Pension buy-outs: deciding how to use surplus on winding-up

On the winding-up of a pension scheme, trustees will be required to secure members’ benefits. If any money is left over after securing benefits in full, there may be a surplus. The question of how the surplus is dealt with can be a controversial one between the trustees and the sponsoring employer.

Although trustees are generally vested with a considerable measure of discretion in deciding how to use surplus, there are several decision-making principles come into play when dealing with surplus in the winding-up process. It is important to start by considering the balance of powers in the scheme rules, and if scheme rules allow for discretion, the usual trust law principles should be considered. Case law is also key to understanding the types of surplus solutions that have been supported by the courts.

The balance of powers in the scheme rules

When trustees are deciding how to use surplus on winding-up, the starting point is the scheme rules. The rules will usually specify how surplus should be used on winding-up. There is often a power to pay surplus to the employer or to augment members’ benefits.

Trustees should look out for various points in the rules, such as:

• who does the power belong to, the trustees or the employer, or is it a joint power;
• on what conditions may the power be exercised – is it a unilateral power or does it require one party to consult with or obtain the consent of the other party;
• whether the power mandatory or discretionary - does the rule may give the trustees a discretion to augment benefits or require them to do so; and
• whether the rules state that all or none of the surplus may or must go to the employer.

Whether the scheme rules will exhaustively deal with every possible scenario is not guaranteed, and some rules do not deal with the issue of surplus at all. If the rules are silent on how to deal with surplus, general trust law principles will apply, and it could be argued that the surplus is held on resulting trust for the employer.

The relevant provisions will differ from scheme to scheme so trustees must take advice on the specific wording of the scheme rules, especially where the rules are silent or unclear.

Trustee duties

When it comes to decision making, ordinary trust law principles apply. However, trustees are vested with a considerable measure of discretion as to dealing with surplus.

Where scheme rules allow for discretion, the usual trust law principles need to be considered. Trustees should exercise the power for the purpose it was given, taking account of relevant considerations and ignoring irrelevant ones. They should not come to a decision which no reasonable trustee could have reached.

Relevant considerations could include:

• the scope of the power;
• the purpose of the power;
• the source or origin of the surplus;
• the size of the surplus;
• the financial position of the employer; and
• the needs of the members of the scheme.

Conflicts of interest also require careful consideration. Trustees should identify, monitor and take appropriate steps to manage any conflicts of interest they may have in connection with the decision.

There is no general rule that members of a contributory pension scheme will have an interest in the surplus, equivalent to rights of property.

If the employer has the power to deal with surplus, case law has established that it is a fiduciary power to be exercised as if it were a trustee, taking account of both the needs of the employer and of the members. Employers can consider their own interests. It is not a breach of duty of good faith for an employer to prefer its own financial interests, but it must act rationally.

Case law on how to deal with surplus

Subject to the rules of their scheme, the trustees have a wide discretion in dealing with surplus. This is borne out by case law where the courts have supported a range of outcomes as to how surplus is used.

In the 2003 Alexander Forbes Trustee Services v Halliwell case, the High Court decided that awarding members limited price indexation (LPI) increases and then splitting the surplus equally between members and employers was reasonable in the circumstances.

The Harding v Joy case, in 1999, confirmed a deal with the employer for one third of a surplus to be used for benefit improvement and for the remainder to be transferred to another scheme.

In 2008, in NBPF Pension Trustees Ltd v Warnock-Smith, trustees were permitted to exclude untraced, dissenting and unknown beneficiaries from the distribution, and to use part of the surplus to purchase run-off insurance.

The ruling in Barclays Bank v Holmes in 2000 shows that it is possible for surplus to be used to pay contributions to a defined contribution (DC) scheme.

Co-written by Samuel Jackett of Pinsent Masons.

Read more on pension buy-outs:

• • Pension buy-outs: trustee liability post winding up 
  • Pension buy-outs: claim limitation periods post winding-up
  • Pension buy-outs: communicating with members about winding-up
  • Pension buy-outs: concluding the winding-up
  • Pension buy-outs: discharging DC assets on winding-up
  • Pension buy-outs: endgame issues for sponsors
  • Pension buy-outs: employer indemnities on winding-up
  • Pension buy-outs: incorporating pension scheme trustees before winding-up
  • Pension buy-outs: issuing individual policies using assignment before winding up
  • Pension buy-outs: making the decision to fully buy-in
  • Pension buy-outs: managing a surplus on winding-up
  • Pension buy-outs: relevance of FCA’s Consumer Duty when winding-up
  • Pension buy-outs: residual risks cover for winding-up pension schemes
  • Pension buy-outs: managing the risk of ‘trapped surplus’ on winding-up