Roll back a few years and defined benefit (DB) pension schemes were focused on bridging a deficit on technical provisions or moving towards self sufficiency. Surplus probably didn’t enter into the thinking of the majority of schemes. Now, in part due to market events of Q2 2022, a number of schemes are in the very real position of having a surplus. In her recent announcement, the UK Chancellor, Rachel Reeves noted that approximately 75 per cent of DB schemes were in surplus, with a collective value of £160bn.
So what are the potential options for schemes that find themselves with a surplus, and what can they do that is right or equitable for all stakeholders?
The first thing to check is the scheme’s trust deed and rules. This should provide further detail on what may or may not be allowable. But what are some of the potential options for use of surplus?
Benefiting defined contribution (DC) members is one of the more eye-catching ones – using a surplus is to increase the contributions for DC members. Currently, this would only be possible where DB and DC schemes are in the same trust, but we understand the Government is looking at enabling trust-to-trust transfers.
Where DB surplus has been used to fund employer DC contributions, the argument has been that this isn’t benefiting members directly. Rather it is improving future cashflow for the employer, as they wouldn’t need to fund this. If the idea is to truly benefit DC savers, then increasing contribution rates, rather than maintaining them would potentially be beneficial.
Paying a lump sum to members could, in theory, be an equitable way of benefitting all members, but under the current regime it isn’t that straightforward. At present, paying a lump sum to a member may be classed as an unauthorised payment. Again clarity from the Government on this would be useful.
Paying the surplus to the sponsor is an argument for which I have some sympathy. Sponsors have paid significant sums into pension schemes and funded the deficit. Now schemes are in surplus, they should potentially be able to benefit from this surplus. While there is no doubt this would help with companies’ cashflow and the Government’s agenda around investing in UK plc, optically there may be challenges around returning surplus to sponsors. There have been some high-profile cases (Bristol Water plc) where the trustee’s decision to return surplus to the sponsor has been challenged. If surplus is returned to the sponsor then this would be subject to the prevailing tax rate, currently 25 per cent.
Increasing members discretionary increases is another option that could be considered. This may look appealing at face value, but there are some key questions to take into account. Would all members benefit from these discretionary increases? If the answer is no, would it be fair to benefit only those who do? Would the discretion be materially beneficial, or would the impact on members’ benefits be low? Factoring in the role of a trustee, which is to act in members’ best interests, not necessarily looking to maximise members’ benefits.
For several schemes where I am trustee, we have looked at scheme expenses and how these are met. Whether these are met directly by the sponsor or by an expense payment through the Schedule of Contributions, we have looked to make amendments so that some, or all, expenses are met by the scheme. While this isn’t an explicit return of surplus to the sponsor, it would no doubt help with their ongoing cashflow.
It may be that a combination of options for sharing the surplus is agreed upon, noting the unique situation of each scheme.
There are certainly advantages to having a more defined process around the use of surplus, and clarification on the options available across all schemes. However, progress needs to be made quickly so schemes have a clear understanding of the regulatory environment they are operating within, and can facilitate active conversations around running on versus risk transfer. The risk is that confidence becomes eroded within the system for members, and that the required steps are too complex – resulting in schemes being less inclined to look at surplus sharing.
Active engagement with the sponsor is key to manage expectations and ensure everyone is on the same page. It seems the Government has identified surplus extraction as a key focus for pensions, and we fully expect that changes to the Pensions Act 2004 will be made over the coming months to help facilitate this.
