DB surplus release: Three key questions to drive better outcomes

If done correctly, this could allow more sponsors to recoup a larger share of their significant deficit repair funding from over the past decade. It could also encourage discussions on how members should also benefit – without jeopardising the payment of promised pensions.

What counts as a ‘surplus’ will be specific to each pension scheme and will vary between stakeholders, so it should largely be left to them to agree what is right in their circumstances (providing the requirements of the new regulatory regime are met).

But there are three other core questions that need to be carefully considered.

1. What covenant is required to release surplus safely?

Over the past few years, a perception has developed that pension schemes are insecure and that insurance is always required to safely pay pensions.

The available evidence does not always support this view. Many (but not all) of the sponsors of these schemes are going concerns with ample covenant longevity, receiving regular investment and financing, trading with suppliers, and employing thousands of people.

While there are good reasons why insurance may still be the right strategy, many schemes will not require it from a security perspective and may be comfortable with releasing at least some surplus assets on an ongoing basis.

No substantive legislative and regulatory changes are required to ensure members remain protected.

The new DB Funding Code of Practice provides a clear framework to test whether the covenant has sufficient longevity and the financial ability to underwrite the scheme’s risks, and sponsors should be required to provide the information needed to do so. (An update to the DB Funding Code is expected to address surplus release specifically.)

The code should be augmented with a tailored protection framework, much like a lending agreement, covering:

• Suitable tests for if the covenant outlook changes
• A contingency plan to address any adverse changes
• Requirements to repay the scheme (or take other action) if its funding position worsens
• Any additional security needed, such as letters of credit or surety bonds

There will be no one-size-fits-all approach: tighter controls will be needed for weaker sponsors and the further that scheme funding levels are reduced. As such, the legislation should provide flexibility for trustees and sponsors to agree what is appropriate in their circumstances.

The Pensions Regulator (TPR) will also need to ensure the right checks and balances are in place in any decision to release surplus.

The risk that a sponsor can appoint a trustee who can then release assets to the sponsor must be considered and clear guidance will be required from TPR – perhaps supplemented by a clearance process where the release exceeds set parameters.

2. How can trustees get comfortable with releasing surplus?

Legal experts have noted that the duties of trustees are nuanced and many schemes’ rules mean that their sponsors retain a financial interest in them. Nonetheless, releasing surplus to the sponsor may be uncomfortable for trustees focused on delivering promised pensions to their members, even where risks can be suitably understood and mitigated.

One option to encourage trustees would be to frame these changes as a ‘refund of deficit repair contributions’ rather than a ‘release of surplus’.

Most surpluses are the result of deficit repair contributions that were not, in hindsight, required. The appearance of repaying a debt (moral, if not legal) may form a key part of justifying surplus release.

The government has indicated that it expects trustees and sponsors to consider whether members should receive higher benefits, which will be a key point of discussion. While the merits are likely to be scheme specific, providing full flexibility on how they can be structured will be helpful.

3. Should constraints be placed on assets returned to the sponsor?

While the government has a policy focus on driving investment in ‘productive finance’, other commentators have suggested that trustees should require any assets released to be invested to improve the long-term covenant.

In practice, cash is fungible and tracing the use of specific funds is difficult. Corporate law is already clear in placing a duty on directors to promote the success of their enterprise and they should be free to do so as needed.

As the SPP has highlighted to policymakers, placing restraints on how funds can be used could result in inefficiency and distraction, when the focus should instead be on putting the right framework in place to ensure the pension scheme remains sufficiently resourced and protected.

Alex Beecraft is a member of the Society of Pension Professionals’ Covenant Committee.