Pension Surpluses: a poor use of capital?

Recent turbulence has led to improved funding positions for many pension schemes (see PwC Pension Funding Index). Many companies are disclosing unexpected, large surpluses on their balance sheets. This comes at a time when they are still paying contributions to fund a deficit identified in a valuation, potentially having taken place years ago.

Not surprisingly, shareholders are worried about overpaying contributions into pension schemes; tying up capital that is almost impossible to get back under the rules of a number of schemes. As often, rules forbid surplus assets to be returned to the sponsor, instead requiring members’ benefits to be increased.

The emergence of surplus is exacerbated by requirements for trustees to act prudently; trustees often see the emergence of surplus as a green light to reduce risks, particularly investment risk. Effectively, giving up future returns, spending the surplus, and continuing to demand additional contributions from the sponsor - rather than retaining some investment risk and keeping the surplus as a buffer if needed. Allowing pension scheme surpluses to build up, can therefore represent a poor use of capital.

An efficient solution for managing surpluses is to use a co-investment vehicle. Under this approach, the sponsor makes further contributions to a separate special purpose vehicle rather than the pension scheme. An agreement is put in place with the trustees on how that money is invested and the circumstances in which money is paid into the scheme. For example, to allow an insurance buy-out (if both parties agree) or if the scheme becomes underfunded. Crucially the sponsor can get any residual surplus back.

In the past, these vehicles were set up as escrow accounts or trusts. Today, the emerging approach is to use a partnership structure given they have greater flexibility and can lead to a win-win situation for all parties involved. In particular, the trustees rights under the partnership, if set up correctly, will be classed as a scheme asset on day one, therefore reducing the need for further contributions and reducing the levy paid to the Pension Protection Fund.

These external funding vehicles are a way to give Trustees and members the security they require while giving the sponsor more certainty and control over its cash. Importantly, they ensure that any excess money, once benefits have been paid or secured with an insurer, can be returned to the sponsor.

If you have any comments or would like to discuss any of the issues raised in this article, please get in touch.