Pension buy-outs: managing the risk of ‘trapped surplus’ on winding-up

Surpluses have arisen in recent years as more schemes meet their statutory funding objectives through sponsor contributions and de-risking their investment strategy with the aim of matching “buy-out” funding. External factors such as a significant rise in interest rates in 2022 have also had a positive impact some schemes which saw their liabilities reduced.

Any surplus that can be returned to the sponsor when a DB pension scheme is wound up incurs a 25% tax charge (reduced from 35% from 6 April this year).

How trustees and sponsors can manage ‘trapped surplus’ risk

To the extent that a scheme is approaching full buy-out funding, or has already reached that level, sponsors and trustees should engage early to:

• discuss the scheme’s funding position with their advisers and determine whether there is (or could potentially be) a surplus;
• establish what the surplus position is under the scheme rules; and
• agree an endgame strategy, deciding the role any surplus may play in it.

Depending on what objective is agreed, this will influence the approach taken to handling any surplus.

For example, if the agreed objective is to get the scheme to full buy-out with an insurer and the scheme’s funding position is already in surplus, this may promote a derisking of the scheme’s investment strategy, freeing up any potential trapped surplus to be used to meet the ongoing scheme expenses subject to the scheme rules.

For schemes approaching full funding, sponsors may begin paring back contributions and instead implement alternatives to making additional scheme contributions. Notable solutions being used by sponsors include:

• escrow accounts – where all additional contributions are placed in an escrow cash account, which may be secured in favour of the trustees with a first-rank priority charge; and
• reservoir trusts – these work in a similar way to escrow arrangements, with the key difference being that the funds invested can be invested more flexibly to achieve higher returns.

From a trustee perspective, these arrangements provide security to the scheme, as trustees can access the funds when prescribed triggers are met. From a sponsor perspective, these arrangements provide flexibility, in that those funds can be returned to the sponsor if it is found that they are no longer required by the scheme.

The duties of trustees in the context of trapped surplus

Trustees are under a duty to act in the best financial interests of beneficiaries, which can include the sponsor, and should make decisions independently.

Trustees should exercise their own judgment and obtain advice from their professional advisers to allow themselves to form a view on what next steps they should take, and whether those next steps are:

• in the best financial interests of the scheme’s beneficiaries; and
• whether in taking those steps, they are satisfied that the scheme’s main purpose – which is to pay members’ benefits in full – will be achieved.

Trustees should also be mindful of their responsibilities to communicate with members and assess what information they are required to share with members regarding any such arrangements.

Avoiding and managing a trapped surplus –TPR guidance to trustees and scheme sponsors

Under the new DB funding code of practice, which will operate alongside the Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2024 (the ‘DB Funding Regulations’), schemes will be required to put measures in place to move towards a ‘low dependency’ basis, where asset returns are matched with benefit payments without requiring any further contributions from the sponsor.

However, depending on how far schemes are from low dependency, sponsors will still be required to make contributions into their schemes to address any funding deficits.

This means that sponsors and trustees will need to closely monitor their scheme’s funding levels to prevent a ‘trapped surplus’.

While the Pensions Regulator (TPR) has recognised this as an issue and suggested that trustees and sponsors should look to implement solutions such as escrow accounts and other contingency planning options to mitigate against this, the DB Funding Regulations do not provide any more guidance to trustees and sponsors than these general comments.

DWP consultation and future policy

On 23 February, DWP commenced a consultation, one of the aims of which was to “[r]emove practical barriers to surplus extraction” (paragraph 21).

To make surplus distribution to sponsors and/or other scheme members a possibility for more DB schemes, the consultation explored the prospect of introducing a statutory ‘override’, which would be a statutory power for schemes to, either:

• amend their rules to allow for payments from surplus assets; or
• exercise a statutory power to make payments directly to the sponsor, independently of any restrictions in the scheme rules.

Regardless of what form the proposed statutory override will take, trustees of DB schemes will need to understand how the introduction of such a power may impact on the balance of power between the trustees and the sponsor  on surplus decision-making under the scheme rules.

Although the DWP’s proposed statutory override would likely make it easier to answer the question of whether trustees can pay a surplus, this will not dispense with the trustees’ obligation to observe its duties to the scheme’s membership when determining whether it should exercise that power.

Furthermore, there are still several outstanding questions on the statutory override that will need to be addressed, two of which include whether the override will apply to a return of surplus on wind up, or from an ongoing scheme (or both), and how it will interact with the current statutory and tax regimes.

Co-written by Mukudi Nkanza 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: deciding how to use surplus on 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