The foreword to the DWP's recently published consultation on options for defined benefit (DB) schemes promises:

"An overhauling of the pensions landscape to provide better outcomes for savers, drive a more consolidated market, and enable pension funds to invest in a diverse portfolio … As part of this work, [the DWP] will ensure that the assets held in UK pension schemes can work harder for scheme members, provide a secure retirement and support the growth of the wider economy".

The consultation is the latest piece of the jigsaw, following:

  • Last Autumn's Mansion House reforms on increasing pension scheme investment in productive finance (broadly investments which support business and the wider economy)
  • The new funding and investment regulations, which come into force this April (and which focus on long term planning and the balancing of the security of members' benefits with the ongoing sustainability of the sponsoring employer)
  • The reduction in the authorised surplus payments charge from 35% to 25% from 6 April 2024, and
  • The anticipated revised Code of Practice on DB Funding from the Pensions Regulator,

which the government hopes will help shape and deliver their agenda for DB schemes.

What does the consultation cover?

At the heart of the consultation lies the government's desire to increase pension scheme investment in productive finance and the part DB schemes have to play in supporting the growth of the wider economy.

The consultation focusses on ways in which surplus can be safely extracted from DB schemes and shared amongst members and sponsoring employers, while importantly ensuring sufficient safeguards are in place to protect the security of member benefits within the scheme.

In broad terms, legislating to allow easier access to surplus may encourage sponsoring employers to run on DB schemes with a view to a surplus emerging (as an alternative to, or a stop gap on the way to, a traditional buy-out of the scheme's liabilities with an insurer). The government hopes that this, coupled with a recalibrated investment strategy, will unlock DB scheme investment in productive finance.

Proposed removal of current barriers to surplus extraction

Practical barriers

A major barrier to surplus extraction from a DB scheme is that typically scheme rules prohibit trustees from returning surplus when the scheme is ongoing.

The position is compounded by the fact that the current statutory power to apply to the Pensions Regulator for an order modifying the scheme to permit a return of surplus only applies where the scheme is being wound up.

Similarly, the evolving line of case law on residual surpluses being held on resulting trust for the benefit of the employer is currently confined to winding-up scenarios and does not assist when looking at a return of surplus on an ongoing basis.

The consultation therefore proposes the introduction of a statutory override to ensure that schemes can choose to share surplus subject to appropriate funding levels being maintained. This is likely to take the form of a statutory power for schemes to amend their rules to allow for payments from surplus or a standalone statutory power to make such payments. 

Alongside this, the DWP proposes to simplify the process under which trustees can make one-off authorised payments to members from surplus (rather than permanently uprating benefits and increasing scheme liabilities).

"Behavioural" barriers

The consultation also identifies the need to remove "behavioural" barriers by bringing surplus extraction in line with trustee duties.

Interestingly, the DWP proposes to introduce additional guidance for trustees when considering surplus extraction, rather than legislating to define trustees' duties in this space. Whether this will be sufficiently robust to give trustees the confidence to exercise a discretion to share surplus between members and employers remains to be seen.

Security of member benefits

The other key tenet of the proposed reforms is to ensure that sufficient safeguards are in place to protect the security of member benefits under the scheme.

It is acknowledged that the extraction of surplus will reduce security for members, hence any changes to help facilitate this must be done in a safe way "to ensure there remains a very high probability that member benefits will be paid in full".

The consultation sets out a range of eligibility criteria being considered for surplus extraction, including:

  • Funding above a low dependency funding basis plus a fixed margin
  • Funding above a low dependency funding basis plus a variable margin based on scheme investment risk
  • Funding above a low dependency funding basis plus a fixed margin and the employer covenant is sufficient to offset any additional risk posed to members, or
  • A buy-out funding level threshold.

Respondents to the consultation are also asked whether:

  • A model involving a 100% PPF underpin (whereby the payment of a super levy would result in 100% compensation from the PPF in the event of an employer insolvency) is another viable option, or
  • Whether there could be other alternatives (for example, insurer backed protection).

Our comment

The consultation raises a number of important considerations for sponsoring employers and trustees currently contemplating their endgame options for their DB schemes.

Some will continue with their flight plan to buying out benefits with an insurer or a risk transfer to a commercial consolidator. Others will continue to run the scheme on a self sufficiency basis, with a view to eventually buying out with an insurer as the scheme matures and insurer pricing improves.

The reforms set out in the consultation may be attractive to larger and more immature schemes, which are well funded and have a sponsoring employer with a good covenant. In such circumstances, where there is potential for the employer to benefit from surplus extraction, the DB scheme may be viewed as an asset (rather than a liability).

For trustees, the focus will be on ensuring that member benefits are appropriately protected. The quality of the proposed guidance "to bring surplus extraction in line with trustee duties" will also be crucial to ensure that trustees can confidently exercise a discretion to share surplus between members and employers.

The consultation runs to 19 April 2024, following which the government will publish their response and set out next steps. With a general election looming it will be interesting to see if a version of these reforms features in the manifestos of the other main political parties.

Get in touch with your regular Pensions team contact if you have any queries in relation to these proposed changes or if you wish to discuss options for your DB scheme more generally.