DB surplus: a trustee’s anxiety of choice (and how sponsors can help) (Part 2)

The Pension Schemes Bill’s surplus refund provisions have focused more attention on surpluses in defined benefit (DB) pension schemes. But DB surpluses were already high on the agenda. With the Regulator's 2025 Annual Funding Statement estimating that 85% of DB schemes are in surplus on a technical provisions basis and 54% in surplus on a buyout basis, many sponsors and trustees have already been doing a lot of thinking about their options in relation to surplus – including some whose schemes are not yet in surplus. 

The Bill promises to broaden significantly the options for a run-on by making it easier to make refunds of surplus to sponsors from ongoing schemes. In the first of this two-blog series, I looked at the considerations for an ongoing scheme wanting to use DB surplus to meet DC costs (the “DB / DC route”) as well as those that apply when deciding whether to return surplus to the employer (the “refund route”). In this second blog, I take a look at the key issues common to both routes – issues which lie at the heart of any decision by sponsors and trustees on whether to run-on or not. 

To run-on or not to run-on

The Pension Schemes Bill is set to simplify the legal position in respect of surplus refunds and allow for consistency between schemes as to what legal principles will govern the decision. Those principles will be largely the same whether the DB / DC route or the refund route is being looked at.

This will put trustees in a more sensitive position, with the potential for more choice to lead to greater anxiety. They will not be shielded from the responsibility to make the decision by a restriction in the scheme rules.  They will not be able to use as leverage a statutory requirement that the use of surplus be in members’ interests. They should in fact be well positioned to make such decisions, being well informed of the circumstances of the scheme and able to take into account, and appropriately balance, the interests of all beneficiaries, including the employer. 

But in many cases, this is likely to increase the pressure on trustees and scrutiny of their decisions, which makes it essential for them inform their deliberations with carefully considered, comprehensive advice. 

For a sponsor, a point to take away is that if it wants to benefit from surplus, it will need to work with this legal framework. It must be ready to put a proposal to the trustee that anticipates and addresses all of the key issues, and thereby help trustees engage in substantive negotiations and reach a decision that is defensible under trust law. 

We’ll now illustrate this by looking at some of the critical considerations that a sponsor and a trustee will need to take into account when discussing whether or not to run-on and make use of surplus while the scheme is ongoing. 

• Interaction with the scheme’s Funding and Investment Strategy. Trustees carrying out new valuations following September 2024 must put in place a funding and investment strategy (“FIS”) and, for most schemes, agree this with the sponsor. The legislation requires the FIS to specify the way in which the trustee intends pensions and other benefits under the scheme to be provided over the long term – viewed as a requirement to spell out the so-called “endgame strategy”. An agreement to run-on is likely to be relevant to this, such that the agreed run-on principles and its objectives would need to be consistent with the FIS, and the relevant matters articulated in the statement of strategy that enshrines the FIS. One point that will need to be considered is the duration of any run-on arrangement – it may be that a sponsor and trustee agree to run-on for a specific period, and use surplus during that timeframe, but that the scheme should be bought out following that. Sponsors may be concerned as to the accounting implications of documenting in the FIS any commitment to buy-out the scheme and the timescale for doing so. 
• Investment strategy. The low dependency funding basis that must be targeted by the scheme’s FIS assumes that assets equal to full funding on that basis are invested in accordance with a low dependency investment allocation. An investment strategy aimed at maintaining a surplus will need to be consistent with this, with careful thought given to the kind of mixture that can be made between liability matching and the seeking of returns. The potential investment downside risks and longevity risk will also need to be taken into account, with mitigants for such risks balanced against other objectives.   Generally, the FIS must also have an objective of ensuring that assets are invested in accordance with a low dependency investment allocation (which is highly resilient to short-term adverse changes in the market) by a certain point but it is worth noting that the relevant regulations make it clear that this does not apply to any surplus on a low dependency funding basis. 
• Minimum funding level. The sponsor and trustee will need to agree on the minimum funding level above which surplus can be refunded or used. The Government has said it is minded to allow refunds above full funding on the low dependency funding basis that will be set out in the scheme’s FIS. However, many trustees and sponsors may still agree that the minimum be maintained at the buyout level, potentially with an appropriate buffer.
• Safeguards. The sponsor and trustee will need to agree on what remedial action should be taken if the scheme funding level falls below the minimum funding level, or another level which they have agreed as an appropriate early warning trigger. It may be that the consequence is limited to ceasing the continued use of surplus, but specific steps may also be agreed in relation to the scheme investments or employer covenant support while the funding level remains below an agreed threshold. 
• Employer covenant. The approach of a trustee to such matters as the minimum funding level, the investment strategy and the extent to which it can continue to include a higher exposure to risk, and the run-on safeguarding arrangements, may be informed by its view of the employer covenant and its ability to underwrite risks relating to the scheme, including the possibility of a deficit reappearing. 
• Whether to benefit members. Following the reappearance of higher inflation in recent years, trustees and sponsors are both aware of the potential for the relative value of scheme benefits to be eroded. The possibility of improving the position of members may play a central role in run-on discussions alongside the ability to continue to exercise discretionary powers (for example to allow for increases on pre-97 benefits). Some sponsors may be of the view that this is appropriate as part of an overall package of measures. However, whether it is appropriate under trust law for trustees to seek to bargain for such improvements would need careful consideration, especially given the proposed removal of the “interests of members” condition from Section 37 of the Pensions Act 1995 covered in my first blog. It should also be borne in mind by both parties that improving members’ benefits, by increasing liabilities, also increases the risks in relation to the scheme. It is notable that the Government has described its proposed changes to the regime as intended to enable “surplus sharing”, when in fact those changes do not mandate sharing the benefits of surplus, nor make such sharing legally easier to achieve. 
• Liabilities.  Trustees and sponsors will need to address whether there is any uncertainty around the level of scheme liabilities (for example in the wake of the Virgin Media decision or simply because admin practice has differed from scheme rules over time).  No decision can be taken around utilisation of surplus until the parties have concluded that they have satisfactorily ascertained the scheme liabilities and agreed the level of due diligence required to do this. 
• Buy-in.   If a scheme is sufficiently well funded to buy-in and is (or can shortly be) transaction ready, trustees and sponsors should challenge their advisers on the assumptions and modelling that underpins the analysis of the potential risks and rewards of run on versus buy-out so that this is properly understood and forms part of their part of decision-making. This analysis should take into account systemic risks such as AI and climate change. 

The Pensions Regulator’s guidance on new models for DB schemes includes a useful list of factors for trustees to consider in deciding whether to run-on, one of them being the expectation that the scheme would be able to deliver sufficient economies of scale as it matures and benefits are paid out – an important point which ties in with the question of duration. 

This short list of issues illustrates keenly how wide-ranging a run-on discussion with the sponsor will need to be. The purpose of running on will need to be properly understood and both considered and justified in the context of the trustees’ fiduciary duties, as will the benefits for all stakeholders, given the need to justify the continued maintenance and potential increase of risk. The more care that is taken in discussing and testing these matters, the less likely it is that a decision to run-on will have adverse consequences or expose the sponsor and trustee to legal claims should such adverse consequences nonetheless occur. 

As always, legal, actuarial, investment and covenant advice will be critical in ensuring that any decision-making process is robust and that there is an appropriate audit trail in the event of any future member challenge or regulatory criticism. By facing these new choices in a collaborative, informed, considered and reasoned way, trustees and sponsors should be able to rest easy at the end of a working day. 

Charles Magoffin