Pension scheme surpluses: The Mansion House Reforms

On 10 July 2023, the Chancellor, Jeremy Hunt, announced several initiatives, the so called “Mansion House Reforms” to help kickstart the UK economy. These included creating a default consolidator for small pension pots and encouraging firms with defined benefit (DB) pension schemes to embrace greater investment risk by investing in “productive finance.”

Separately, nine of the largest Defined Contribution pension providers have agreed to allocate 5% of assets in their default funds to unlisted equities by as part of the ‘Mansion House Compact’.

The stated aims of the Mansion House Reforms are:

• to secure the best possible outcome for pension savers.
• to always prioritise a strong and diversified gilt market as we seek to deliver an evolutionary, rather than revolutionary, change in our pensions market; and
• to strengthen the UK’s position as a leading financial centre to create wealth and fund public services.

They seek to divert, in other words to release, a chunk of trillions of pounds of UK pension money into investments deemed more productive by the Government and are part of a wider Government effort to increase risk-taking in pensions and drive greater long-term economic growth.

Current position

Multiple Government consultations designed to help deliver the Mansion House Reforms closed on 5 September 2023 and we are now watching and waiting to see how the Government takes their proposals forward.

Use of Surplus to boost UK Plc

The Government is banking on the implementation of the Mansion House Reforms to release billions of pounds of pension fund surplus into the economy.  Surplus for this purpose looks like meaning a set percentage over a scheme’s self-sufficiency target on the new proposed scheme funding basis.

Many DB schemes now have a surplus on this proposed new basis as well as on the more traditional buy out basis. This is because their funding positions have improved substantially in the past year or so, in large part because of a dramatic rise in gilt yields but also due to the strict funding regime that has been imposed on scheme employers and groups over the last fifteen years.

How achievable is the Government’s ambition?

We think the Government’s objective will have to bulldozer its way through some significant obstacles, described below. Whether the Government ends up achieving its objective without some considerable compromise will be interesting.

• Risk

Any changes need to balance the potential for boosting investor returns and supporting UK Plc with the associated risk to people’s retirement savings. If employers could access this new-found surplus as though it were a windfall, that would present a clear danger to the financial solvency of the scheme. Benefits could also be put at risk if gild yields were to shift in the wrong direction, as that could materially affect the funding position of the scheme.

• Whose surplus is it anyway?

Ownership of surplus is different for every pension scheme and at the moment, the position depends, in part, on the wording of each scheme’s trust deed and rules and whether the scheme is ongoing or in winding up. Of course, Government legislation could override a scheme’s trust deed and rules. While this might be acceptable action for a Conservative Government, it may be less so for a Labour Government who may be under greater pressure to ensure that at least some of the surplus is used to augment members’ benefits.

• Is there even a surplus?

Surplus is only known with certainty when trustees cease to have any obligation under their scheme to provide any benefits. In more recent years, this has meant when all benefits have been secured with an insurer, through a buy in leading to a buy out and the scheme is on winding up.  On any other basis, whether there is truly a surplus is summed by the phrase, “it depends”. There are a number of different funding bases now and these have changed over the years. Most recently pension schemes have been treated in funding terms largely as quasi small insurance companies which can be frustrating. However history has shown that members’ benefits can be at risk on any lesser funding basis.

We know there are a significant number of DB schemes who do have a surplus on a self-sufficiency funding basis.

• Politics / PR

There are potential reputational risks in overriding a scheme’s trust deed and rules to return surpluses to employers. However, this is likely to be necessary otherwise the Government’s proposal may fail at the first hurdle. Members may feel that at least some of the surplus “belongs” to the members, on the basis that the surplus is comprised not only of employer contributions, but also investment returns on assets allocated to pay for member benefits.

• Using the surplus for other purposes

Where the surplus cannot be easily returned to the employer under current restrictions, parties may also find there are other significant legal and practical complexities when considering how to use any surplus “productively” in other ways from an employer perspective. It is not straightforward nor particularly attractive, for example, currently to use surplus to help fund an employer’s defined contribution pension obligations and there are strict restrictions in using surplus to help fund a less solvent scheme, for example through a scheme merger.  It will be interesting to see whether the Government’s proposed changes will result in higher values being put on DB schemes commercially when companies and business are bought and sold or by superscheme consolidators when they price their transactions.

• Tax hit?

With limited exceptions, at the moment, a tax charge of 35 per cent applies on any return of surplus to employers. To what extent would this be changed if the surplus is used to kick start the UK economy through the employer/group using the money to invest in their businesses or if it is used in other ways?

• Ongoing compliance cost and risk

The burden of compliance and risk to run on a DB pension scheme is huge. Why would trustees and sponsoring employers/groups want to switch from a clear, certain and cautious route of securing all benefits with an insurer and winding up the scheme to a riskier, let’s invest our surplus funds in “productive finance” and see what happens, approach? Perhaps this is only really for the largest of UK DB pension schemes- that are too large to buy out their benefits?

• Further down the line – challenge decisions made now?

In the pensions world, it is not unusual for seemingly sensible decisions made at a defined point in time to come back many years later to haunt you. Do trustees and their employers really want to risk that occurring?