What measures of pension scheme surplus does a CFO need to know?

Shifts in market conditions and increased pension scheme funding have dramatically improved the financial position of the average UK pension scheme. At the end of 2022, across the FTSE100 companies there was a disclosed accounting surplus of £130bn. So, does this mean that pension schemes are finally an asset of UK Plc?

At an individual company level, does the surplus in the most recent valuation report now mean the pension scheme is an asset? And if the scheme is in surplus, why is there still a cost to secure the benefits with an insurer?

All surpluses are not created equal. To answer these questions, we need to understand why there are so many ways of measuring pension surplus– and when the different metrics are relevant? This is a frequent topic of discussion with my corporate clients and the subject of this blog.

Beyond that, to understand how the value of surplus can be realised in practice we need to know the characteristics of the individual business and pension scheme in question – a subject for a separate blog.

Accounting Surplus

An accounting surplus is often the most readily available measure of pension scheme funding (and thanks to accounting standards enables a degree of comparison between schemes). It is an important metric which can be key in external perceptions of the business, but generally has little relevance beyond determining the disclosed Balance Sheet position.

For example, the existence of a pensions accounting surplus does not in itself provide comfort against the need to make significant contributions to meet an existing funding deficit, even less to suggest that pensions represent a realisable asset of the business.

Funding Surplus

A “better” measure of surplus, or at least one that is more relevant to the funding required, is the cash funding position (also called Technical Provisions). This measure is required to be prudent and is an assessment of whether additional cash is required by the scheme in future. A surplus on this measure might mean a sponsor could expect not to have to pay contributions to the pension scheme. But proceed with caution…!!

• The cash funding position is a measure at a point in time - funding positions can and do deteriorate (they can also improve).
• The assumptions that determine the funding position are typically driven by the pension scheme's trustees as part of the three-yearly actuarial valuation cycle. From valuation to valuation, the trustees will revise their view of appropriate assumptions to reflect market trends and regulation. In the UK, regulations have been steadily strengthened, resulting in increasingly prudent approaches to scheme funding. Therefore, even absent other changes in the pension scheme, evolving regulation could lead to a surplus at one valuation being eradicated by the following valuation and replaced by a requirement to pay contributions.
• Trustees will use more cautious assumptions if the strength of the sponsoring employer (employer covenant) supporting the scheme is weak. This means that if, for example, an M&A transaction weakens the support provided to the pension scheme, the trustees are required to take a more prudent approach, potentially reducing, or eliminating any surplus (or increasing a deficit) and increasing contribution requirements.

In a situation where there is a cash funding surplus, one needs to consider these points to confirm it is reasonable to expect this position to be maintained at the next valuation.

Where this analysis results in an expected deficit and thus future contribution requirements, pensions would typically be considered a strain on the business and, for example, in a transaction situation, an adjustment to the offer price made to allow for these costs.

Beyond a Funding surplus

Whilst it is good news if a funding surplus is expected to exist at the next valuation, there still a risk that future cash support needed. For example, contributions could be required in the future if:

• The Funding position worsens, for example if the scheme’s asset strategy underperforms. Analysis should enable a sponsor to understand the risks around this and if this is a risk they wish to work with the trustees to mitigate; or
• There is a change in the strategy for running the pension scheme. For example, a move to target full funding on a lower risk funding measure such as self-sufficiency or buy-out, which many schemes have committed to as an unofficial funding target.

Therefore, it is important to consider the surplus on more prudent measures.

"Self sufficiency”

Many schemes now assess the position of the scheme on a low-risk measure, called the self-sufficiency (or low dependency) measure. This is the level of funding at which a scheme could be expected to be able to run-on without relying on further support from a sponsor, and with investment in low-risk assets. Full funding on this measure means pensions are unlikely to be a strain on the business in future. If considered appropriate, funding at this level may mean a transfer of the scheme to pensions consolidation options like Clara might also be possible, at a cost lower than securing member benefits with an insurer.

“Buy-out”

The insurance buy-out measure typically represents the highest liability, and therefore the lowest chance of a surplus on this measure. This represents the cost of securing all benefits with an insurer, which can only be known with certainty after approaching the insurance market. However, a surplus on this measure means that all promised liabilities could be transferred to an insurer with money left over.

At this level of surplus, and potentially at the lower self-sufficiency level it is possible that the surplus could reasonably be considered an asset of the business.

Improvements in funding positions have reduced the strain that pensions place on businesses and many schemes will show a surplus on certain measures. This is clearly welcome news. However, all surpluses are not equally valuable- a surplus on an accounting measure alone is unlikely to mean pensions are a realisable asset of the business. To assess whether pension schemes are truly an asset it is important to understand the various measures of surplus.