UK private sector defined benefit (DB) pension schemes hold around £1.5 trillion in assets, and these schemes are better funded than ever. Many are on a path towards a very substantially de-risked asset portfolio, as part of their journey plan towards buying out with an insurer.
There are two major consequences of this direction of travel. First, neither employers nor their current or past employees stand to benefit from the opportunity presented by well-funded DB pension schemes. Second, the aggregate effect is contrary to the Government’s desire for UK pension savings to support economic growth by investing more in productive finance.
Some fundamental changes are needed to the pensions regulatory regime; otherwise the opportunity presented by strongly funded DB plans will be missed. Making it easier for employers, DB members, and employees saving through defined contribution (DC) schemes to benefit from surpluses, albeit with appropriate checks and balances in place, would encourage more employers and trustees to retain growth assets in their pension portfolios with the aim of making the surpluses more persistent. This would also benefit the wider UK economy.
We estimate that most pension schemes are already in surplus on the Pensions Regulator’s proposed ‘Fast Track’ low dependency basis; this is a conservative funding basis, which assumes very low future investment returns. Many more are close. The opportunity for the UK to take advantage is therefore one that exists today; equally, unless the pensions regulatory regime changes in the very near future, the opportunity will be missed.
The key to realising this opportunity is unlocking ‘trapped surplus’: with appropriate checks and balances, it should be easier to access surpluses when they arise. This would give employers and trustees a reason to invest in assets with higher expected returns. By extending schemes’ time horizons and delaying the journey to buyout, it would also facilitate investment in less liquid assets such as UK infrastructure projects.
We propose six changes the Government should make:
Create a legislative mechanism by which a DB scheme’s surplus can be used to finance contributions to benefit DC members in a different scheme used by the same employer group, without incurring tax penalties that arise under current rules (although we are also proposing to change these; see below), subject to appropriate conditions.
Reduce the tax rate on refunds of surpluses to an employer, ideally to align with the corporation tax rate so that, in circumstances where using the surplus to pay for future pension provision is not achievable, employers are not penalised for funding their scheme well and remain incentivised to invest in a manner that should generate surpluses without the fear of penal tax treatment where a refund ultimately arises.
Amend legislation to more readily allow refunds of surplus while a scheme is ongoing. Legislation requires a scheme to be fully funded on a buyout basis before a refund of surplus is permitted, and many trustees are comfortable with allowing refunds only once a scheme has actually bought out and removed any possibility of the buyout position deteriorating. We propose a lower legislative threshold for allowing refunds, set by reference to a scheme’s low dependency basis, so that accessing a surplus and continuing to invest in a manner that aims to make surpluses more persistent are not mutually exclusive. We do not, however, propose a legislative override to existing scheme rule provisions, where these are less permissive.
Remove tax barriers to sharing DB surpluses with members. Surpluses can be used to increase pensions, but this carries an uncertain eventual cost for employers and drip-feeds the benefit to members. One-off lump sums, similar to Uncrystallised Funds Pension Lump Sums (UFPLSs) from DC arrangements, would be more attractive to many employers, but trigger penal tax charges for members and the scheme because they are not ‘authorised payments’. This should change.
Ensure that the final funding and investment strategy regulations do not funnel schemes into excessive de-risking, and that they allow open DB schemes to thrive. In particular, proposed requirements around “highly resilient” asset allocations at the point of low dependency may threaten schemes’ ability to target returns expected to generate a surplus. Further, genuinely long-term open DB schemes, with strong employers to support them, should be exempt from the requirement to fund for low dependency.
Revisit the Pensions Regulator’s statutory objectives to encourage an approach to regulating DB pension schemes that considers members’ broader interests beyond solely protecting accrued pensions – for example, by exploring whether it should be tasked with looking after members’ interests or, say, “supporting adequate retirement incomes for members of workplace pension schemes” rather than just protecting accrued benefits, or by giving it a new objective modelled on the proposed “competitiveness” objective for the FCA.
These changes could reasonably be expected to result in DB schemes directing tens of billions of pounds into higher return seeking assets.
Beyond DB, the expansion of Collective DC (CDC) via multi-employer, master trust and decumulation-only arrangements should provide further opportunities for boosting retirement savings and for them to be invested in higher returning assets. This will become increasingly important as nearly all private sector DB schemes have a finite investment time horizon. We have played a leading role in bringing CDC to the UK market, working with Royal Mail, and we support the Government’s plan to bring forward draft legislation later this year to make all forms of CDC a reality so that as many people as possible can benefit. It is our view that decumulation-only CDC arrangements will have the broadest reach.
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|Six changes to seize the DB pension surplus opportunity