Net surpluses: A paradigm shift for DB pensions

After talking for decades about a crisis in defined benefit funding, successive interest rate rises mean final salary schemes are suddenly entering a new paradigm. 

Given this new net surplus position, there are fundamental questions to ask about how to set the funding regime and what choices that presents to the overall system.  

We can make some choices around policy interventions, but we should also recognise that not everything in the wider garden is rosy.  

While scheme funding is strong, we are facing recessionary forces, which will have a call on employers in future. That may be coming sooner rather than later.  

That being said, the funding position of schemes is really strong. Members’ benefits have not been as secure for 15 or 20 years, so we need to be pleased about where we are and think about the flexibility we can introduce. 

Harnessing surpluses 

Against total assets of £1.4trn, the aggregate surplus of the 5,131 private sector DB schemes in the PPF 7800 Index is estimated to be around £446.1 billion at the end of July 2023, with 4,673 schemes in surplus and just 458 schemes in deficit. In June analysis by PWC indicated schemes buy-out surplus (a higher funding requirement) at £150bn.  

With significant improvements in funding there has been renewed interest in the treatment of scheme surpluses. On face value, there is some appeal in allowing trustees and employers to extract this potentially ‘trapped surplus’ prior to wind-up.  

Firstly, neither employers nor their current or past employees stand to greatly benefit from DB pension schemes being significantly ‘over-funded’ - if the overfunding is not put to some purpose. Second, the aggregate effect is contrary to the Government’s desire for UK pension assets to support economic growth by investing more in productive finance.  

Discussion about how surpluses might be deployed have provoked concern in some quarters about a repeat of the contribution holidays and surplus extraction from pension schemes which took place in the 1980s and early 1990s. Memories of Robert Maxwell loom large in the public consciousness.   

However, with over 30 years of added safeguards and changes to the regulatory regime, including the funding regime, governance and accounting requirements for companies and pension schemes today is incomparable, with strict requirements and severe sanctions for directors, and trustees that infringe upon them.                                     

The starting point for any discussion between the sponsor and trustees around the use of surplus is of course the scheme rules. Many schemes’ rules will allow surpluses to be returned to the sponsor on the winding up of the scheme, others won’t. A recent PLSA survey of 100 schemes found a quarter of respondents said that their DB scheme permits a return of surplus other than at wind up (25 per cent). 

PLSA view  

Before any decision is taken to extend the criteria for extracting surpluses, we believe the exact conditions that should apply will need further consideration and testing with trustees as part of a broader industry-wide consultation process.  

The primary focus of scheme trustees is their fiduciary duty to their members – ensuring their benefits are secure and get paid. In doing so they must act prudently.  

Based on feedback from PLSA members, the overriding condition that needs to be met before any extension is introduced to the criteria to allow the extraction of a DB surplus is that the DB scheme needs to be very well funded on a low dependency basis – a definition set by the Pensions Regulator. Essentially, this would require the trustees to be confident that the scheme could pay the member benefits in full, even if there was a change in the wider economic conditions, which impacted the scheme funding i.e. a buffer that also accounted for investment risks.  

Other conditions that should apply are that the employer must be in a good financial position with a strong employer covenant in place along agreed regulatory definitions.    

These conditions are important to mitigate the risk of sponsors in financial difficulty seeking to access the surplus of their pension scheme. They will also protect against conflicts of interest that could potentially create moral hazard risks. For example, where there are employer-nominated representatives, or scheme rules allowing employers to select trustees. 

Tight controls should also lessen the impact of unforeseen events in the future that significantly impact a scheme’s funding position and lead to member detriment. 

Above all these measures that might govern release of scheme surpluses is trustees’ fiduciary duty to ensure trustees act prudently and responsibly, and in the best interests of the scheme beneficiaries.  

Potential benefit of returning surpluses 

So, what actions might scheme sponsors be permitted to take with their returned surpluses? The potential to increase scheme benefits should certainly be explored, for example, through changes to accrual rates or indexation.  

Some schemes will have shared cost requirements which will have resulted in employees paying higher contributions to close schemes deficits. It would be reasonable for those members to also benefit from any surplus the scheme has built up.   

Arguably, lowering the legislative threshold for allowing returns of surplus, as well as a supportive DB Funding Code, could potentially encourage trustees (in conjunction with their employers) to adopt a more ambitious mindset and take on slightly riskier investment strategies for their DB assets, including greater investment in UK assets. 

This could also benefit employers if assets no longer risk becoming ‘trapped’ in the scheme, which could potentially lead to a very different alignment than that of recent between trustees’ and employers’ investment philosophies around taking on greater risk. 

Above all, surpluses have been won through a combination of careful management by trustees and contributions from employers and scheme members. For many sponsors and schemes, this has not been an easy journey and undoing hard fought gains is not something that anyone would seek to risk.  

Joe Dabrowski, is deputy director of policy, Pensions and Lifetime Savings Association