Scheme surpluses – good news for all

I’ve been a covenant adviser for almost 20 years now and over that time a lot of the focus has been on situations where schemes are struggling. However, now many schemes are much better funded one thing I’ve really enjoyed recently is working with employers and trustees to make the most of their well-funded DB pension schemes for all stakeholders. DB pensions are no longer necessarily a liability – quite literally in fact, they are an asset!

Running on

In this year’s Annual Funding Statement The Pensions Regulator said that it thinks half of schemes may have exceeded their buy-out funding level! That means there’s a lot of schemes of all sizes thinking about their options and whilst buying out might have been the standard approach previously, there’s much more interest now in ‘running on’ the scheme and using those surplus assets for the benefit of both the employer and scheme members.

As ever, these new approaches tend to start with the larger schemes and over the last year we’ve worked with several £1bn + schemes to put in place surplus sharing arrangements. But we’re seeing interest from many more schemes of all sizes now and these win win solutions should be available for all, which is why we’ve created the Elevate framework to support our clients.

Contingent support

Some schemes have built up such large surpluses that they have sufficient assets to maintain a healthy risk buffer, allowing trustees and employers to be comfortable in extracting some surplus for alternative uses provided the scheme’s funding remains at an agreed margin above buy-out.

However, for many schemes their buy-out surplus is fairly small and understandably, if some of that surplus is going to be used (even though they are still targeted to be above the estimated buy-out level funding), trustees want to make sure the security of member benefits is not put at risk if downside events do occur. Employers too have an aligned objective of maintaining their pension scheme in a healthy position so there’s not any unexpected calls for additional contributions.

This is where contingent support comes in. We’re seeing letters of credit and surety bonds play a key role in surplus sharing arrangements. These provide access to support which is independent from the employer covenant, because they are effectively guarantees for an agreed amount either from a bank (letters of credit) or insurer (surety bonds). See our Contingent Funding Handbook for more information on these options.

A popular use of surplus has been funding DC contributions which can benefit employer cash flows freeing up resources for investment in the business, strengthening the employer covenant and in turn providing further comfort for the DB scheme’s future security.

Another use is enhancing legacy DB benefits for example where no automatic inflationary increase is made, providing discretionary pension increases, meaning that the value of a person’s pension doesn’t in real terms reduce so much over the years.

Covenant is still important

Despite the strong funding position of these schemes and many of them having some contingent support in place too, covenant remains important as trustees will want comfort that if any additional cash is required that it will be paid over a suitable time period.

This means that having in place a structure for monitoring the employer covenant, together with the scheme’s funding position, is really important. Setting up a framework agreement with suitable triggers and actions is a must, so everyone is clear how the arrangement will operate and if/when either the contingent support or additional funding from the employer will be triggered.

Most of the arrangements we’ve worked on are still thinking about targeting full buy-in / out for the future – but this is a longer-term aspiration and to be done when the time is right for all stakeholders. And who knows what other options and opportunities may be available for DB schemes by then!