The Pension Schemes Act (the Act) will have a sizeable impact on the pensions industry, from value for money to small pot consolidation and defined contribution (DC) megafunds. One impact that is seemingly less well known, but may present a significant opportunity, is for Surety Pension Bonds from surplus run on.
Generally speaking, the main objective of the Act is to encourage greater investment in the UK economy, whilst on a more granular level it aims to increase flexibility for surplus extraction from defined benefit pension schemes as part of the overall drive to increase investment in the UK economy.
Despite there being no strict legal restrictions on how surplus monies should be used when returned to the scheme sponsor, the UK pensions industry is heavily regulated so sponsors should be careful not to abuse the system. A sensible approach for sponsors may be, for example, to allocate any pension surplus to capital expenditure.
There is a significant pot of UK defined benefit (DB) pension scheme surplus to the tune of £160bn based on what is called ‘Low Dependency’. Put simply, this means that schemes have about £160bn more than needed to pay pensions as they fall due. When considering how surplus should be distributed, there are a number of things for trustees to consider.
- Firstly, trustees must consider how and when surplus should be distributed. There have been warnings from the Regulator that the timing of a distribution may not always be in the members’ best interests but, equally, if a scheme is significantly overfunded for a material period with no plan to release surplus that could point to poor governance.
- Secondly, trustees will need to familiarise themselves with the scheme’s governing provisions on surplus and ensure they engage collaboratively with the employer.
- Thirdly, schemes will need to produce a surplus release policy which should be integrated into the scheme’s long-term funding objectives. This policy will need to be developed with employers and be informed both by member views as well as by legal and covenant advice under the new regime.
Following the above steps being completed, trustees can then determine the funding level above which they would be comfortable releasing surplus.
The Act sets out four key amendments for DB schemes in surplus, the most notable of which is the creation of a new statutory resolution power that will allow ongoing schemes without an existing power to pay surplus to the scheme sponsor, and those with such a power to ‘remove or relax any restriction imposed by the scheme’.
Whilst the pot of surplus stands at £160bn, it is estimated that between £11.2bn and £20bn will be returned to scheme sponsors.
So, where does surety fit in with all this?
A Surety Pension Bond comes about when the pension scheme sponsor as Principal asks the surety (or sureties) to issue the Bond with the pension scheme trustees as Beneficiary to underwrite the risk of sponsor insolvency, preventing the sponsor from supporting the pension trustees by way of contributions in the future.
When it comes to how much is covered by the Bond, usually it is the full amount the trustees of the pension scheme need, in addition to the assets they hold, to secure pension benefits with an insurance company in the business of buying out DB pension schemes.
If the pension scheme is in surplus on a buyout basis the amount of the Bond payout reduces to zero. Therefore, in a surplus run on scenario there may be a real possibility the Bond payout is theoretical, and it will pay nothing if the scheme can buy out relying on its own resources.
Surety fits in by providing an extra wall of security against the sponsor covenant, helping to ensure the pension scheme can secure pensions in full if the sponsor becomes insolvent.
So, an on-demand Surety Pension Bond for the extra funds if needed would go down the traditional route of buying out the pension scheme with an insurance company if the scheme sponsor goes insolvent. In these circumstances, trustees should be careful to stipulate this in the surplus release policy.
The following example scenario helps to put this into perspective.
Pension Scheme X has a surplus on the Pension Regulator’s New Funding Code Low Dependency basis of £50m. Pension Scheme X’s trustees have considered how and when surplus should be distributed, as well as studied the scheme rules and worked with the scheme sponsor to produce a surplus release policy.
Shortly after the scheme valuation, and in accordance with the policy, the trustees direct £10m to pension increases on benefits which would otherwise be eroded by inflation, pay £10m a year for the next three years to the scheme sponsor (based on certain conditions continuing to be met, total £30m) and put plans in place to reconsider the matter at the next three yearly valuation (triennial) when they might also dispose of the remaining £10m which, in the meantime, will act as a buffer.
To make use of the £30m it will receive, the scheme sponsor may decide to utilise this in three equal directions – £10m towards current workforce auto-enrolment pension contribution cost, £10m towards a strategic acquisition and £10m on capital expenditure, such as modernising equipment or refurbishing premises.
A Surety Pension Bond will underpin the sponsor covenant, ensuring the scheme can buy out all its benefits in full with an insurer if the sponsor becomes insolvent.
In order to aid surety-backed surplus run on good practise would be for the industry standard policy to mention surety as an option.
What’s clear is that the opportunities are there for surety in surplus release policy and this can only serve to achieve the objective of increased investment in the UK economy.