Written by:
Head of Funding and Covenant
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7 minutes
Published:
15 / 06 / 2023
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Avoiding the trap of trapped surplus
The recent consultation from The Pensions Regulator (TPR) on the draft DB funding code provides us with the next iteration of the development of TPR’s framework for UK pension scheme funding regime. In many respects, most of the key aspects of the draft code have been well-trailed and will not be a surprise to many pension scheme trustees or sponsors. Indeed, pension schemes will likely see the draft code as supporting existing practices as part of their integrated approach to scheme funding.
One of the key aspects of TPR’s new proposed framework is the adoption of a longer-term low-dependency funding basis and requiring trustees to target achieving full funding against this long-term measure by the time a scheme reaches significant maturity. Consequently, many pension schemes will be revisiting their journey plans and assessing their long-term low-dependency funding targets. For some pension schemes, these new requirements will lead to trustees targeting full funding on a buy-out basis with a view to passing their liabilities across to a third-party insurer or superfund. For others, it may lead to targeting self-sufficiency and ultimately running off in order to retain potential future value within the scheme rather than hand that potential to an insurer.
The problem with prudence
The requirement to pre-fund de-risking a scheme’s investment strategy and to do so on a low-dependency basis is well-intentioned but can have unintended consequences. In particular, the requirement to fund prudently means that funding surpluses are, by definition, even more likely than not to emerge through time as the prudence in the funding basis unwinds.
Targeting full funding on a self-sufficiency basis is likely to lead to an increased likelihood of excess funds building up in a scheme; that is a trapped surplus.
From a sponsor’s perspective, this is likely to represent a source of concern and frustration as once a surplus is created, current legislation means there are very few circumstances where this excess funding can be accessed in future by the sponsors.
As such, excess funding is likely to be viewed as an inefficient use of cash for scheme sponsors who will be looking for the best return on their capital. This issue is also potentially exacerbated by TPR’s framework pushing for shorter recovery plans for schemes in deficit and will inevitably make negotiating valuations more difficult.
Building confidence with innovative solutions
In recent years, there has been a growing trend for sponsors to establish an alternative funding vehicle outside of their pension scheme which can act as a funding buffer or contingent payment vehicle ensuring security for the trustee whilst meeting the sponsor’s requirements.
Such vehicles can take a variety of forms including escrow accounts, asset-backed funding, co-investment vehicles and innovation continues to evolve in this area.
From the sponsors’ perspective, the benefits of these alternative funding arrangements can be significant. Contingent funding solutions can provide the flexibility to return funds to the sponsor if it turns out they were not needed providing mitigation to shareholders and other creditors against the risk of a trapped surplus.
Equally from the trustee perspective, these solutions can provide additional security to the scheme protecting member benefits and may also encourage sponsors to accelerate funding by giving confidence that any excess funds will be returned.
Whilst these solutions can help, they are only able to partially mitigate the issue of a trapped surplus however as ultimately once money is paid into a scheme, it can still become trapped, particularly if the event that resulted in the funds being needed reverses, as is often the case.
Trustees and sponsors need to balance their respective objectives in order to find an appropriate solution.
This is where there is scope for innovation to provide trustees and sponsors who prefer to go down the ‘DIY’ route and run off the scheme over time with a more comprehensive solution to a trapped surplus. Brightwell has researched and implemented solutions to mitigate against the risk of a trapped surplus in a pension scheme and is able to provide bespoke solutions to provide the support that you need.
Transformation through BTPS
By way of example, Brightwell worked closely with the BT Pension Scheme Trustee and BT Group to develop a funding solution for the 2020 valuation that provides some protection against the risk of overfunding by allowing money to be returned if not needed by the Scheme, enabling BT Group to provide upfront funding with greater confidence.
Under the agreed arrangement, BT Group has the option to pay deficit repair plan payments into a co-investment vehicle which will be invested as part of the overall BTPS investment strategy. The value of the assets held in the vehicle will be included in the assets of BTPS for the purposes of calculating both the funding deficit and the IAS 19 deficit. To the extent, that if there is a funding deficit at 30 June 2034, the co-investment vehicle will pay funds to the BTPS.
Any remaining funds in the co-investment vehicle are returned to BT Group in three annual payments in 2035, 2036 and 2037, unless the Scheme has subsequently moved into deficit or the Trustee, acting prudently but reasonably, decides to defer or reduce these payments.
If you are interested in finding out more about how Brightwell can develop innovative solutions for your scheme, please contact us at hello@brightwellpensions.com.
