How to avoid surpluses in DB pension schemes

With many DB schemes unexpectedly approaching buyout thanks to higher funding levels, how can sponsors and trustees avoid generating a surplus?

For the past twenty or so years, a pension scheme surplus has been nothing more than pipedream for many schemes - an unobtainable goal in a low interest rate world.

However, following the economic events of 2022 and the rise in interest rates, a surplus is now looming on the horizon for many schemes. This sounds like a good thing, and the improvement in scheme funding levels is certainly most welcome, but it can also present issues for scheme sponsors, who for many years have underwritten the scheme and pumped in significant deficit repair contributions that could have been spent investing in the business.

Below, we’ll break down the current landscape for pension schemes, highlighting what schemes need to be aware of as and when they approach surplus.

Less impactful surpluses

Of course, there are several types of surpluses in pension schemes. Some are worth worrying about and some are not.

A surplus on the corporate accounting is one such surplus that isn’t much of a concern (unless you also have to worry about regulatory capital) because the accounting measure of scheme liabilities is pretty meaningless; it’s not a real-life measure, just a way to compare relative scheme liabilities between companies.

Similarly, a surplus on the technical provisions basis isn’t usually a concern unless the technical provision basis is very prudent. If the scheme still has members accruing benefits then the surplus can be used to offset the cost of this. For schemes with no accrual it can be used to offset annual running costs.

Concerns for sponsors

A surplus on a buyout basis, though, is a concern for scheme sponsors, mainly because once the scheme has been bought out, any surplus repaid to the employer is taxed at a penal rate, currently 35%. Whilst sponsors will usually have had corporation tax relief on contributions paid into the scheme, they will view the overall picture as tax inefficient, especially considering the alternative uses which they could have put some deficit contributions towards.

Another concern is that sponsors may not even be able to get a refund of any surplus left after a buyout, as the scheme rules may not permit it or may direct the trustees to use surpluses to augment members’ benefits. This hardly seems fair on sponsors who have underwritten and funded pension risks for many years – they will have had all of the downside and none of the upside.

Generating a surplus to improve member benefits is also not really the objective for trustees, as schemes were designed to provide the benefits due under the rules. Any requirement to improve benefits can also slow down the buyout process and result in much of the surplus being spent on adviser fees.

So how can you go about avoiding a surplus?

How to avoid a surplus

A key part of our five step DB Navigator framework is monitoring against your chosen endgame target. For most schemes and sponsors this will now be buyout. However, unless the scheme is well advanced in the buyout process, has sorted out its benefits and data, and approached insurers for pricing, sponsors will only be able to monitor against an estimate of the buyout cost. These estimates are usually based on insurer indicative rates but give a buyout liability which could, for example, be up to +/- 5% of the actual pricing that could be obtained in the market.

So whilst it is relatively straight forward to put in place monitoring procedures against an estimate of the buyout cost, sponsors still need to be wary of surpluses arising on an actual transaction. Sponsors still paying deficit contributions can consider the following:

• Agree with the trustees that as the scheme moves closer to the estimated buyout cost, deficit contributions can be switched to an escrow account. These accounts are simple and cheap to set up and can be used to top up the scheme assets if required once an insurance transaction takes place. Any funds remaining in the escrow account after the transaction can be returned to the employer without penal tax.
• Agree with the trustees that running expenses can be funded out of scheme assets if they are not already. This can be done in such a way that the sponsor can still reclaim the VAT on eligible expenses.

For example a sponsor could agree with the trustees of its scheme that when the monitoring shows that the scheme is 90% funded against the estimated buyout cost, deficit contributions are switched to an escrow account. Similarly, sponsors considering making a special payment to their scheme to effect a buyout (because they are now within the so-called “cheque writing distance”) should consider using an escrow account to guard against a surplus on buyout.

For sponsors no longer paying contributions, the expenses option may still be available to them but they may have to take the philosophical view that the dramatic improvements over 2022 are a windfall and may give rise (or have already given rise) to a surplus sooner than may otherwise have been the case. In that case the 35% tax may seem bearable.

Finally, we have also seen some sponsors set up DC sections in their DB trusts and using the DB surplus to pay ongoing DC contributions. However, this is likely to be an extreme scenario – many employers with “own-trust DC” schemes have been moving to mastertrust arrangements due to the seemingly ever-increasing compliance and regulatory requirements on DC schemes introduced over the last few years. We would not expect many sponsors to go down this route.

As illustrated above, the key to avoiding a surplus, or avoiding the potentially high costs to sponsors associated with them, is preparation. The funding level changes that occurred across 2022 may have been unexpected, but for the majority of schemes there is still time to put a plan in place. Our buyout experts are ready to discuss your options, backed up by our specialist endgame framework, the DB Navigator.