Consultation is expected “this winter” on making it easier to take surplus out of a defined benefit (DB) scheme. No details have been given so far, but the proposals are expected to cover:

• Design;

• Eligibility;

• Overcoming restrictions in scheme rules;

• Safeguards (including levels at which surplus can be taken and employer covenant strength);

• Use of surplus to fund defined contribution (DC) contributions in another pension scheme; and

• Viability of a Pension Protection Fund (PPF) underpin in return for a higher levy (please see below).

In addition, the tax payable on an authorised repayment of surplus to an employer will be reduced from 35% to 25% from 6 April 2024.

Sharing surplus with members

Deciding to return surplus to the employer can be a difficult decision for a trustee to reach – and it is often appropriate for trustees to negotiate some benefit for members before agreeing to the surplus repayment.

However, current authorised payment restrictions limit how surplus can be shared with members. In particular, current tax rules do not allow payment of a one-off “bonus”, though this would undoubtedly be welcomed by members and would be a simple way of sharing part of a scheme’s surplus without increasing the pension liability going forward. At present, surplus may be used to augment scheme pensions in ways which are payable for life – but doing so requires actuarial input and is administratively much more complicated than simply paying a one-off “bonus”.

According to the consultation response, new measures will be introduced to ensure that surplus can be shared with members. No details are given but allowing one-off “bonuses” to be authorised member payments would be helpful.

Revised funding and investment regulations and DB funding code

Revised funding and investment regulations are expected in the New Year, to be followed by a revised defined benefit (DB) funding code from the Pensions Regulator (TPR). There have been lengthy delays in issuing the finalised regulations and code. Our latest understanding is that the new requirements should apply to actuarial valuations with an effective date after September 2024, but this may be subject to change.

The draft DB funding code issued in late 2022 was widely criticised by the pension industry for its high level of focus on avoiding risk, although TPR was constrained by the restrictive wording of the draft funding and investment regulations. Given the policy shift to promoting productive investment, we expect significant changes to both the final regulations and the code, including:

• Making explicit that there is headroom for schemes to engage in productive investment;
• Clarification of what prudent funding plans will look like; and
• Requiring schemes to be explicit about their long-term strategy for providing member benefits.

100% benefit coverage from the Pension Protection Fund (PPF)

The consultation response floats the possibility of defined benefit (DB) schemes being offered a 100% Pension Protection Fund (PPF) underpin, in return for paying a higher levy. No detail is given but our understanding is that members of a scheme which opted to pay the higher levy would see 100% of their benefits covered if the sponsoring employer subsequently became insolvent.

A 100% PPF underpin would give significant comfort to trustees to adopt a more adventurous investment strategy with a view to generating a surplus, whilst safe in the knowledge that downside risk is protected. We must await further details (and consultation is expected “this winter”), but the initial proposal raises interesting questions:

• Currently the PPF provides standard PPF compensation to all its members. Providing 100% of individual scheme benefits (as provided for under each scheme’s rules) would add significant complexity to the PPF’s administration processes. A practical approach would allow some streamlining of benefits, such as adopting a common pension increase date or standard indexation and revaluation, provided that benefits are overall no less valuable than those provided under scheme rules.
• Will a scheme only be allowed to opt into higher PPF coverage if it meets certain conditions, such as being funded to a particular level, or agreeing to invest a certain proportion of its assets in “productive finance”? If no conditions are required, why wouldn’t all trustees of schemes which are not imminently buying out opt into 100% PPF coverage?
• Will trustees be able to decide unilaterally to opt in to full PPF coverage, or would this require the sponsoring employer’s consent? It would make sense for both employer and trustee consent to be needed for the initial decision to opt-in to the higher level of cover – agreed as part of negotiations over funding and investment and, potentially, treatment of any future surplus. Employers would, in practice, continue to shoulder the “balance of cost” of providing members’ benefits – only if they become insolvent would that burden pass to the PPF. It would therefore be logical to permit employer involvement in these decisions.
• How would the higher rate levy be calculated (and how would it be adjusted in light of claims experience)? Would assets backing the 100% underpin promises be ringfenced from current PPF assets? Would a scheme which had opted in to the higher rate cover be obliged to continue paying higher levies, even if the levy rate increases significantly?
• A PPF arrangement providing a 100% benefit guarantee could be a commercial challenge to insurance companies and new superfunds, raising issues of unfair competition and state aid.
• Current case law prohibits trustees from taking the existence of PPF compensation into account when deciding their investment strategy (in other words, trustees cannot “game” the PPF). Presumably, a legislative override will be needed to overturn the effect of the caselaw.
• It may be necessary to introduce a statutory override to restrictions in trust deeds that prohibit refunds to employers out of ongoing surpluses or require members’ benefits to be augmented on winding up before any surplus can be paid to the employer.

