The Pensions Regulator (TPR) continues to refine its guidance on funding defined benefit (DB) schemes,[1] having recently published its Employer Covenant guidance.[2] A key aspect of the guidance is how contingent assets influence scheme funding and the evolving role of the so called “Section 75 guarantees”.
Contingent assets can include guarantees, letters of credit, surety bonds and other forms of security in favour of the DB scheme, and are put in place to provide additional covenant support. Guarantees are one of the most common forms of contingent assets. Typically, a third party, such as a parent company or another financially stronger entity, will agree to guarantee the payments of the sponsoring employer to the scheme. For example, this can include any debt which can be triggered in the future on the employer under section 75 of the Pensions Act 1995, on the insolvency of the employer or on the winding-up of the scheme. In this case, the guarantee can be referred to as a Section 75 guarantee.
The impact of contingent assets on covenant assessments
Contingent assets can support the scheme’s reliability and longevity periods (as referred to in the new guidance) if they provide genuine additional security. However, there is a risk that some contingent assets do not offer real financial support but instead serve as paper-based commitments with limited legal enforceability. There are also difficulties in actually assessing the value of contingent assets, particularly when considering their enforceability and effectiveness in meeting pension obligations. Trustees are expected to engage actuarial experts to validate whether these assets can be relied upon for scheme funding and risk mitigation. They must also ensure that they have sufficient legal advice on the enforceability of contingent assets. This means looking beyond face-value commitments and considering the security mechanisms, legal frameworks and enforceability provisions that underpin these assets.
Interaction between contingent assets and scheme risk
A key issue will be how contingent assets interact with a scheme’s overall investment risk strategy. Where a scheme has a high level of investment risk, but insufficient contingent asset backing, it may be exposed to a funding shortfall if adverse events occur. The guidance suggests that, in some cases, trustees may need to reduce investment risk unless additional support or contingent assets can be secured. This highlights one of the challenges of ensuring that contingent asset arrangements are structured effectively to justify ongoing risk exposure.
Future trends and market evolution in contingent assets
Since traditional guarantees and contingent asset structures may no longer be sufficient under TPR’s revised guidance, schemes may adapt and seek to:
- modify existing guarantees to meet TPR’s “look through” criteria allowing trustees to directly assess the guarantor’s cash flow and affordability (more on this in “Section 75 guarantees: the ‘look through’ approach” below);
- introduce contingent contribution mechanisms, which require an employer (or guarantor) to make additional payments under certain pre-agreed conditions. These mechanisms could include trigger-based funding support, where contributions are automatically activated if investment underperformance, economic downturn or covenant deterioration occurs. Such an approach offers greater flexibility compared to traditional guarantees, while still providing measurable financial support to the scheme; or
- explore alternative financial support structures. This could include using escrow arrangements, where funds are set aside for the pension scheme but only drawn upon under specific conditions, or securing asset-backed contributions, where companies pledge reliable, liquid assets instead of traditional guarantees. Other innovations might include structured financing solutions, such as pension funding partnerships or collaborative agreements with insurance providers to mitigate long-term risks.
Section 75 guarantees: the “look-through” approach
TPR’s new guidance details that traditional Section 75 guarantees may not always provide sufficient security unless they meet the “look-through” criteria provided in TPR’s draft DB funding code.[3]
A “look-through” guarantee allows trustees to assess the guarantor’s cash flows when evaluating affordability of contributions to the scheme. If this condition is met, the guarantor’s financial strength can be considered in funding and risk assessments, potentially influencing deficit repayment expectations. To meet the requirements of a “look-through” guarantee, the following conditions should be satisfied:
- Coverage of the full Section 75 deficit: The guarantee should underpin the entire Section 75 debt should it become due.
- Protection against missed contributions: The guarantee should cover missed deficit reduction contributions under the scheme’s schedule of contributions.
- Ability to assess the guarantor’s cash flows: The legal framework must enable trustees to “look through” to the guarantor’s financial position when setting contributions. Without this mechanism, affordability assessments would be limited to the statutory employer alone.
- No time limitations (evergreen structure): The guarantee should not be time-limited but should remain in place indefinitely unless appropriately replaced.
- Absence of onerous conditions: The guarantee should not include conditions that could restrict the powers of trustees or TPR.
- Enforceability across jurisdictions: The guarantee must be legally enforceable both in the UK and any relevant overseas jurisdictions, with legal advice confirming its effectiveness.
- Information-sharing protocol: A mechanism should be in place to ensure trustees have access to up-to-date financial information about the guarantor, enabling them to monitor its strength effectively.
Guarantees that do not meet these requirements are unlikely to qualify for look-through treatment under TPR’s guidance and so their role in supporting investment risk is limited. However, they can still provide value by improving a scheme’s insolvency position and diversifying covenant risk. Trustees should assess whether non-look-through guarantees still align with regulatory expectations and whether alternative arrangements could offer stronger financial security.
Final thoughts
Ultimately, adapting to TPR’s latest guidance will require trustees and sponsors to take a critical and proactive, tailored approach to scheme funding, ensuring that any contingent asset or guarantee structure genuinely strengthens scheme security, aligns with regulatory expectations and remains enforceable in a range of financial scenarios.
[1] See https://www.ukemploymenthub.com/the-pension-regulators-defined-benefit-funding-code/
[2] Covenant guidance | The Pensions Regulator
[3] Paragraphs 156-159, draft DB funding code of practice | The Pensions Regulator
