Navigating surplus extraction: balancing employer opportunities and member protections

Fifteen years ago, 90% of defined benefit (DB) schemes were underfunded. Today, the situation has reversed, with the Pension Protection Fund (PPF) reporting an aggregate surplus of £424.5bn, and 90% of DB schemes now in surplus. This shift has prompted the Government to explore options for “unlocking” these surplus funds in an attempt to bolster the UK’s economy and aid the solvency of sponsoring employers.

To date, surplus extraction on both an ongoing and winding-up basis has been heavily regulated, including by sections 37 and 76 of the Pensions Act 1995, and trustees’ ability to return surplus on an ongoing basis is subject to them having passed a resolution prior to 6 April 2016 in accordance with section 251 of the Pensions Act 2004. Consequently, it has been rare for trustees to return surplus to an employer whilst their scheme is ongoing.

Many scheme rules contain absolute prohibitions on returning surplus to an employer or amending rules to permit such return, a hangover from the pre-A Day regime or part of the scheme design. Scheme rules may require trustees to augment member benefits (or give them discretion to do so), so there is no guarantee that any surplus funds would automatically be repaid to the sponsor. Trustees have to take account of a number of factors when deciding whether and how to exercise any discretion to apply surplus on winding up and, for those limited examples of pension schemes which allow surplus to be extracted (or otherwise used) on an ongoing basis, the key consideration will be the impact that the use of such surplus may have on the security of members’ accrued benefits.

1. Options for extraction of surplus

The UK Government is currently consulting on the introduction of a statutory override to provide greater freedoms for surplus extraction from pension schemes. This could significantly affect the decision-making of trustees and the financial strategies of sponsoring employers. The consultation suggests two options:

• (i) Option 1: Allow schemes to amend their rules to enable the return of surplus.
• (ii) Option 2: Directly grant a power to make surplus payments to the employer.

From a legal perspective, this suggestion is relatively surprising. Statutory overrides have historically been reserved primarily for matters of equal treatment or widespread tax changes, rather than to alter the bargain struck in trust deeds.

• If Option 1 goes ahead, trustees and employers could negotiate terms which incorporate the fiduciary duties owed by trustees to scheme members. This would involve considering amendments to discretionary benefits, member consents, funding levels and decision-making criteria. It would, however, possibly cut across any amendment power restrictions which already exist and introduce the possibility of employer vetoes on use of surplus.
• If Option 2 is implemented, it is unclear whether this would be a trustee-only power (although the Government implies that it will be). If there is any scope for the employer to compel surplus payments this would diminish trustees’ influence surrounding surplus-related decisions, altering the current balance of powers captured in scheme rules. Trustees of schemes with historic prohibitions on returning surplus may find themselves in the difficult position of having to defend not using a power they have never had since inception of the scheme.

The consultation, which is due to close on 19 April 2024, acknowledges the challenges which may come alongside greater surplus freedoms, outlining that this should only occur if high levels of member protections are maintained (for instance, by surplus extraction whilst a pension scheme is ongoing only being possible if funding levels exceed full buy-out). It remains to be seen what kinds of safeguards could be acceptable.

2. What should trustees be considering now?

Trustees should be proactive in understanding how any proposed legislative amendments may fundamentally impact the balance of powers struck with employers surrounding surplus decision-making. Some trustees may already be engaging in discussions (including with employers) on the use of surplus on the winding up of a pension scheme in the context of de-risking, and those with such transactions in mind should consider reviewing their rules to prepare for discussions about surplus extraction, considering:

• restrictions on surplus extraction, noting historic restrictions and the evolution of any surplus power over time;
• the source of surplus (i.e. whether it has arisen as a result of the “over-payment” of contributions by the employer or as a result of the trustees following a particular investment strategy over time);
• related powers/triggers (the power to terminate the scheme, the power to wind up, and the ultimate decision-making power on the use of surplus to augment benefits), and
• how any potential statutory override may affect the bargaining position between the trustee and the employer (especially if the employer is being asked for additional contributions).

Such proposed changes may also impact any applicable funding agreements and are likely to be relevant to conversations about surplus and schemes’ de-risking journeys, as it may become more attractive for sponsoring employers to support trustees is pursuing a run-on strategy, rather than supporting buy-out and the use of any residual surplus (which will usually only be possible in a winding-up context, once the employer has formally terminated the pension scheme). On the other hand, an employer with the prospect of a benefitting from a refund of surplus on the winding-up of a pension scheme, where there were previously prohibitions or restrictions on such a refund, may be incentivised to accelerate any de-risking journey, noting the reduced tax charge that is now payable on surplus funds returned to an employer.

Irrespective of whether surplus extraction would help to fulfil the Government’s intention of investment in the UK economy, trustees should be prepared that the legal status quo could change going forwards, and therefore should be ready to discuss the balance of powers, member protections, and the long term-journey of their schemes in a new world.