Capital-backed journey plans

There is increasing interest in alternative means of funding defined benefit (DB) liabilities, including with support from a third party provider in a “capital-backed journey plan” (CBJP). Typically, a commercial provider will put in place additional capital to support a scheme’s liabilities, in return for the trustees adopting a more adventurous investment strategy, with greater risk but opportunities for higher returns.

The Pensions Regulator (TPR) has recently issued a blog stating its general support for CBJPs, where these are entered on appropriate terms, In particular, where a sponsoring employer is distressed, a CBJP can help to take the scheme’s funding above the Pension Protection Fund (PPF) level – enabling benefits above the level of PPF compensation to be secured for members should the employer subsequently become insolvent.

TPR intends to issue new guidance on CBJPs “in the new year” to help trustees considering whether entering a CBJP is appropriate for their scheme. In the meantime, trustees are encouraged to have regard to TPR’s existing superfunds guidance, as some parts are relevant also to CBJPs. Trustees investigating a CBJP route are also expected to engage as early as possible with the employer, TPR and, if applicable, with the PPF.

DB superfunds

Defined benefit (DB) superfunds, when fully up and running, are intended to provide an option for employers wishing to sever the link with their DB scheme where its funding level will not allow buyout in the short term.

So far, only one superfund (Clara) has successfully completed the Pensions Regulator (TPR)'s assessment process, in November 2021. Clara has recently announced its first superfund transaction – agreement with the trustees of the Sears Retail Pension Scheme for the transfer in of around 9,600 members, with their benefits backed by an additional £30m of ring-fenced funding provided by Clara. The aim is to fully insure all members’ benefits in five to 10 years’ time.

We are still awaiting legislation to establish a statutory superfund authorisation regime. In the meantime, guidance from TPR sets out its expectations of would-be superfund providers and of prospective ceding trustees and employers.

A public consolidator?

Transferring to a superfund will not be an option for some more poorly funded schemes. To address this gap in the market, the government has decided to set up a limited public consolidator, to be established by 2026 and run by the Pension Protection Fund (PPF).

For more details, we must await a further consultation “this winter”. However, we do know that it will be for schemes to opt in to the consolidator, and that the target market will be those schemes which would be unattractive to commercial providers. How much a public consolidator may decide to invest in productive finance in accordance with government policy is likely to depend on what, if any, guarantees or other underpins are offered to protect the benefits transferred in.

As with the proposal to offer a 100% PPF underpin in return for a higher levy, the prospect of a public consolidator raises questions about market distortion, especially if there is some form of government subsidy for start-up costs or an ongoing guarantee. To address some of these concerns, it has been suggested that strict entry criteria should apply, with transfer to the public consolidator only available to schemes which had failed to secure benefits with a commercial consolidator.

In general, a decision to cut loose the employer covenant through consolidation will be very hard for most trustees to take. We also have little or no detail of how consolidators are intended to work: in particular, whether assets and liabilities will be pooled – with assets from better funded schemes supporting payment of benefits from weaker schemes – or segregated on a scheme by scheme basis.