Higher interest rates may have left many of us worrying about our mortgages, but in boardrooms up and down the country, employers with final salary pension schemes are seeing something quite different: an opportunity to use hard-earned scheme surpluses to improve member benefits, support their sponsoring employer and, potentially, generate some growth in the UK economy.
After talking for decades about a funding crisis in the nation’s £1trn defined benefit (DB) pension scheme sector, successive interest rate rises mean final salary schemes now have a £235bn aggregate surplus.
As things stand today, a combination of higher interest rates and prudent, professional management by trustees mean the funding position of defined benefit schemes has rarely been stronger.
Neither employers nor their current or past employees stand to benefit from DB pension schemes being significantly ‘over-funded’ if that overfunding is not put to some purpose.
This is why many pension managers, even accounting for their legal duty to ensure the members of their schemes get the pensions they are promised, now think there would be benefits, with the right controls, in permitting trustees and employers to put some of these surplus funds to more productive use – for example, enhancing member benefits, DC contributions or investing in growth.
Many schemes’ rules allow surpluses to be returned to the sponsor on the winding up of the scheme, others won’t.
The treasury’s decision to explore relaxing the regulatory regime to allow a surplus to be more flexibly deployed might provoke concern in some quarters about a repeat of the contribution holidays and surplus extraction from pension schemes that took place in the 1980s and early 1990s.
Memories of Robert Maxwell loom large in the public consciousness.
However, with more than 30 years of added safeguards and changes to the regulatory regime, including the funding regime, governance and accounting requirements for companies and pension schemes, the situation today is incomparable, with strict requirements and severe sanctions for directors and trustees that infringe upon them.
The criteria to allow the extraction of a DB surplus should be that the scheme is well funded with low dependency on their sponsoring employer – a definition set by The Pensions Regulator.
Essentially, this would require the trustees to be confident that the scheme could pay member benefits in full, even if there was a change in the wider economic conditions, which impacted scheme funding, that is a buffer that also accounts for investment risks.
Other conditions that should apply are that the employer must be in a good financial position with a strong covenant in place along agreed regulatory definitions.
These conditions are important to mitigate the risk of sponsors in financial difficulty seeking to access the surplus of their pension scheme. They will also protect against conflicts of interest that could potentially create moral hazards. For example, where there are employer-nominated representatives, or scheme rules allowing employers to select trustees.
Tight controls should also lessen the impact of unforeseen events in the future that significantly impact a scheme’s funding position and lead to member detriment.
So, what actions might scheme sponsors be permitted to take with their returned surpluses? The potential to increase scheme benefits should certainly be explored, for example, through more generous accrual rates or inflation indexation.
Some schemes will have shared cost requirements which will have resulted in employees paying higher contributions to close scheme deficits. It would be reasonable for those members to also benefit from any surplus the scheme has built up.
Arguably, lowering the legislative threshold for allowing returns of surplus could potentially encourage trustees (in conjunction with their employers) to adopt a more ambitious mindset and take on slightly riskier investment strategies for their DB assets, including greater investment in UK assets.
This could also benefit employers if assets no longer risk becoming ‘trapped’ in the scheme, which could potentially lead to a different dynamic than existed during the last decade or more between trustees’ and employers’ investment philosophies around taking on greater risk.
Released surpluses could also be redirected to fund contributions to sponsoring employers’ defined contribution workplace schemes.
The knock-on benefit for the chancellor is that these funds invest more in the types of assets that drive higher growth – UK shares, domestic infrastructure and private equity – rather than being eventually funnelled into low-risk assets via the insurance buyout market.
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