Yassin Isman, Associate Partner, Aon.
Aggregate defined benefit (DB) funding levels have improved to over 130% resulting in over 80% of DB schemes now being in surplus.*
Unsurprisingly sponsors and schemes are increasingly looking at ways to use or access surplus assets. However, under current legislation, DB surpluses can only be returned to sponsors on wind-up (this also assumes, of course, that a pension scheme's rules allow for this). While the Department for Work and Pensions (DWP) recent DB options consultation may eventually provide more flexibility, this is very much in the early stages and it could be years before any material changes.
For DB schemes closed to accrual, the options are even further limited, as there is no potential recourse to use the surplus assets built up to fund future benefit provision. Therefore, subsiding employer DC contributions is likely to be the most realistic way to access DB surplus for many schemes and sponsors in the short-term.
However, less than 1 in 9 schemes today are 'hybrid' in nature – which would allow this potential option to be explored. Some have now taken bold steps by moving back in DC provision to sit alongside the existing DB scheme to facilitate an efficient route to accessing surplus. But, what is needed to make this sort of process a success?
Considering all the angles
For those looking at the option of moving DC back into an existing DB scheme, you will need to consider:
1. Legal advice – a crucial first step is understanding whether this could be done under the scheme's trust deed and rules. Questions to pose to your legal advisers could include who has the power to use surplus assets, for what purpose(s) can surpluses be used, are the existing DB sections of the scheme sectionalised (meaning they are effectively separate legal structures) and can a new DC section be established to enable this?
2. Cost/benefit analysis – the cost and reality of running a good quality trust-based DC scheme is not to be under-estimated and, with increasing regulatory requirements on DC trustees, this is only likely to increase. Therefore, this option is most likely to appeal to only those mid-sized or larger schemes which have sufficient scale and where ongoing employer DC costs significantly outweigh any DC scheme running costs.
3. Trustee agreement – trustees need to be comfortable that member security would not be undermined in doing so. This could perhaps mean that only surpluses up to agreed levels can be used, or alternatively, ensuring a minimum level of funding is maintained.
4. Regulatory viewpoint – The Pensions Regulator (TPR) has been clear that DC trust-based schemes not delivering value for money should consolidate and schemes considering adopting this approach will need to ensure that they can deliver value for money now as well as in the future.
Thinking ahead
The Chancellor's Mansion House speech set out a vision for the changes required to the DC eco-system, so that the long-term ambition of boosting retirement outcomes for members can be achieved. With the focus on ensuring that DC schemes deliver value for money, a push towards greater investment in productive finance as well as helping savers to understand their pension choices, it may be that DB surpluses now provide a real opportunity to support a number of these initiatives.
We have already seen cases where DB surpluses are being used to benefit DC members. Examples include, increases being made to employer DC contribution levels - which has made a real difference in bridging the retirement income adequacy gap - and extending paid-for IFA support to DC members to support with retirement decision making. These measures could help schemes to demonstrate the delivery of good value and convince key stakeholders such as trustees and trade unions, that a change in scheme structure could be in the best interests of DC members.
As we look ahead, DB surplus assets could also be deployed in other innovative ways. One theoretical example being subsidising DC investment in private markets or illiquid assets. High investment management costs are typically seen as a one of the biggest barriers to DC schemes investing in these assets, so there could be an opportunity for meeting ongoing investment costs through DB surplus assets.
The DC market will also need to continue to innovate to provide further choice and support to the trustees and employers who are now operating under different circumstances.
Bringing this all together
There are benefits to be had through accessing DB surplus to support DC provision and, where it is done correctly, there is real potential to achieve a win-win scenario for trustees, sponsors and (most importantly) members.
This approach can also be used as a key pillar in Aon's Active Solution To Run On (ASTRO) model and you can find out more detail about ASTRO here.
*Source: PPF's 2023 Purple Book
