Introduction
Following the Chancellor’s 10 July Mansion House Speech calling on pension schemes to invest in UK growth – a theme which continued in November’s autumn statement – there has been some interesting commentary on the options that could be available to defined benefit (DB) pension schemes as a result of recent funding improvements.
Insurance buy-out may now be within reach for many schemes and, for most, it is likely to remain the ideal scenario – freeing the employer of an uncertain ongoing liability and securing benefits in full for members.
However, for a select few with a strong employer covenant and a reluctance to pay a premium to an insurer, could running on the scheme be a genuine option to consider?
We asked Crispin Freeman and Helen Woodford from the pensions team at leading independent UK law firm Burges Salmon, for their thoughts on this and what tweaks to the law might be required so that the risk of trapped surplus could be removed.
Why schemes may want to run on
DB schemes have been seen as a risk and cost for employers. However, due to improvements in pension scheme funding positions, an opportunity has arisen for DB schemes to be used to the advantage of employers, members and employees.
Some reports suggest it could now be realistic and achievable for there to be a benefit to a scheme generating surplus by making some changes to current regimes. DB schemes would no longer need to switch to higher risk assets to contribute to UK growth and help savings. It is suggested DB schemes could run on, invest safely, and build up surplus reserves.
A recent report produced by Burges Salmon, XPS Pensions Group and investment firm Premier Miton suggests that with a target investment return of 1% above risk-free gilt yields, long term surplus could be generated. If this surplus was split across members, employees and the employer, it could lead to benefit increases for DB members and/or employer contributions to employees’ defined contribution (DC) accounts and increases to employer capital expenditure spend. It sounds like a ‘win’ for all.
If there was an incentive for schemes to generate surplus, it could be done in a way that allows trustees to still act prudently, while boosting the wider economy and working towards the Mansion House reforms goal of UK growth.
How can this surplus be achieved?
There are three key changes that the government could facilitate to allow pension schemes to run on and generate surplus and ensure this is used to improve member benefits and support UK growth.
1. Changes to surplus legislation
The current rules on the return of surplus in ongoing schemes have been in place since 2006. What schemes can do with surplus depends on the ‘rules lottery’ of historic drafting.
A statutory override would be useful to allow employers the right to a refund from surplus assets despite what is said in the scheme’s rules. This could be conditional on, for example, an appropriate “buffer” being in place before surplus could be used, using the surplus repayment to augment DB benefits, improve employer DC contributions or invest in the employer’s UK operations.
2. Changes to the tax charge on a return of surplus
Schemes are currently penalised for any surplus return by a 35% mandatory free-standing tax. This can be eliminated or reduced by Treasury Order (no primary legislation being needed). In the autumn statement published 22 November, the Chancellor confirmed that this charge would be reduced to 25% from 6 April 2024 – a useful step in the right direction although there is scope for reducing this still further without a legislative process needing to be carried out.
3. A new Code of Practice from the Pensions Regulator (TPR) on the role of trustees
It is important that trustees retain oversight of the distribution of surplus to provide a safeguard to the members of the scheme.
It has been argued that a new Code of Practice from TPR to support trustees in this role would be appropriate. Areas to be covered in such guidance could include: the importance of reflecting employer covenant in any decision to continue to run on; how to take account of DB members’ interests; and best practice in operating, monitoring and distributing surplus.
Final thoughts from Burges Salmon
It is likely that buy-out will remain the most appropriate and attractive option for most trustees and employers of occupational pension schemes with the necessary funding to achieve that. However, it will be interesting to see if the Government’s appetite for the reforms it has promoted in the Mansion House speech extends to taking positive action to put in place changes such as those set out above in order to encourage a new approach by trustees and employers to run on schemes to generate surplus.
In his autumn statement, the Chancellor announced a consultation (which we understand will be launched this “winter”) on “whether changes to rules around when surpluses can be repaid, including new mechanisms to protect members, could incentivise investment by well-funded schemes in assets with higher returns”. The signs are promising that changes may be made.
This consultation will seek further views on the feasibility of other related matters raised by the DWP in their call for evidence on “Options for Defined Benefit Schemes” issued soon after the Mansion House Speech (including whether enabling schemes to pay a higher levy to secure a guarantee of 100% PPF coverage might lead to greater investment in assets which could support businesses and the wider economy).
MHM opinion
A story like this would have seemed unthinkable a couple of years ago, but a change of political and economic outlook may now make continuing with a DB/hybrid scheme a genuine alternative to a bulk annuity contract for some schemes. The Pensions Regulator has also said that it will not push trustees towards the buy-out option.
Our thanks for this article to director Crispin Freeman and senior associate Helen Woodford in the pensions team at independent UK law firm Burges Salmon.
Use the links shown above to contact Crispin and Helen, or call Steve Button at MHM on 01423 229029
