Changing course: The case for reinvesting pension scheme surpluses

The pensions industry has a long memory, and the all-too-recent spectre of defined benefit (DB) scheme deficits looms large.

We live in a world that seemed inconceivable a decade ago. Most DB schemes are in strong funding positions. The aggregate section 179 funding ratio for the schemes in the Pension Protection Fund’s PPF 7800 Index was at 148.4% at the end of September 2024 – producing a combined surplus of £476bn.

For many DB scheme fiduciaries, any alternative to taking the changed economic situation as an opportunity to de-risk would be met with reluctance. Changing course, running on and reinvesting those surpluses would seem inconceivable.

After all, the future is still unknown and until members’ pensions are paid, surpluses are theoretical.

As Anna Rogers, senior partner at Arc Pensions Law, put it in an interview with Pensions Expert contributor Samantha Downes: “Until all liabilities are covered, it is not surplus, it is a reserve. The surplus is money that may yet be needed in the future. We have had years of this debate. The money is there to provide a pension for [the scheme’s] members.”

Ed Francis, managing director for Goldman Sachs Asset Management’s UK fiduciary management business, adds: “Running a pension scheme is not trivial and involves a lot of expense. Settlement transactions make a lot of sense for a lot of DB schemes, for all the reasons that they made sense before, which are around governance. So, I think that argument remains.”

However, Francis caveats: “I think the thing that has become very clear to people when thinking about a scheme surplus is, in a sense, there’s a feeling that they’d be giving that away if they conduct an insurance transaction.

“The reality is that’s always been the case. When the insurance transaction takes place, there’s a transfer of risk, but there’s a transfer of expected value as well, and that becomes a bit more real when there is a surplus sitting on a balance sheet.

“So naturally people are thinking: could that surplus be used, either for other things, or retained for the benefit of beneficiaries?”

As Francis says, some in the pensions industry believe that a sea of insurance transactions constitutes a missed opportunity for members, employers, and the wider UK economy.

Missed opportunity?

Jos Vermeulen, head of solution design at Insight Investment, points out that the UK is facing a national debt of well over £2trn, an ageing population that will demand resources in the form of pensions and medical care, and a low birth rate – meaning fewer people to support the ballast.

DB schemes still have more assets under management than their defined contribution (DC) counterparts; they are the obvious place to look to reinvigorate the country’s fortunes, Vermeulen argues.

Vermeulen says: “If you were going to look to potentially change the fortunes of the UK, that’s where we would start, because clearly, that’s a big pool of capital.

“There are a few simple rules that need to change to unlock the potential of that capital and impact the fortunes of the UK for generations to come.

“Because if nothing happens, the vast majority of this one and a half trillion will go to insurance companies in buyouts over the next decade or so.”

What could DB schemes do with their surpluses?

From improving the lot of DC savers to boosting the pensions of DB pension-holders, there is much that could be done with the investment returns generated from running on.

Alastair Greenlees, Van Lanschot Kempen Investment Management’s head of investment strategy UK, says: “The opportunity is across schemes, but overwhelmingly, larger schemes are going to have a bigger impact on the end result.

“Should there be appetite, [schemes] can run on or look at different options, build up surplus and create value for DB and DC members. I think that’s hugely compelling.”

Greenlees acknowledges that the idea will be controversial for many trustees.

“You can see their conundrum, because the reality is they’ve spent a long time debating deficits, and now DB schemes in general are in pretty rude health, and that means they’ve got more than enough assets to meet their liabilities and do something with [the surplus]. And actually, I think the DC angle is particularly interesting.”

Running on more DB schemes could significantly bolster the government’s mission to boost the UK economy through investing in productive finance projects like the energy transition, infrastructure or housing.

DB schemes have already contributed significantly to this mission, Vermeulen acknowledges. The devil’s in the detail, he caveats, and DB schemes would have to invest while taking a level of risk they are comfortable with.

Goldman Sachs’ Francis agrees: “For very well-funded schemes that are looking to make falling into a deficit situation again a very low possibility, but wish to continue to make modest progress to build a funding buffer through time, then the natural investment strategy is high quality bonds. Either government bonds, or high quality corporate and other entity bonds.”

Van Lanschot Kempen’s Greenlees adds: “I think there’s huge value to the members where you have impact, and you have local impact, to show that the assets are being put to work in projects that are potentially beneficial to those members and to the wider community.”

Tread with caution

Careful governance is vital to make run-on a success, warned consultancy Hymans Robertson in a paper published in July.

Sachin Patel, senior actuarial consultant at Hymans Robertson, explained: “Run-on can be transformative for DB schemes, but to ensure the smoothest transition it is imperative that consideration is given to the potential changing of dynamics between a business and its pension scheme.

“In a day-to-day context, run-on could amount to a huge change with the potential for the DB scheme to be thought of as a division, or in some cases a subsidiary, of the broader business. This will bring about complex changes to reporting lines and interactions that will need to be reviewed annually as a minimum.

“Similarly, any market guidance and the reaction of any shareholders must be considered when choosing to run on a DB scheme. It’s vital that shareholders are left feeling assured of the strategy adopted and how this will change the business profile.”

Finally, alignment between a sponsor and trustee board is vital, said Patel. “There must be complete agreement, and alignment, between parties to ensure a scheme’s run-on objectives are joined up. Once a collaborative framework is in place, and key stakeholders have been considered, a successful run-on strategy is ever more likely.”

What should the chancellor do?

Chancellor Rachel Reeves will deliver her first Mansion House speech later this week, with her focus expected to be on DC schemes and the Local Government Pension Scheme.

However, experts have urged the chancellor not to forget corporate DB schemes and the potential benefits of allowing more flexibility over the use of surpluses.

Tom Froggett, senior consultant at XPS Group, says that while buyout with an insurer is still the preferred path for many schemes, “giving employers and trustees more flexibility to take the right approach for their circumstances is important”.

“We’re therefore calling on the government to introduce changes to help private sector DB schemes to build and use surpluses where appropriate, which could unlock up to £100bn in value over the next decade,” he adds.

Nikesh Patel, head of client solutions UK at Van Lanschot Kempen, argues that “incentivising efficient use of DB scheme surpluses is key to unlocking growth”.

He calls for schemes to be empowered to separate investments into separate pools, one of which would cover member benefits and be invested conservatively, and another to manage surplus assets.

Patel estimates that the aggregate surplus of DB schemes could grow to £1trn over the next decade – a pool of capital that could be reinvested into long-term assets such as housing and infrastructure.

Schemes should be given the power to access surpluses annually, rather than having to wait until they are in wind-up, he adds. Schemes, or their sponsors, could also be given tax breaks to encourage them to invest surplus capital into UK assets.

“As part of their fiduciary duty, well-funded schemes will want the chancellor to be clear on how they can allocate capital to these UK assets in a way that does not create additional risk for members,” he says.

Additional reporting by Nick Reeve.