Empowering the £1.5trn in private sector DB pensions

UK private sector defined benefit (DB) schemes are in excellent shape. This has set the stage for a dramatic shift in approach, which could lead to widespread benefits for members, sponsors and the UK economy.

Unlocking this potential could be transformative for the UK, which faces record debt levels and challenging demographic trends.

The £1.5trn invested by these DB schemes represents an unparalleled pool of capital which could set the foundation for future growth – but without a change in approach from the government, this opportunity could be lost.

The strength and opportunity of UK DB schemes

The UK corporate DB system is now one of the most robust pensions systems in the world, with the pension promises of almost 10 million members protected through multiple layers.

These schemes’ liabilities are, in aggregate, backed by more than enough assets, with a surplus amounting to hundreds of billions of pounds even on conservative funding measures.

Trustees, bound by a fiduciary duty to act in their scheme members’ best interests, provide independent oversight.

How these schemes invest is shaped by clear regulation, with the DB funding code setting out minimum funding level requirements and maximum levels of risk pension schemes are allowed to take. Most DB assets are invested in gilts and high-quality credit, providing a secure base for their members’ retirement income.

These schemes are in turn backed by over 4,000 companies, operating in multiple sectors around the world, with a combined value of several trillion pounds. And in the unlikely event that a scheme is in deficit, and its sponsor fails, the Pension Protection Fund (PPF) – which also boasts a healthy surplus – is in place to cover most member benefits.

This combination of healthy funding, low-risk investment strategy, regulatory oversight, independent governance, the diversity and combined strength of backing sponsors, and funded protection, means many view the UK corporate DB system to be highly secure.

If DB schemes run on for the long term, they could both unlock accrued surpluses, offering a meaningful cash injection for members and sponsors, and enable ongoing investment and growth of surpluses over time.

Why urgent change is needed

Despite the security and strength of the system overall, the current regulatory and legislative regime incentivises trustees and sponsors to pursue insurance buyouts as soon as these become affordable.

Almost £50bn worth of insurance transactions were completed last year. The vast majority of DB pension schemes will likely conduct insurance buyouts over the next five to 10 years unless there are changes in policy.

Buyout may be the right thing for many schemes, but for others – particularly medium and large schemes with a healthy sponsor – we believe it could lead to a significant missed opportunity for their members, sponsors and the UK as a whole.

We would also note that, following buyout, insurers would be expected to sell the gilts they receive, replacing them with other long-term assets. If DB schemes continue to buy out at scale, the implications for the gilts market could be significant.

The future of DB schemes is therefore not just about a missed opportunity for the UK, but about the future of the gilt market.

Two clear ways to adjust policy

There are straightforward changes that the government could implement to enable and encourage trustees and sponsors to run on their schemes where this is in the best interests of their members.

The first change would be to streamline surplus-sharing mechanisms, with appropriate guard rails in place.

Making it easier for members and corporate sponsors to share surplus could offer scope for increasing the size of pension payments, as well as bring about additional scheme benefits to members.

In our view, changes to the relevant regulatory frameworks should specify that after any surplus release, a DB scheme should remain above 100% funded with low dependency on their sponsor (a prudent minimum level in line with the DB Funding Code).

Second, we believe that PPF protection must be enhanced to offer security for all DB pension promises – giving schemes confidence they can deploy their capital for the benefit of all.

This can, in our analysis, be achieved at a minimal cost, and moral hazard concerns can also be managed. Extending the PPF underpin is crucial for ensuring peace of mind for trustees and scheme members when surplus-sharing is under consideration.

It is encouraging that both of these changes are under active consideration by the government, with questions on these options included in its consultation earlier this year.

A prize worth winning

If DB schemes run on for the long term, members could enjoy increased benefits; sponsors could use surplus assets for other purposes, including bolstering defined contribution schemes or other projects; and the government could receive sizeable tax revenues from surplus released.

These benefits could be realised without reducing the security of members’ existing pension payments. This is a prize worth winning.

Jos Vermeulen is a member of the Society of Pension Professionals’ investment committee.