available cash is limited in the short term, we would expect the trustees to take steps to manage this risk such as:
- requesting DRCs to be prioritised ahead of covenant leakage and discretionary payments
- seeking further protections where available, such as security or a guarantee, to mitigate the short-term risk of not receiving cash or receiving less cash into the scheme"
As detailed in the code, back-end loading recovery plans can only be acceptable where you are able to evidence that the overriding reasonable affordability principle has been applied, and the employer is unable to take reasonable steps to recover the deficit at an earlier date.
Reference to back-end loaded recovery plans is not intended to cover modest annual increases, for example linked to inflation or where employer performance is expected to improve in line with market factors (eg inflation-linked increases), if the increase is linked to reasonable sustainable growth (eg profitability is expected to increase because of additional capacity or annual efficiencies) or is set as a percentage of salaries (most likely relevant for open schemes).
Material back-end loading of recovery plans is only acceptable where you can evidence that annual DRCs are set in line with the reasonable affordability principles set out above. This includes prioritising DRCs ahead of covenant leakage and discretionary payments, particularly in the short term where affordability is constrained. Where possible, you should seek contingent asset support or further protections such as contingent mechanisms linked to improvements in profitability and cash generation.
In addition to ensuring that short-term DRCs are set as high as reasonably affordable, you should be reasonably certain that higher DRCs in later years are achievable. Where such payments are not expected to be achievable, the recovery plan should be updated to reflect this even if it ends up being longer.
You should generally not agree to recovery plan proposals that include the following.
- Minimising contributions paid into the scheme until the next valuation (unless based on reasonable affordability) with the hope that the scheme’s funding position will have improved and contribution levels can be renegotiated.
- Bullet payments at the end of the recovery plan, unless based on reasonable affordability. In such cases, the early years of the recovery plan typically have extremely low (or even nil) DRCs, with most DRCs committed in the last year(s).
For instances where an employer may be distressed, see the ‘Investment and risk management considerations’ section of the code.
Considerations for not-for-profit employers
In line with the code, trustees of schemes with 'not-for-profit' employers should seek to recover any deficit as soon as the employer can reasonably afford.
As is the case with 'for profit' employers, you should:
- review any reasonable alternative uses of available cash in line with the principles outlined above
- consider how they impact the employer’s ability to support the deficit, eg understand the employer’s plans for investment in sustainable growth as well as payments to other DB schemes and payments considered as 'other' reasonable alternative uses of cash
Funds spent on charitable activities, which are aimed at further enhancing its reputation and impact on its target communities could enhance its prospects and therefore might be reasonable to consider as a form of sustainable growth. This may result in a longer recovery plan being appropriate. Depending on the level of confidence in the outcome of the expenditure and its ability to improve the prospects of the not-for-profit, you might also consider seeking contingent asset support to underpin any additional risk being taken.
Not-for-profit employers will typically not make distributions to external shareholders, and we would expect this to be less of a concern. However, there is still the potential for 'covenant leakage' from the employer. This could be from internal dividends or cash pooling as part of a wider group, and where covenant support is constrained to certain entities within the group.
As noted in the cash flow section, trustees of not-for-profit schemes also need to consider whether any of the employer’s cash flows and/or assets are restricted. This will help to understand the level of available resources the employer has to support the scheme’s recovery plan.
Considerations for NAME schemes
A key consideration for the trustees of NAME schemes is the allocation of contributions among employers (the contribution structure). For example, contributions may be evenly spread among all employers or distributed unevenly, based on different factors.
The same factors that need to be considered when determining affordability and contribution structure are likely to be required when determining how to assess the maximum affordable contributions of each employer (See the ‘Determining the covenant inputs required to assess supportable risk’ for further details).
Factors informing your assessment of affordability should include the following:
- the legal obligations and status of each employer
- the employer’s share of liabilities to the scheme (including, where relevant, orphan liabilities allocated between employers)
- whether the scheme is last man standing
- whether any employers have employed active or eligible members
- the mechanics of employer withdrawal or insolvency
- whether participating employers are required to remain in (or contribute to) the scheme even after they have paid their section 75 debt
- the trustees’ powers to impose contributions
- any restrictions that might apply to the allocation or payment of contributions due to the scheme
When setting contribution structures, you should be mindful of the different levels of affordability across the employers, and how this may evolve over time. Any adjustments to reflect such dynamics should have clearly defined parameters.
For example, employers with the same amounts of scheme liabilities and deficit, but with different affordability, may need to pay the same aggregate value of DRCs over different periods. This is to avoid overall reasonable affordability being set to the level of the employers with least affordability (resulting in longer recovery plans), and reasonable affordability being set to the level of the employers with greatest affordability (resulting in financial pressures on other employers).
These sensitive issues can be made even more relevant by the fact that employers within NAME schemes may be commercial competitors. However, subject to these considerations and robust controls, you should implement an approach which ensures overall contributions are not fundamentally constrained by the position of the employers with least affordability.
It may be appropriate to consider contingent asset support, for example security over unencumbered assets of an employer with limited cash flows to support the scheme.
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.