What can DB schemes do with funding surpluses?

As the Department for Work and Pensions (DWP) has released its consultation on scheme surpluses, some in the sector are pushing back on the government’s plan for surpluses to be freed up to invest in ‘productive finance’.

When the DWP’s call for evidence on “options for defined benefit schemes” closed in November, responses highlighted a disconnect between chancellor Jeremy Hunt’s investment wishlist and pension industry concerns over the duty to savers.

The new consultation, launched late last week, proposes a “statutory override” to allow trustees to skirt scheme rules and share surpluses “subject to appropriate funding levels”.

Pension surpluses have soared over the past two years and stood at £425.4bn at the end of January, according to the PPF 7800 index. Data from the Pensions Regulator show there are more than 3,750 defined benefit (DB) schemes in surplus on a low dependency basis.

Hunt said he believed it was possible to free up the estimated £1.4trn of UK pension assets to enhance investment in UK productive finance, while also safeguarding member benefits and prioritising a strong and diversified gilt market. He has already promised to cut the tax on scheme surpluses transferred to employers from 35% to 25%.

Duty to members versus investment risk

Nigel Cayless, senior counsel at Sackers, said fears faced by schemes over meeting liabilities had fuelled the growing demand for insurance transactions – a sector that may be facing a capacity crunch.

He said: “Trustees could be forgiven for thinking that driving economic growth is not their responsibility, or for that matter, the responsibility of their sponsoring employers.”

Investing in illiquid assets – a key element of the productive finance proposals – will require schemes to run on rather than transfer to an insurer.

Cayless said allowing pension schemes to feel they can carry 100% of the funding risk also meant being comfortable with allowing a surplus to build up in the first place.

“If employers can’t easily extract surplus, then this is likely to make them wary of the risk of overfunding and trapped surplus, which might translate to an aversion to risky growth assets or productive finance,” he said.

“All of this talk of schemes supporting economic growth assumes that DB surpluses are here to stay. What happens if trustees decide to run on and things don’t go as planned?”

Surplus or reserve?

Anna Rogers, senior partner at Arc Pensions Law, said the idea of a pension surplus needed to be reframed.

“Until all liabilities are covered, it is not surplus, it is a reserve,” Rogers said. “The surplus is money that may yet be needed in the future.

“We have had years of this debate. The money is there to provide a pension for [the scheme’s] members.”

Meanwhile, Penny Cogher, pensions partner at law firm Irwin Mitchell, said unless the law was changed many schemes would be unable to invest in productive finance.

Restrictions that have been added to the trust deeds and rules of pension schemes by HM Revenue & Customs over the years needed to be lifted in order to make it easier to put surpluses to use.

“These restrictions on the use of surplus while the scheme was ongoing meant that trustees and employers used the surplus to provide discretionary benefits instead,” Cogher said. This was particularly important for benefits earned before 6 April 1997, which are not subject to statutory increases.

Graham McLean, head of pension scheme funding at WTW, said the publication of revised defined benefit funding regulations last month had done little to convince the pensions industry it would be supported with the correct regulatory and legal framework to better support the productive finance agenda.

“Trustees might still question whether the ‘highly resilient’ test allows them to assume for funding purposes that 20%-30% of their portfolio is in growth assets,” he said.

McLean added that an opportunity to write something clearer and more explicit “had been missed”.