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Pensions: A good funding challenge for employers?

07 March 2023

Employers with defined benefit schemes may be facing a different sort of challenge: dealing with surpluses, whether in negotiating ongoing contributions or on securing benefits and winding up a scheme

This article was originally written for and published in the Journal of the Law Society of Scotland, February 2023

Many pension scheme employers are facing, or if not managed, may face a different challenge – a surplus in their defined benefit pension scheme. At the end of November 2022, according to the Pension Protection Fund PPF 7800 Index, 4,385 schemes (out of 5,131) were in surplus.

Funding levels have been improving for many schemes, most recently with the impact of the mini-budget in September 2022. Trustees are also managing risks to maintain and improve the funding position.

Aside from negotiations on surplus in corporate transactions, last seen in volume back in the 1980s, what does this mean for those schemes planning to secure members’ benefits with an insurer? Approaching a funding level that means members’ benefits can be secured with an insurer, with the scheme then being wound up, surely is good news?

Employers should be thinking about their funding strategy as part of overall financial planning for the business, and the implications of a surplus in the scheme after benefits are secured. Clearly if the strategy for a scheme is to buy out benefits with an insurer, trustees need to be able to do so and to meet the expenses of winding up the scheme. Employers will want to do so in a way that optimises use of funds for their business alongside providing financial support to the scheme, whether running on or aiming to buy out, without risking a trapped surplus.

Allocation of a surplus as part of a winding-up process depends on various factors, including the rules and statutory requirements, but tax currently at 35% is deducted from any payment to an employer.

Mitigating the risk

Crucially, employers need to understand the statutory, regulatory and scheme requirements on funding, tax treatment, and accounting implications of decisions, and be clear on their strategy for the scheme, before negotiating with trustees.

Many employers and trustees have a clear strategy and agreed timetable in place, with a funding and investment strategy aligned to that. The Pensions Regulator (“TPR”) is consulting on a new Funding Code that may impact, so that should be monitored.

Employer contributions

What options might be available to manage employer contributions going into the scheme as part of funding plans?

Trustees must apply the scheme rules within a statutory and regulatory framework, always protecting members’ benefits, so must assess risks, including the risk of employer insolvency. However, employers can look to agree funding plans so that funds can be paid in only as required, by agreeing triggers and mechanisms that still protect members’ benefits.

This could include deferral, suspension or reduction in contributions or payment of additional contributions, if agreed triggers are hit. An escrow agreement and account can allow changes to be made and additional contributions triggered, plus an agreed mechanism to release funds and resolve any disagreements. This still leaves the risk of employer financial difficulty and insolvency. Setting this up using a Pension Protection Fund approved agreement using employer assets as security could mitigate that risk and make it easier for trustees to agree to a framework permitting flexibility for employer contributions. Additional benefit is reduction in the annual PPF levy.

Surplus after benefits bought out

A surplus in the scheme after members’ benefits are secured and wind-up is nearly complete, poses a different challenge for employers. Tax is deducted from any surplus before any possible payment to an employer.

The scheme rules will set out triggers for wind-up and powers once wind-up starts. Often, it will be an employer decision to trigger wind-up. Once wind-up is triggered, trustees generally have more powers and must follow the winding-up rules and statutory requirements, as it is their responsibility to complete the wind-up process. It is important that employers understand how the rules of their scheme operate, and in particular the powers trustees will have on wind-up, before wind-up is triggered. The employer may have a veto on some options. Once wind-up has begun, it is irrevocable, so employers should have a dialogue with trustees before that happens.

Statutory conditions also apply before trustees can pay out any surplus, such as informing members of the proposal. Members can then make representations to TPR. TPR then decides whether the requirements have been met.

So, an employer should arm itself with information and advice and have a clear strategy for the scheme, including on funding, which it can then discuss with trustees to be in the optimum position to meet its responsibilities to members while protecting and helping the business that supports the scheme to flourish.

Further Reading