The Centrality of Covenant in DB Surplus Management: From Principles to Practice

Charles Marandu
Sep 5
2 min read

It's an old cliché that actuaries love numbers.

But solutions cannot be found in numbers alone.

With UK long-dated gilt yields offering 30 year highs, defined benefit (DB) pension schemes are generally in a strong position of surplus on a low-dependency basis. Trustees and sponsors looking to run-on are asking an increasingly pertinent question: how should surplus be managed, secured, and potentially shared?

The answer depends critically on the strength of the sponsor covenant — the employer’s legal responsibility and financial ability to support the scheme.

The Pensions Regulator (TPR) places covenant as a central consideration within the DB Funding Code.

Key dimensions for Trustees to assess and account for under the Code include:

1. Covenant Reliability – For how long can the sponsor be reasonably depended on to continue to provide cash flow to support the scheme?

2. Covenant Longevity – For how long into the future will the sponsor remain able to stand behind the scheme?

3. Maximum Supportable Risk – How much scheme risk can the sponsor reasonably absorb?

Hallmarks of a Fully Integrated Decision Making Framework

To make sound decisions requires going beyond the quantum of the surplus.

The covenant provides the foundation for investment risk-taking and the funding strategy. In practical terms, any operational framework to manage surplus requires that trustees and sponsors can integrate the covenant into real-time decision making.

A fully integrated decision framework enables:

1. Assessment of dynamically evolving risk exposure on the sponsor.

2. Determination of whether that risk exposure is tolerable, too high or too low (i.e. is risk within supportable levels).

3. Actionable strategic outcomes (including but not limited to surplus release) which reset risk exposure to within its tolerable range.

In taking the above approach, trustee boards, sponsors and members can enjoy the advantages of surplus release, whilst avoiding over-caution (leaving excessive surplus value behind) and over-optimism (releasing too much surplus leading to future over-reliance on the sponsor and insufficiency in the scheme).

To further explore these concepts, or to discuss how our Surplus Management Framework could help in your case, please get in touch via the Contact link above.

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