Scheme surpluses – potential concerns for employers and trustees

Many pension schemes have recently experienced substantial reductions in their funding deficits, which means schemes are looking to secure some or all of their liabilities with insurers.

From an employer perspective, the decrease in the gap between scheme assets and liabilities will be welcome after a long period in which scheme deficits were significant and employer contributions were required to meet the shortfall.

However, recent improvements in the funding position of pension schemes are not without risk. As schemes’ asset values begin to approach the level of scheme liabilities, the risk of a “trapped surplus” may develop.

Trapped surplus –  a concern for employers

A ”trapped surplus”, from an employer perspective, is where the pension scheme is overfunded compared to the scheme’s liabilities but there are legal or commercial obstacles to the surplus being returned to the employer or being used by the employer for other purposes.

This situation might arise for a number of reasons:

• Rules – The rules of the pension scheme may not permit a refund of surplus, or may (as is common) give the trustees discretion to use the surplus to augment member benefits before the surplus is paid to the employer.
• Legislative restrictions – There are legislative restrictions on when a surplus can be paid to an employer, both on an on-going basis and whilst the scheme is in wind-up. These restrictions may prevent surplus being repaid, or may otherwise require the completion of processes that are likely to be complex, time-consuming and require engagement with members and the Pensions Regulator.
• Tax – With limited exceptions, a tax charge of 35 per cent. applies on any return of surplus to employers.
• Politics / PR – There are reputational risks in returning surpluses to employers. Members may feel that the surplus “belongs” to the members, on the basis that the surplus is comprised not only of employer contributions, but also investment returns on assets allocated to pay for member benefits.
• Using the surplus for other purposes – Where the surplus cannot be easily returned to the employer, parties may find there are significant legal and practical complexities when considering how to use any surplus “productively” from an employer perspective (i.e., in using the surplus to meet other employer liabilities or commitments).

Is this just an employer issue, or also an issue for trustees?

Where pension schemes will likely develop a surplus, trustees should anticipate employers opening a dialogue with the trustees to discuss options for either:

• avoiding the surplus altogether. For example, the employer may propose alternatives to further employer contributions into the scheme, such as paying contributions into escrow or charged accounts which the scheme would only have access to in certain circumstances.
• using the surplus “productively” (from the employer perspective) if it does arise. For example, the employer may wish any surplus to be used to meeting administrative expenses or to off-set future employer contributions (whether in respect of existing or new members).

What preparatory steps might trustees wish to take?

Trustees who anticipate being approached by the scheme’s sponsor in relation to potential or existing surpluses should take stock of their scheme rules. It will be important for trustees to understand what the scheme rules stipulate with regard to the return or other use of surplus (both whilst the scheme is on-going and in wind-up) and understand how this interacts with the legislative restrictions.

In addition, trustees will need to be conscious of their duties to members before agreeing to any measures for either avoiding a surplus or on how any surplus should be utilised. Trustees will likely require substantial advice from their lawyers, actuaries and covenant advisors before being able to agree to any employer proposals. This is especially important where the trustees have powers to augment member benefits in the case of a surplus, or where the employer proposal for using the surplus is non-standard (for example, proposals to use the surplus to meet underfunded liabilities from another pension scheme).

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