Over the past few years we have seen unprecedented improvements in the funding levels of DB pension schemes. This has resulted in more DB schemes being in surplus and, as a result, trustees and their sponsoring employers grappling with the questions of what can and should be done with those surpluses.
The Government has also clearly been giving this some thought. As part of the avalanche of pension reforms announced by the Chancellor in his Mansion House speech in July, we saw the DWP launch a call for evidence on options for DB schemes to support the development of “innovative policy options” and how DB schemes could use their assets more flexibly, while maintaining appropriate member security and not undermining trustees’ fiduciary duties. This included options regarding access to and the use of DB surpluses.
In its response, the Government acknowledges a lack of consensus as to the path forward. A further consultation is expected “this winter” addressing, amongst other things, measures to make surplus “extraction” easier. Appropriate safeguards, such as the levels at which surplus can be taken and covenant strength, will also be covered as part of this. In the meantime, some welcome news for employers – the tax rate on an authorised surplus repayment to a sponsoring employer will be reduced from 35 per cent to 25 per cent from 6 April 2024.
The mood music coming from the Government could be seen as a challenge to the traditional model of DB schemes targeting buy-out. On top of this, TPR has also recently joined the debate stating that – as funding levels improve – it will not push trustees to buy-out.
So, where does this leave the growing number of employers whose DB schemes are in surplus? Is insurance still the default option for trustees of DB schemes and their sponsoring employers? What are the other endgame options and are they realistic under the current regulatory regime?
In broad terms, the current options for DB schemes can probably be summarised as insurance, superfund, or (at a push) running on to generate surplus. The insurance solution has traditionally been the default gold standard for many years. However, there are some signs that this mindset is starting to change. We have recently seen the first superfund transaction with the Clara Pension Trust, with more expected to follow. Might we also start to see schemes giving serious consideration to running on to generate surplus?
From an employer’s perspective, it is probably safe to say that an insurance solution remains the gold standard for the time being. The evidence for this is that the bulk purchase annuity market has never been busier and 2023 looks on track to be a record year in terms of both the number and value of transactions.
From the corporate perspective, an important consideration when discussing any insurance solution with trustees will be the accounting impact that a buy-in and the subsequent buy-out will have on the sponsoring employer. It will be important that an employer raises this with its auditor before trustees get too far down the de-risking road.
Where there is likely to be a surplus following buy-out, it is well worth employer and trustees coming to an understanding early on regarding how this might be used. The options and the balance of power regarding who makes the final decision will be specific to each schemes’ rules. Key to any discussion with trustees on use of surplus will be how that surplus has arisen. For example, where a scheme is in surplus as a result of significant employer contributions then the employer may feel this is a good reason why any surplus should be returned to it.
Employers should also be mindful that there are various options to avoid a surplus arising in the first place. These include escrow accounts and reservoir trusts. However, it should be noted that there will be costs involved in setting up these structures, so they won’t be appropriate in all situations.
Turning to running on a scheme as an end game option, what issues might an employer need to consider? As a starter, it goes without saying that the scheme’s trustees will need to be on board. The extent to which a trustee board is willing to consider running on will largely depend on the strength of the employer covenant that supports the scheme. Trustees will need to be comfortable that the employer covenant supports both running on and the corresponding changes to the scheme’s investment strategy. To assist with this, employers should consider formalising wider corporate group support for their pension arrangements. Formalising covenant support can certainly help with the development of common employer/trustee strategies and also potentially give trustees the confidence to explore alternative investment strategies.
Putting all of the above to one side for a moment, as things stand today there remains a fairly major obstacle in the way of the Government’s goal to use DB pension scheme assets to drive economic growth. This is the fact that many employers are likely to be of the mindset that they are not in the business of running on a pension scheme to generate surplus. This is not why these schemes were set up in the first place. It remains to be seen what the Government can do to change this.
