Those who attended Pension PlayPen’s coffee morning yesterday (24/10) will have been treated to a high-powered discussion on surplus distribution from the panel and from Peter Cameron Brown, Chair of UKAS trustees  and a leading figure in financial reporting.

Peter promised us “edited highlights” of his submission to the DWP following its  DB options consultation. Here it is – presented as a discussion paper. Peter asks that you post questions and comments on the blog and not directly to him.

Why have a Surplus Distribution Plan?

The key suggestion is that the Trustees of a DB pension scheme in surplus should be able to agree a Plan under which, on a controllable basis, the surplus could be shared with the Scheme sponsor.  This Plan could be subject to supervision by the Pensions Regulator as a mirror image of Deficit Recovery Plans and provide for the controlled release of surplus funds, measured on an appropriate and accurate basis, to the sponsor (employer or theoretically a consolidator) over a minimum number of years reflecting actual scheme experience.

Present Position

Under the Pensions Act 1995 s37, irrespective of the provisions of the Deed and whether a resolution to confirm the power had been passed, the Trustees alone can agree to refund a surplus to an employer and only then if they believe it is in the interest of the Scheme members to do so.

If a pension scheme is open, subject to minimum auto-enrolment contributions, the sponsor can benefit from a reduced funding rate for the pension benefits of the current and future Members, whether DB or in a DC section.  However unless a closed scheme reopens to benefit accrual, there is little scope to distribute the surplus to the employer before the benefits are bought-out.  The buy-out, being on a fixed basis, may not necessarily be in the best interest of the Members.

In considering a buy-out of benefits, the Trustee has to consider whether the buy-out is in the interest of the Members and if there are surplus funds over the buy-out costs, the Trustees are advised to take a balanced, fair and equitable approach in trust law between Scheme beneficiaries and sponsoring employer.  Usually this involves sharing of the surplus by way of Members’ benefit enhancement before distribution of the balance to the employer.  The refund to the employer is subject to a 35% tax deduction.

Benefits to be protected

If the surplus is to be distributed prior to a buy-out, and hence would not be available for an equitable distribution after buy-out, it appears appropriate to establish a target level of benefit to be protected before any surplus is distributed.

By definition, the Members’ benefits in a DB Scheme are defined, usually  as a percentage of pensionable pay.  The real value of pension rights thus accumulated and in payment are then protected against inflation, with minimum statutory revaluation rates usually reflected in Scheme rules.

It is suggested that a minimum benefit to be protected in a Surplus Distribution Plan should be more than the existing rights in the Scheme and the suggestion here is to provide protection of the real value of the pension both during periods of accumulation and deferral and in payment.  This would involve the dis-application of past inflation caps and also provide for future full inflation protection in the calculation of the surplus.

Whether the Trustees alone have the power to grant these enhancements is not necessary for the protection of the contingent surplus.

Use of the surplus by the Sponsor

As a surplus in an open scheme can be used, as far as is permitted by auto-enrolment requirements, by the Employer to provide pension benefits for current active members with reduced contributions, it does not therefore seem inappropriate for an employer to use the surplus available under a Trustee agreed Surplus Distribution Plan as a contribution towards the Members’ benefits in a separate arrangement, such as say a multi-employer CDC Scheme.

In this situation it would seem equitable that the taxation of the surplus distributed under the Plan should offset the relief that would otherwise be available on the contributions to the replacement arrangement.  This would also be related to the tax relief obtained by the employer on previous deficit contributions into the Scheme.  “Windfall” gains to the sponsor on distributions other than those from a Surplus Distribution Plan, e.g. on buy-out, would remain taxable at the higher rate.

A Surplus Distribution Plan agreed by Trustees independent of the sponsor under the supervision of TPR could also be used where the sponsor is no longer an employer, such as in a capital backed scheme or a scheme consolidator as a method of controlled “profit extraction”.

Measurement of the Surplus

As a Surplus Distribution Plan would distribute the Scheme’s assets at potential risk to Members’ benefits, it is vital that the determination of the surplus should accurately reflect the cash flows of the Scheme and actual Scheme experience.  The current risk assessment valuation methods do not fulfil this role.  For example, it now appears that mark to market gilt based valuations have in the recent years inflated Scheme liabilities, but might be currently undervaluing the liabilities and hence overstating surpluses.

It is therefore suggested that the estimate of the surplus to be distributed each year should be based on a cash flow forecast with initial estimates based on the pension scheme’s accounts for the previous year.  Such a forecast should project forward pension payments with inflation assumptions appropriate for each year (e.g. short term inflation above long term expectations would be reflected), lump sum payments, transfer payments, and administration costs to be paid.  On the income side, interest and dividends for individual assets classes can be projected forward with appropriate assumptions.  Redemption proceeds from fixed term investments can be mapped.  The model will then show the amount necessary to realise from the capital assets of the scheme to meet the cash outgoings in the year and the distribution to the sponsor with the resulting effect on income flows in subsequent years reflected.

It is suggested that this forecast should cover a nine year period (3 valuation cycles) with the more traditional valuation models used to provide an assessment of the funding requirements after the end of that period to ensure the scheme remains in surplus, albeit with values discounted back to a present value.  It is suggested that mortality assumptions should not be reflected in the cash flow forecast, but that the forecast should be updated each year reflecting actual scheme experience.

If the Surplus Distribution Plan formed part of the reporting pack to The Pensions Regulator, the reasonableness of the individual assumptions made can be independently reviewed at each valuation.  The Trustee should then update the forecast each year and if there had been a major deterioration in the cash position, e.g., from the forced sale of assets to meet collateral calls, existing powers allow the reduction or the suspension of the distribution. If the Trustee deemed it was in the Members interest to increase the distribution within the 3 year cycle, the Trustee could approach the Regulator with a revised forecast.

Benefit to Sponsor

As well as providing justified, predictable and relatively secure annual cash distributions from the Pension Scheme, a sponsor is also provided with an appropriate measurement of the asset value of the pension scheme to reflect in its accounts under the IAS19 asset ceiling value rules.

It is believed that this should encourage sponsors to continue to guarantee the pension scheme into the indefinite future, rather than meeting the increased funding requirements of scheme buy-out.

PPF protection continues by TPR overview of the Surplus Distribution Plan, forecasts made on a self-sufficiency basis, continuing sponsor guarantees, and by the Trustee’s capacity to alter the distributions on an annual basis.  It is believed that PPF protection at 100% of accrued benefits would provide additional reassurance to Members at little additional risk to the PPF.

Mansion House Proposals

Given the main direction of the Mansion House proposals was to encourage investment by pension schemes on a long term basis in “productive assets”, it is considered that the introduction or the prospect of Surplus Distribution Plans should encourage both trustees and sponsors to run on pension schemes and invest on a long term basis to meet the income requirements of the Scheme.

The video of the Pension PlayPen “post match analysis”of the PLSA Conference, (including the debate on surplus) is available here.