The times they are a-changin' for defined benefit pensions, with apologies for plagiarising a title from perhaps Bob Dylan’s most famous song.

For years UK PLC has seen its legacy defined benefit (DB) pension obligations as just that, obligations. The funding regime meant that in practice money only ever went one way – into the scheme. Market conditions, a growing regulatory burden and increasing life expectancy combined to push most schemes into deficit. Even where surpluses arose, they usually became trapped as scheme rules rarely allowed an employer to receive a refund and even if they did the tax regime punished it. Companies, understandably, viewed their DB pension schemes as a potential liability – even when fully funded or in surplus – and were looking for ways to offload their schemes as soon as possible. This fuelled the growth of the insurance buyout market from a trickle 20 years ago to a £50bn torrent in 2023.

Rising bond yields and stalling life expectancy

But the times they are a-changin’. Rising bond yields and stalling life expectancy have pushed many DB schemes into surplus positions. Many commentators are of the view that all this will do is fuel demand for buyouts, but I think it’s much more nuanced than that.

Indeed, Jeremy Hunt, the current Chancellor, seems to agree. In his 2023 Mansion House speech, Mr Hunt spoke about how he wants DB schemes to de-risk less and to invest for growth in order to provide private sector capital to the UK economy – so-called ’productive finance‘. He is now acting. He has already lowered the tax on refunds of surplus (with effect from April this year) to broadly align with the corporation tax rate, so that putting money into a DB scheme and then later receiving a refund is now (broadly) tax neutral. Further, a recent series of consultations from the Department for Work and Pensions (DWP) indicates that the rules on surplus ’extraction‘ may be about to change dramatically, opening up the possibility that a large number of employers will be able to receive refunds of surplus.

"For companies with DB pension schemes this could be signalling a sea change in how to view it. It’s no longer an obligation – it could be about to become an asset."

The numbers involved are potentially huge – under the proposals in the consultation a company with a DB scheme fully-funded on a buyout basis, as many now are, might easily have an ’extractable‘ surplus of 10-15% of assets, or maybe more depending on exactly how the surplus rules work. Even for a £100m DB scheme this could be £10m to £15m. For very large DB schemes, say over a billion pounds of assets, the numbers could be in the hundreds of millions.  This raises the question of whether schemes that are fully-funded or could be made fully-funded with a cash injection, should run-on beyond full funding on a buyout basis. That said, smaller schemes will find their running costs are large relative to the potential size of any extractable surplus and so are likely to still want to buyout.

Of course, this is just a consultation. Lots could happen which would mean these changes never come to pass. For example, DWP may decide it doesn’t want to make these changes once it has consulted. And, of course, the UK is likely to face a general election before any of this gets done anyway. The Labour Party looks in pole position to form the next government and it’s not clear yet what they think of these proposals. They may support them, or they may not.

But, and it’s a big but, if you were thinking of buying out a medium or large-sized DB scheme, say over £100m, then you might want to think twice. It may be better to at least wait to see how this pans out, because once you’ve made the first step towards buyout by entering into an insurance contract there’s usually no way back. You may look back in two or three years’ time at the lost potential if your business competitors are then able to access significant surpluses from their DB schemes.

The natural reaction of many in the pensions industry will be to see surplus extraction as a bad thing for members of DB schemes. At first glance, that feels right as less money in the scheme clearly means a greater risk of members’ benefits not being paid in full, all else being equal. However, all else is not equal; we would expect surplus to be shared. We would expect that whenever a business takes a refund of part of a surplus that it is a pre-agreed condition that members of the DB scheme also see an uplift in their benefits, funded from the remaining surplus. That means members are building a ’buffer‘ and so even if there is a cutback of benefits later then they may still actually be better off. And if the surplus extraction rule is based on a buyout-affordability test, as we expect it to be, then the scheme would remain funded above the buyout level and so could execute a buyout transaction at any time. We think this means the security of members’ benefits will be similar to that offered by an insurance company – before taking account of any benefit uplifts.

Seismic effects for the pensions industry

If implemented, these changes will have seismic effects for the pensions industry. Here are just a few of the things I think might happen:

  • The buyout market may see contracting demand from larger schemes as these schemes are the most likely to be able to run-on efficiently.
  • Insurers may refocus on smaller schemes as these schemes are unlikely to be economic to run-on and so will still be keen to buyout.
  • Companies may use their DB surpluses to fund DC benefits for existing employees, rather than simply taking the cash, especially as this has better ’optics‘ with employees and stakeholders.
  • Some may even re-open their DB schemes (or delay closing them) to get value from the surplus. 
  • We may see increased merger and acquisitions (M&A) activity in businesses that have long been thought to have an intractable ’pensions problem‘. 
  • Scheme mergers, or bulk transfers, may become part of corporate M&A activity again, as smaller DB schemes can be merged into larger ones, magnifying the potential for surplus extraction. 
  • We may see businesses with multiple small schemes looking to merge them together to access the new flexibilities.
  • We may see new consolidators enter the market looking for ways to enable businesses with smaller DB schemes to club together to access the new flexibilities.
  • Demand for long-dated gilts may fall, and demand for risky assets may rise, as schemes look to put in a little bit more investment risk to accelerate the growth of their surplus. 
  • Corporates may be even keener to pursue member option exercises, e.g. enhanced transfer value programmes, to the extent this generates, or accelerates, surpluses that are ’extractable’.

To sum up, there’s a lot potentially about to change, and that means it’s probably wise to proceed with care. If you’d like to chat through what all this could mean for your DB scheme, then please do get in touch.

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