Surplus: can too much money be a bad thing?

Like many pensions lawyers, I have spent much of my career talking about underfunded defined benefit schemes – section 75 debts, recovery plans, deficit reduction contributions, covenant, contingent assets, PPF entry, journey plans…

But as uncomfortable, even distasteful, as it may sound in the middle of the cost of living crisis, there is a new pensions conversation to be had. A new word is increasingly coming up. The word is surplus.

In almost every other context you can think of, having more money than you need can only ever be a good thing. You get what you want and you get to keep what’s left over, right? What’s not to like?

But, when it comes to pension schemes it’s not that simple.

How surplus can be used depends on your scheme rules 

For each defined benefit scheme, what surplus funds can be spent on, and who gets to decide how and when to spend them, will depend on the scheme’s rules.

These rules can vary considerably from scheme to scheme. They may have been drafted in a different age by reference to law that no longer applies, and/or have evolved over time as and when rules have been updated and reframed. As a result, they aren’t always straightforward to interpret and it is likely trustees and employers will need legal advice to confirm the position under their scheme. A trip to leading counsel may even be on the cards for some.

The rules are also likely to be different in relation to how you can use surplus whilst a scheme is ongoing and how you can use it when the scheme is winding up.

Most scheme rules will include some provision to return surplus to employers at the very end of the day, but the key question is what has to happen before you get to that stage?

In particular, do your rules provide for surplus funds to be used to augment benefits first? If so, is there a discretion to augment or a requirement to do so? Does the decision rest solely with the trustees or do they need employer consent to any augmentation, or at least to consult them? Do the rules specify any particular type or level of augmentation or is there complete discretion?

Ultimately, where rules give trustees a power to augment benefits before returning surplus to the employers, those trustees can only decide how to exercise that power when they actually get to wind-up. This doesn’t give employers much comfort now as to their chances of eventually getting surplus funds back out of the scheme.

Plus there are statutory requirements and a tax charge 

Even if the scheme rules allow surplus funds to be returned to the employer, the trustees will need to comply with a layer of statutory requirements before they can do so.

At the point of wind up, the requirements are largely procedural but they take time. You need to tell members how you intend to use the surplus and give them an opportunity to comment and ask questions and then get a green light from the Pensions Regulator. What if members do challenge a proposal to return surplus?

Not surprisingly, the requirements for returning surplus to an employer whilst a scheme is still ongoing are much, much, more stringent (because you haven’t yet fully secured member’s benefits). The actuary will need to certify the maximum level of surplus which could potentially be returned (ie the true surplus) and the trustees will need to satisfy themselves that making the payment is in the interests of the members. This is not an easy threshold to meet.

Any refund of surplus to the employers will also be subject to a, currently 35%, tax hit.   So even if employers want their money back, they may want to explore options for doing so in a more tax efficient way – for example, utilising the funds within the scheme to meet costs and potentially meet any ongoing money purchase contributions.

So what is there to talk about?

It depends on the scheme’s rules, funding position and plans for the future.

As a result of recent market movements and investment performance, some schemes have suddenly found themselves with a, sometimes sizeable, surplus.

These schemes may be thinking about how the surplus can be used and naturally employers and trustees may have quite different views. Trustees may see opportunities for derisking. Employers may see opportunities to cut costs. Employers may also be thinking about the extent to which they can recognise any surplus in their accounts.

Where schemes are not already in surplus, but have seen an improvement in funding or are targeting buy-out and wind-up in the near future, discussions are likely to focus on how to avoid ending up with a material “trapped” (or at least heavily taxed) surplus.

These schemes may therefore be discussing an appropriate funding approach to close, but not overshoot, the gap. This may include looking at measures which allow the employer to provide additional funding or financial support which the trustees can access if and to the extent they need it but without actually putting more money into the scheme. However, these sorts of arrangements aren’t straightforward to put in place, and they need to strike a delicate balance between security for members and flexibility for employers.

So can too much money be a bad thing? 

From some perspectives, yes. At the very least having a surplus, or even just being concerned about creating one, can bring challenges.

Ultimately, like Goldilocks – when it come to funding a pension scheme, the ideal is to have exactly the amount you need when you need it.

Not too much and not too little.

But with asset and liability values, as well as the price of buying out benefits and running costs all moving around, is this just another fairy tale?

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