Pension buy-outs: managing a surplus on winding-up

Trustees and sponsors not only need to consider the various ways in which surplus can be managed, but also should weigh up the legal risks and practical issues associated with each option.

Augmenting member benefits

In some cases, it is decided that surplus should be used to augment benefits for members. If this is the case, the scheme rules may oblige trustees to use the surplus in this way or at least consider it before returning any surplus to the employer.

Trustees must consider the practicalities and process for using surplus to improve members benefits. There are three key risk areas in this regard:

• Benefit design decisions – are the augmentations fair or do they disproportionately favour high earners or those with long service? Could there be direct or indirect discrimination issues if augmentations favour men or women or older members over younger members?
• Issues for members – there are potential tax issues for members. It is important to manage expectations and communicate surplus plans with them to avoid any potential disputes or claims.
• Practical concerns for insurers – there needs to be flexibility in the bulk annuity policy to change members benefits subsequent to taking out the original buy-in policy. Augmentations need to be administratively workable for the insurer.

This option would be popular with the scheme’s membership and may also be attractive to the trustees. However, from a sponsor’s perspective, it is more likely that it would want to have the surplus returned to it or run-down or avoided in some way.

Employer refunds

The scheme rules will dictate how the surplus can be used and whether any surplus can be returned to the sponsor.

Even if the scheme rules allow surplus to be returned to the employer, there is a legal process set out in legislation which must be followed before this can be done. Correct notice, appropriate member communication and tax are among the issues trustees and sponsors must take into account.

In addition to these requirements, members must be given notice of the decision. The first consultation notice must inform members of the estimated value of the surplus, set out to whom and in what proportions surplus is to be distributed and invite written representations from members by a specified deadline. The deadline should be at least two months after the first consultation notice. The second consultation notice must be sent after the consultation period has expired but at least three months before surplus is paid.

If the statutory requirements are not followed, the Pensions Regulator can suspend the refund and the payment could be classed an unauthorised payment and be subject to penal tax charges as a result.

Member communication and managing expectations in relation to surplus plans is vital when surplus is to be returned to the company, as it helps avoid any potential disputes or claims.

Any successful refund of surplus to employers is also subject to a 35% tax charge (25% from 6 April 2024). For this reason, it may not be the most attractive option to all sponsors.

Expenses

As a pension scheme approaches buy-out and wind-up, it is possible to think about ways in which the surplus might be absorbed by scheme expenses. This could be mutually beneficial to sponsor and trustees.

Expenses can include general scheme expenses, wind-up expenses and costs relating to run-off cover and residual risks cover.

From a sponsor’s perspective, it might be an attractive proposition for expenses to be met from scheme assets as this reduces the risk of a large “trapped” surplus and potentially reduces the burden on the sponsor to directly meet the costs of running and winding up the scheme.

There are benefits from a trustee perspective too. Trustees may be able to use scheme assets to pay for run-off cover and residual risks cover.

Case law makes it clear that trustees have a very wide discretion for dealing with surplus which included using it for expenses. It is still necessary to check the scheme rules to see how surplus can be used, consider relevant case law and consider trustee conflicts of interests. Trustees must also consider that, if surplus is used to meet scheme expenses or trustee liability insurance protection, there may be less surplus available for the benefit of members.

Innovative surplus solutions

The main driver for innovative solutions to dealing with surplus is tax efficiency. The more surplus is used in a way that minimises the tax charge, the better benefit it can provide to the sponsor.

It can be a win-win solution if it also works from the trustee point of view.

There are various established ways of “avoiding” surplus, including escrow arrangements, reservoir trusts and funding buffers. These solutions only work if the scheme is not yet in surplus, which gives the trustees and sponsor the flexibility to prevent a surplus arising.

From a sponsor’s perspective, these solutions allow them to continue to contribute to their scheme with the option of the funds being returned to them in certain circumstances. For trustees, these solutions can provide additional security to the scheme and protect member benefits due to the confidence given to sponsors that any excess funds could be returned.

Where a scheme has both a defined benefit (DB) and a defined contribution (DC) section, another solution may be to run-on the DB section of the scheme and use the surplus funds to pay the employer contributions in connection with the DC section.