The Government is consulting on legislative changes to introduce greater flexibility to access surplus funds in defined benefit pension schemes.

The Department for Work and Pensions (DWP) opened consultation further to publishing a paper entitled “Options for defined benefit schemes” on 23 February 2024. The consultation will close on 19 April 2024 and is designed to explore proposals by the DWP to introduce legislation which (a) has overriding effect and (b) would allow occupational defined benefit (DB) pension schemes to return surplus funds to (for instance) scheme employers or other (member) beneficiaries.

The consultation follows on from the Chancellor’s Mansion House speech made in July 2023. After that speech, the DWP issued a call for evidence through which the DWP stated it wished to hear views from the pensions sector about the rules and obstacles around DB scheme surplus funds. 

Objective regarding surplus

The DWP intends to make it simpler to extract surplus funds from DB schemes and to establish a new public “consolidator” vehicle which would be managed by the Pension Protection Fund (PPF).  February’s consultation exercise is the next step in implementing legislation. 

The DWP will consider views from the sector as to how to make it easier for DB scheme surplus to be shared with scheme beneficiaries (e.g. employers and members). The objective is to use that surplus to invest in “productive asset allocations” (and include a reduction in the scheme surplus repayment charge to 25% from its current 35%, a change which is set to come into force on 6 April 2024). The wider proposals will require enabling legislation. This would override current legislation and, where applicable, pension scheme rules.  Readers will be aware that some DB schemes contain provisions which prevent surplus funds to be returned to their scheme employers. 

Views the DWP is seeking

The DWP is collecting opinions on how to achieve its objective. Should it, for instance: 

• legislate to allow scheme trustees to apply the statutory override or should the scheme employer’s agreement be needed?
• introduce the statutory power for scheme trustees to make an amendment to scheme rules for a one-off payment to be made and, if so, what consequential amendments to legislation would be necessary – to tax legislation for example? 

Finally, the DWP wishes respondents to consider the consequences of the legislative power on other areas namely the insurance buyout market.

Readers’ memories will not need to stretch back far to remember that DB pension scheme surpluses were not common a few years ago. Part of the consultation (therefore) asks what safeguards should be placed on enabling legislation to protect scheme beneficiaries’ rights. Perhaps the most obvious protection, which is under active consideration, is to require schemes to be funded above the “low dependency funding basis” - a principle set out in secondary legislation relating to scheme funding. The intention is that qualifying schemes would need to be funded on this basis and have a pre-determined level of headroom. Alternatively, the margin could be variable and based on the scheme’s investment risk or else access to surplus could be confined to schemes with (i) a low dependency funding basis plus (ii) a margin and (iii) evidence that the scheme employer’s covenant is sufficiently robust to offset additional risk to members. 

The DWP proposals also envisage a scenario whereby employers would be able to pay an additional levy to the PPF out of surplus funds in return for scheme members’ benefits being backed up to 100% in the event of its (i.e. the employer’s) insolvency.

PPF Consolidator

The DWP proposal is to establish, by 2026, a consolidator scheme which could be used in buyout situations by those schemes which are “unattractive to commercial consolidation providers”. Views are sought by the DWP on a number of factors including consolidator eligibility, structure, member benefits, governance, funding, underwriting and how scheme deficits and surplus would be treated. 

Comment

An option to use scheme surplus funds to give members’ rights additional protection through the PPF seems unlikely to be attractive, since members of a scheme in surplus and with a strong employer covenant seem unlikely beneficiaries of additional security with the PPF – a scheme designed to deal with the fallout from employer insolvency and underfunded schemes. This apparent contradiction will form the subject matter of a further update.

Readers will acknowledge that economies move in cycles with most economists agreeing that a typical economic cycle lasts for 6 to 10 years. Economic cycles over the past decades have been mirrored by legislation applicable to pension funding (funding regulations), pension deficits (debt regulations) and pensions surplus. Previous governments have legislated to encourage and then discourage the return of pension scheme surplus. Readers with long enough memories will recall the Finance Act 1986 which was designed to return surplus funds to employers - net of tax. The Pensions Act 2004 (PA04) (s.251) changed the law again to prevent the return of surplus to employers where the scheme was ongoing – except where scheme trustees expressly resolved to retain scheme’s power to return such funds.

Experts have blamed the funding problems that beset DB pension schemes until recently on a number of things. One such thing was the effects of previous legislation requiring surplus funds to be returned to the scheme employer (net of tax). We seem now to be in a position where DB scheme surpluses are relatively common but this is a relatively recent phenomenon. Readers will acknowledge that when the soon-to-be effective funding regime was first being considered in 2020, UK DB pension schemes had a combined deficit of several billion pounds. Current estimates indicate that the same schemes now have a combined surplus of several tens of billion pounds. This fact gives context to the current proposals on the return of surplus and perhaps explains the DWP’s incentive to reduce the surplus repayment charge from 35% to 25% (from 6 April).

The proposal to permit the return of surplus funds is understandable and it seems sensible that enabling legislation should include parameters which must be met before surplus can properly be returned. Our view is that DB scheme trustees who decided not to retain their schemes’ powers to return surplus funds in and around 2011 in accordance with PA04 s.251 would need to be presented with a strong case supported by robust advice to be convinced that returning surplus funds today would be a good idea. Whilst we are confident that the DWP will give serious consideration to all concerns, this firm’s views - which it will submit along with the views of its clients - will include the concerns set out above. Without them, the maxim “history will teach us nothing” will continue to apply.

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