On 5 September 2023, the Government’s call for evidence on how defined benefit (DB) pension schemes could increase the amount invested in productive asset classes closed.
The call for evidence formed part of a wider package of proposals announced by the Chancellor in his Mansion House speech to revitalise capital markets and deliver greater economic growth in the UK. We previously published a blog post on the Government’s wider agenda here.
One notable part of the call for evidence relates to the rules on the use of DB scheme surpluses. A surplus arises when the value of a scheme’s assets, which are generally built up through employer contributions and investments, exceeds the value of the liabilities which are required to be paid to scheme members. Under legislation, sponsoring employers cannot easily access surplus unless the scheme is being wound up, leading to any surplus being ‘trapped’ in the scheme. In some cases, provisions in the scheme’s trust deed and rules, which may reflect the requirements of tax approval conditions that applied decades ago, may also make it difficult for the employer to use the surplus, even in a winding-up scenario.
Furthermore, even when the stringent conditions in legislation or scheme rules can be met and surplus can be paid out of the scheme, whether the scheme is ongoing or in winding-up, a tax charge of 35 per cent of the payment applies, which is widely viewed as penal.
Taken together, these obstacles are seen by many as a deterrent to return-seeking investments, as employers do not believe that they would be rewarded for the underwriting of pension scheme investment risk that would come with seeking higher growth in asset values.
The call for evidence explores various options to make it easier for sponsoring employers to access scheme surpluses, including:
- making it easier for trustees and employers to extract surplus at a point before wind-up;
- relaxing the conditions, including the level of surplus, that a scheme should have, before being able to extract surplus. For example, currently the legislation only allows surplus to be paid to the employer from an ongoing scheme if the funding level is above the buyout basis. Moving away from this may prove controversial;
- changing the tax rules to make paying surplus to the sponsoring employer more attractive; and
- allowing sponsoring employers to use the surplus generated by a DB scheme to provide additional contributions to a defined contribution (DC) scheme operated by that employer. A number of employers already do this, but such a route is not automatically available, depending on the terms of schemes’ trust deeds and the way in which employers have set up their DC arrangements.
These proposals are likely to be welcomed by sponsoring employers of DB schemes because the recent surge in interest rates and improvements in gilt yields, together with a renewed focus on the pensions ‘endgame’, means that many schemes have found themselves in a funding surplus. The Pensions Regulator’s Annual Funding Statement 2023 reported that 76 per cent of schemes with valuation dates between September 2022 and September 2023 were in a surplus. In addition, the aggregate surplus for DB schemes is estimated at over £300 billion.
We now await the Government’s response to the call for evidence. The Government has made clear that the direction of any future policy in this area will be shaped by the evidence gathered and guided by three overarching principles:
- ensuring fairness for DB pension members;
- prioritising a strong a diversified gilt market to fund public services; and
- strengthening the UK’s position as a leading financial centre.
Nevertheless, the potential impact of these proposals on DB scheme sponsors is clear. Recent analysis has suggested that if the proposals are implemented circa £50 billion of surplus would be available to be returned to sponsors of FTSE 350 DB schemes.
If you would like to discuss any issues relating to ‘trapped’ surplus or scheme funding more generally, then please get in touch with your usual Freshfields contact or any of the authors. We have extensive experience securing the return of surplus funds to the sponsoring employer under the current rules, or otherwise utilising the surplus for the benefit of the employer.
