As the government casts its eye over well-funded DB pension schemes, Pensions Expert explores the industry’s calls for this to be done responsibly.
By the end of last year, those working in the DB sector may have been feeling a little left out. The new government had wasted no time in proposing reforms to defined contribution plans and the Local Government Pension Scheme, but had remained largely silent on DB.
For many, this was a missed opportunity. Over the past three years, the funding levels of private sector DB pension schemes have been improving, with the majority now recording a surplus.
Data from the Pensions Regulator showed that private sector DB pension schemes had an aggregate funding surplus of £179bn as of 31 March 2023, on a technical provisions basis. Unfortunately, in most cases this can’t be accessed until a scheme is wound up.
‘A seminal moment for UK pensions’
All that looks set to change after the government unveiled plans to overhaul the rules governing DB surpluses and give trustees the power to take money out of schemes.
The Treasury stated yesterday (28 January) that trustees and the sponsoring employers could use money from surpluses to “increase the productivity of their businesses” through higher wages, or by paying more to pension scheme members.
The move comes as the government is exploring multiple avenues to encourage investment in UK industries and infrastructure. It aims to boost economic growth after a period of low to no expansion.
Matthew Arends, head of UK retirement policy at Aon, described the plans as “a seminal moment in UK pensions”, marking a move away from the regime that only allows refunds when schemes are wound up.
“Employers will no doubt welcome the apparent flexibility over the use of surplus, although it remains to be seen what share of refunds is reinvested in the UK economy,” he said.
The previous government launched a consultation last year about giving trustees a ‘statutory override’ on surplus rules to allow money to be returned to members or sponsors.
Parliament’s Work and Pensions Committee also recommended that the government look at ways to ensure that surpluses can be used to grant increases to benefits accrued prior to 1997. These are not subject to statutory inflation-linked increases.
The importance of fiduciary duty
Reaction to the announcement has been broadly positive – particularly since many organisations have been urging the government to consider surplus extraction. The central message from responses this week, however, has been one of caution, emphasising the importance of fiduciary duty.
“Until all member benefits have been paid out or externally secured, ‘over-funding’ is really just money in reserve, given that circumstances can change.”
Sonya Fraser, Arc Pensions Law
Sonya Fraser, partner at Arc Pensions Law, said the government’s full proposal – expected to be published in the spring – would need to include a definition of what a surplus is.
“Until all member benefits have been paid out or externally secured, ‘over-funding’ is really just money in reserve, given [that] circumstances can change,” she said.
“Trustees will not want to find themselves in a position where surplus has been paid out and then funding levels – and security of member benefits – deteriorate.”
Alistair Russell-Smith, a consultant at Spence & Partners, agreed that the government should set clear thresholds to control when surpluses can be accessed. These could be based on achieving low dependency status under the Pensions Regulator’s new funding code for DB schemes, he said.
The proposals could see DB pension schemes “become an asset rather than a liability” for UK companies, Russell-Smith continued.
“The key to success is ensuring that pension scheme trustees have enough guidance and confidence that distributing surplus aligns with their fiduciary duties to act in the best interests of their members.”
Alistair Russell-Smith, Spence & Partners
“The key to success is ensuring that pension scheme trustees have enough guidance and confidence that distributing surplus aligns with their fiduciary duties to act in the best interests of their members,” he said.
Maggie Rodger, co-chair of the Association of Member Nominated Trustees, said the proposals needed to include “substantial safeguards” to protect accrued benefits, and sponsoring employers would still need to stand behind their pension schemes.
“Trustees have a fiduciary duty to members and must be free to exercise it,” Rodger stated. “Stronger employer companies and a stronger UK economy can be good for the security of member pensions, but history shows that there can be sudden reversals to asset values too.”
Sankar Mahalingham, managing director at professional trustee firm LawDeb Pensions, said there was “no denying that DB surplus pots look attractive” to a government eager to explore “every avenue” to boost economic growth.
But he said it was essential that any extraction is carried out with the consultation and agreement of a scheme’s trustee board. Many trustees, he added, may “harbour concerns over any government plans that include mandatory rules on surplus release”.
How should surpluses be used?
The focus of the current and previous governments has been on ‘productive finance’ – encouraging private sector institutions such as pension schemes to invest in areas such as UK infrastructure and private equity.
However, there have been several other views put forward as to what any excess assets should be used for.
LawDeb’s Mahalingham said some trustees may want to explore how surplus assets could be used to provide additional funding to defined contribution pension schemes.
Spence & Partners’ Russell-Smith added: “Providing a tax-efficient mechanism for surplus distributions to fund higher DC contributions outside of the DB trust would also be welcome and go some way to assist with intergenerational fairness and DC pensions adequacy.”
Others have suggested reinstating some form of pensions uplift for those with benefits accrued before 1997, which do not automatically rise in line with inflation.
And sponsoring employers will likely want access to surplus too, either to meet ongoing costs or to reinvest into the business.
“Surplus extraction will be a more effective driver of economic growth than the currently proposed DC consolidation plans or the introduction of any sort of compulsion on trustees to invest in UK assets.”
David Lane, TPT
David Lane, chief executive officer at TPT Retirement Solutions, said the proposals would likely receive strong support from DB scheme sponsors – particularly given that many will be paying higher national insurance contributions following October’s Budget changes.
“In this respect we believe that surplus extraction will be a more effective driver of economic growth than the currently proposed DC consolidation plans or the introduction of any sort of compulsion on trustees to invest in UK assets,” Lane said.
The role of the Pension Protection Fund
Allowing surplus extraction could require a rethink of DB pension schemes’ relationship with the Pension Protection Fund (PPF).
Several experts have called for the lifeboat fund to grant a “100% underpin”, rather than its current guarantee of 80% of member benefits.
TPT’s Lane said member protections needed to be central to any surplus extraction plans. A full underpin from the PPF would help allay concerns that trustees may have when choosing to release surplus assets, he said, “subject to certain conditions or other similar guarantees”.
LCP partner and former pensions minister Steve Webb (pictured) said: “In some cases, it will be possible as things stand for an employer to give a trustee enough comfort about the security of member benefits for the trustee to allow some surplus to be extracted.
“But ideally the government would go further and offer a way of guaranteeing member benefits, such as enhanced cover by the Pension Protection Fund, which would allow all surplus schemes to participate in this new option.
“We need something bigger and bolder to maximise the potential of these reforms.”
David Brooks, head of policy at Broadstone, highlighted the concept of a publicly owned consolidation vehicle for DB schemes, potentially to be run by the PPF. This was put forward as part of last year’s consultation, and the PPF has said it is confident it would succeed if asked to take the concept forward.
“It will be interesting to see whether the public sector consolidator idea is revived to allow smaller scheme to consolidate and then invest in productive finance,” Brooks said.
“The rhetoric for the government is clear – there are billions of pounds in pension schemes that should and could be used,” he continued.
“However, similar to the arguments in the DC space over ‘megafunds’, the ultimate fiduciary duty for the trustees is to secure the members’ benefits that have been accrued over many years, which may well be the ‘Achilles heel’ of surplus utilisation.”
What happens next?
The government has pledged to follow through on this week’s announcement with a full consultation “in the spring” – although political deadlines are often quite flexible.
In the meantime, de-risking among DB pension schemes continues at pace, with WTW estimating that last year’s bulk annuity market reached a record level in terms of volume of new business.
The majority of these deals were buy-ins, however – meaning that many schemes may still be sitting on surpluses waiting to understand how they can use them.
