The financial position of many UK defined benefit (DB) schemes has improved significantly over the last two years, with a significant proportion now exceeding full funding on every measure of interest, including their solvency (or ‘buyout’) measures.
To date, many schemes that have reached full funding on buyout have looked to transfer their liabilities to insurers, with sponsors being released from ongoing DB obligations. However, this isn’t the case for all, and a number of schemes and sponsors have agreed a variety of ways of using surplus and have consciously chosen to run-on. Typical approaches have involved meeting scheme expenses, funding the costs of ongoing DB accrual, or paying DC contributions where a DC section exists within the same trust. For a smaller number of schemes, members have also benefited from agreements to grant discretionary pension increases or other enhancements to member options. Whilst these options are available to some schemes, the ability to use surplus in these ways does not exist for all schemes for a variety of reasons and can therefore limit the benefits of and appetite for running a scheme on.
A key disincentive for running schemes on relates to a fundamental asymmetry inherent in the current funding regime – where funding shortfalls are addressed through contributions but access to surplus funding is restricted; in nearly all cases refunds from surplus are available only in a wind-up situation (following a scheme buyout).
The consequence of this systemic asymmetry is that it has been relatively common for sponsors to be more “pro-risk” and trustees to be more “anti-risk” while schemes are in deficit. However, when a scheme reaches a position of surplus, as we have seen in recent years, sponsors have often leapfrogged trustees in then being more focused on reducing risk and offloading liabilities to insurers, given the limited upside for many sponsors.
The Government’s consultation on “Options for DB Schemes” looks to address this asymmetry and considers proposals that could be made to make it easier for both employers and members to access surplus on an ongoing basis, with appropriate checks and balances to ensure that members’ benefits remain appropriately well-funded. With many more schemes now fully funded on a low dependency measure or buyout basis, the opportunities and opportunity costs of insuring liabilities or running on have come to the fore, and the possibilities raised in this consultation could open up new avenues for many schemes to find ways to deliver value to all stakeholders.
We set out our key views on the surplus aspects of the consultation below.
We welcome the Government’s proposals on making access to surplus easier and earlier in appropriate circumstances. Our perspective is that the incentives in a system are paramount to influencing behaviour and the changes proposed would provide a rationale for some schemes to consider running on for longer and investing in ways that can benefit members, sponsors and the wider UK economy.
Permitting, where appropriate, the opportunity for sponsors to gain access to some surplus before wind-up and at a lower funding threshold than is currently the case, as well as changing legislation to allow one off lump sum discretionary increases, would create more appetite for some trustees and sponsors to revisit endgame objectives, timeframes and investment strategies. Of course, there will be schemes that are rightly steadfast in pursuing buyout as soon as possible or where the flexibilities to make refunds from surplus would be inappropriate and counter to members' interests. There will be many relevant factors in determining the appropriate course of action for any particular scheme, but the proposed changes should allow trustees and sponsors to explore these options in a balanced and scheme-specific way.
This view is also supported by our recent survey of over 150 clients about the Government’s proposals that we undertook to inform our response to the consultation. Almost half of the respondents said they would be likely to defer buyout if surplus sharing were made easier. Furthermore, just over a half expected that they would review their investment strategy with a view to holding growth assets for longer.
When asking clients what actions they may take if it were significantly easier to enable payments from surplus, subject to satisfactory member safeguards, around half of the respondents said they would be likely to agree a surplus sharing package.
In addition, the support for allowing one-off discretionary lump sum payments, by changing the legislation to class these as ‘authorised payments’, was also high amongst our respondents. This is also a policy change we strongly support as it would enable value to be delivered with cost certainty by providing additional benefits to members more rapidly and without increasing the long-term liabilities and risks of the scheme. Almost two-thirds of respondents suggested this change would make it easier to agree a surplus sharing package, and over two-fifths of respondents said it would increase the likelihood of running the scheme on.
One area that the Government’s consultation did not touch on was how changes would be reconciled with the current legislative requirement that trustees must be satisfied that payments to an employer from an ongoing scheme must be in the interests of members. We think that guidance from the Pensions Regulator, including examples of the relevant considerations, may be especially helpful in this area.
We believe that great care needs to be taken by Government to ensure that any legislative overrides are crafted so as not to upset any existing balance of powers between sponsors and trustees and to ensure that agreements previously negotiated remain valid and are not adversely affected.
Existing scheme rules will sometimes allow payments to the employer and/or one-off lump sums to members once legislative barriers are removed. However, we still believe a statutory override in some form would be useful but it is important that both trustee and sponsor consent is required before there is any impact or action taken on any scheme. In particular, the changes should not force trustees to take inappropriate action but give them more flexibility to be able to make decisions they consider to be in the interests of their scheme’s members.
In terms of accessing surplus, one of the current hurdles is that schemes need to be fully funded on a buyout basis in order for payments to be made to an employer from an ongoing scheme. We believe this bar is usually too high and should not be the statutory condition that applies to all schemes.
We think that a more appropriate approach to providing access to surplus should have two limbs:
The new funding regime will not itself require schemes that have reached 100% funding on a low dependency basis to target a funding level above 100% or to seek payments from the employer to help achieve such higher funding. Minimum thresholds to be met under legislation for surplus access requirements should be symmetrical with this: legislation should not automatically prevent payments to the employer where the scheme would remain at least 100% funded on a low dependency basis. Instead, trustees should have to consider whether (and at what level) a higher threshold would be appropriate in their circumstances.
Retaining a buffer above 100% funded on the low dependency funding basis may often be appropriate but prescribing a minimum margin centrally (e.g. the arbitrary 5% buffer referred to in the consultation paper) will not take account of scheme-specific circumstances. In some cases, an arbitrarily prescribed buffer could even be counterproductive from a benefit security perspective – e.g. where sponsors might have otherwise been prepared to provide additional guarantees or contingent assets in return for fuller access to the surplus on a low dependency funding basis.
Therefore, we believe it would be more in keeping with the scheme-specific nature of the funding regime for trustees to be required to take into account relevant factors with supporting guidance on how one might do so from the Pensions Regulator.
Our client survey indicated a more mixed response in this area. However, the majority agreed that the current buyout threshold was too high – especially amongst the larger schemes, who may have more rationale to run on due to their scale. About a third of schemes consider either 100% of the low dependency basis or with some additional buffer for scheme-specific risks, should be the measure used before surplus can be accessed.
We are sceptical about the idea to require schemes to purchase 100% contingent protection of scheme benefits from the PPF before surplus could be accessed on an ongoing basis. The consultation indicates that the PPF estimated the annual charge could amount to 0.6% of buyout liabilities (i.e. £6m pa for every billion pounds of liabilities). This would be prohibitively expensive and 85% of schemes we surveyed indicated that they would be unlikely to be willing to pay them.
Furthermore, either:
It would also be unclear how much ‘extra’ protection schemes were purchasing – this is a moving target when core PPF compensation is likely to be improving but could in theory be cut back in future. Furthermore, there are well-trailed practical difficulties in the PPF taking on the nuances of scheme-specific benefits; for example, in the PPF’s response to the Government’s consultation it highlights that if it were to act as a public sector consolidator, it would need to operate only a limited range of ‘standardised’ benefit structures.
We eagerly await the Government’s response to the consultation. However, with the General Election now looming, timing is even more uncertain than before, and there will not be an official Government response until after polling day. Whilst we understand there is cross-party support on the general theme of increasing investments in growth/productive assets as schemes run-on, whether the topic of access to surplus will maintain its momentum remains unclear. Despite this, those managing DB schemes should proactively consider their endgame options and timings to understand the opportunities and trade-offs that could be involved.
