A changing landscape for employers sponsoring defined benefit pension schemes

The current picture for employers sponsoring defined benefits pension schemes has changed almost beyond recognition in the last three years and according to The Pensions Regulator. The publication last month of the Annual Funding Statement, showed continued improvement in schemes’ funding positions, which has opened-up options for employers that they were not expecting at the beginning of the decade.

According to The Pensions Regulator, most defined benefit schemes continue to see positive funding levels, with estimates as of 31 December 2024 showing around 85% of schemes with a surplus of funding over liabilities. The continued strong funding position, has given rise to expectations that most schemes will be shifting their focus from deficit recovery to endgame planning.

So, what does this mean for sponsoring employers?

Since the late 1990s employers sponsoring DB schemes have been faced with constantly increasing costs, in light of reduced investment returns, more expensive liabilities and an increasing risk burden. The majority of DB schemes have closed to future accrual as a result of the increased costs and unmitigated risks, with the only option for employers to continue to fund schemes until the accrued benefits are finally paid.

However, a significant increase in the value of scheme’s assets, at the same time as a decrease in the costs of liabilities following increase Gilt yields, has largely reversed the position and offers options to employers for the future of their schemes.

Buyout

The attraction of securing pension scheme benefits by transferring the liabilities to an insurance company was for many years, an option far out of the financial reach foremost employers. The structure of and process for buying out defined benefit pension schemes is a straightforward one. Determine the total value of benefits due to scheme members and entering into a bulk annuity purchase contract with an insurer, using the scheme assets, for it to take on all pension liabilities. At a stroke the sponsoring employer is free of the scheme and the funding obligations.

So, why haven’t more employers taken the opportunity? The answer is that up until the last year or two, the funding position of most defined benefit schemes has fallen far short of the required level of assets required to fund a buyout. Whilst the last five years has seen schemes’ assets rise, so too has the cost of the liabilities, providing the accrued pension due to the members.

Now, however, that has changed markedly. As fund values continue to rise, the cost of the liabilities is also falling. Largely because of increasing Gilt yields, the gap between the cost of buying out benefits and the value of schemes’ funds has been reduced, often to the point of elimination. As a result, buyouts are becoming increasingly popular transactions.

Figures show that the UK pension transfer market is now at record levels, with a £49.1bn of pension assets completing a buyout in 2023, and similar amounts likely to have been completed in 2024. Scheme are now largely able to finance buyouts through scheme assets rather than relying on an injection of funds from their employer. The buyout can be completed within the scheme and result in the employer being free from the financial risk of a defined benefit scheme without additional costs.

Surplus on winding-up

A scheme buyout where the scheme is in surplus, ie assets in excess of the cost of liabilities, can mean, potentially, an injection of not insignificant funds to the employer.

The majority of defined benefit schemes do not allow for a refund of surplus funds from the scheme to the employer whilst the scheme is ongoing, even where it is closed to future accrual. However, following a buyout, schemes move to wind-up and terminate, where any remaining funds that have not been used to purchase the bulk annuity contract may be returned to the employer. Currently, a well known high street name is in the process of winding-up after buyout, resulting in a refund to it of c£50m, to be used for strengthening the business and exploiting growth opportunities.

The road to refund is not straightforward however, and advice should be taken. Schemes will often be governed by provisions that allow the trustees to exercise a discretion over whether to enhance members’ benefits through the use of surplus funds, either in stead of or in addition to paying a refund to the employer. The exercise of that discretion is one that trustees have not had to consider for many years, if ever, and legal advice should be taken on the employer’s rights in such a situation and how to manage any potential conflicts pf interest. It should also be borne in mind that any repayment of surplus to an employer is liable to tax at 25%.

Release of ongoing surplus

In January, the Chancellor of the Exchequer announced that, as part of the government's plans to encourage growth, restrictions on how well-funded defined benefit pension funds are able to invest their surplus funds will be lifted.

The government’s plan is to allow scheme trustees agree to share a scheme’s surplus with a sponsoring employer, with the employer free to choose to invest such funds in their core business.

This is a fundamental shift away from accepted practice over the last two decades, which has largely prevented surplus scheme funds being paid to employers. The change reflects quite fortunate timing, with the increase in schemes’ funding levels coming at a time where the government is looking to stimulate growth in the economy. Currently, of the UK’s 4,800 pension defined benefits schemes, 50% are now in a buyout surplus, with collective surpluses of c£100bn. 75% of those 4,800 schemes are operating on a “low dependency” basis, meaning that their employers are not having to contribute to reduce any funding deficit, with collective surpluses of c£160bn.

An early stimulus for the release of surplus came last year when the tax rate payable by employers on pension surplus received being reduced from 30% to 25%.  The proposals for easing the rules on payment of surplus to employers are currently going through the government consultation process, but with the Pension Regulator giving its support, it seems likely that the legal framework will be revised to allow payment of surplus funds to scheme employers relatively soon.

Overall, for the fist time since perhaps the late 1990s, employers are now faced with positive options relating to mitigating liabilities and costs of running a defined benefit pension scheme. They may also soon be presented with an opportunity to access much needed funds to stimulate growth in their businesses.