Dealing with a surplus
Higher interest rates and surplus pension assets mean that full exit becomes more affordable and it presents an opportunity for employers to consider a medium-term defined benefit exit strategy. The challenge with surplus funding is that control of those funds is ceded to the trustees, potentially for a very significant period of time. For this reason, employers will want to ensure that they are contributing to the scheme with a very clear purpose. Employers paying into a defined benefit pension scheme is an ordinary occurrence, but employers getting money back is extraordinary.
The issues are not clear cut, though. In the UK in early 2022, there were reports that the Pensions Regulator entered discussions with the trustees of the Bristol Water section of the Water Companies Pension Scheme. Members' benefits had been insured through an annuity purchase, however the subsequent decision to transfer surplus to the sponsor and not to use surplus assets to improve members' benefits drew attention. And separate to the Pensions Regulator intervention, the trustees received a letter from the chair of the UK Work and Pensions Committee seeking justification for the transfer of the £12.1 million surplus to Bristol Water.
Is your scheme in, or heading to, surplus?
Some employers will be more likely to see a surplus arising than others. Employers who closed their schemes to benefit accrual, have implemented benefit changes in the last 15 years, target high funding levels and whose pension assets haven't yet been fully de-risked will all be more likely to see a surplus arising.
Market volatility may create a pension opportunity
As we potentially enter a new era for interest rates, with the Federal Reserve raising interest rates in June 2022 by the largest amount since 1994 coupled with continued investment market volatility, there are new opportunities for defined benefit pension schemes to consider their medium- to long-term goals. That said, sponsors should be aware of the challenges and we encourage the following actions.
1. Identify whether your scheme risks surplus being trapped
If an employer who reports under IFRS cannot demonstrate that it has an unconditional right to a surplus, then the amount of any surplus it can recognise on its balance sheet will be restricted and the surplus will be "trapped" as the employer does not get credit for it. Employers will first look to identify whether they have an unconditional right to a surplus.
The issue of trapped surplus goes beyond financial reporting. Defined benefit pension funding means that an employer sets money aside in advance to pay benefits to its employees over a significant period of time into the future. It also means that funding is provided based on a point-in-time set of expectations and assumptions about the future. With the benefit of hindsight, surplus means that employers have overpaid into their schemes, or at the very least paid into their schemes too soon, and that has consequences for both the employer and the scheme.
2. Identify the potential scale of the issues
Employers should consider both the financial and legal aspects of any potential surplus.
The scheme's legal documentation will also determine powers around contributions and benefits, and may give the employer the ability to formally influence the financial position. For example, the employer may have the ability to agree or disagree to discretionary awards and they may have a role in setting the scheme funding rate.
While funding rates are fixed at a point in time, that does not preclude a simple interim update.
3. Identify the potential uses of the surplus
The employer, members and trustees will have their own preferences for the use of surplus funds.
Employers will be concerned with overpaying into the scheme or, at the very least, paying into the scheme too soon because advance funding means that funds get locked away for a significant period of time. It also means that the employer cedes control of those funds to the trustees.
The trustees will be concerned about acting in members' interests, including benefit security, and market movements will mean that an opportunity to de-risk has emerged.
Members may look for a share in the surplus to offset inflationary pressures, particularly where there was a practice of granting additional discretionary benefits in the past.
4. Identify the preferred use for the surplus
Employers will want to ensure that they are purposely contributing to the scheme, but the employer's objectives will not be perfectly aligned with those of the trustees and members', and the employer may need to concede on a portion of the surplus. Being able to demonstrate the security of the benefits and the continued support of the employer will help build trustee assent to any proposed use.
Act now to deal with any (potential) surplus
Strictly, the trustees control the surplus funds and they will come under pressure to utilise the surplus by either de-risking sooner than planned or by granting additional benefits to members. Both result in an increased cost, and that cost is met from the surplus funds.
In a simplified world, the opportunity cost of that spend is that the employer does not get a share of it. Through a more complex lens, it means that the surplus is not spent in a way that furthers the employer's objectives. For example, where ultimate exit is a target, using surplus funds to change the nature of the benefits being delivered in such a way that also reduces the exit cost and removes risk would further the employer's objectives.
The defined benefit pension model means that funding decisions are bipartite and historically, there has been pressure to resolve funding shortfalls over a short time horizon. Pensions represent a long-term obligation for sponsors, and long-term issues merit a long-term view. The current environment presents an opportune time for employers to revisit their long-term view and consider any changes to their funding and investment strategies.
We are here to help you
Pension scheme funding is a complex issue and the views of a range of stakeholders must be navigated. The changing economic backdrop creates a business need to rethink how organisations finance and manage their pension obligations. Our Pensions team is here to help you develop a long-term funding approach that meets your specific needs. Contact us today.
