Surplus to requirements? Why the Government wants more law on returning surplus

In this our latest blog on Mansion House reforms, we turn from DC to DB, and more specifically to those record surpluses that many schemes are now enjoying.

These have understandably caught the eye of the Government. Imagine what UK plc could do with a £150bn cash injection – and imagine the tax on it. Pensions law does not prohibit return of surplus while a scheme is ongoing, but it is rare. Why might reform be necessary, and what will the Government be thinking about as it fleshes out its policy?

Scheme rules governing surplus return vary significantly: some prohibit the return of surplus entirely; others grant trustees discretion; yet others impose more or less strict conditions. This “rules lottery” was made more complicated in 2006, when new legislation gave trustees ten years to pass a resolution confirming their ability to return surplus, subject to any further conditions specified by the trustees. If no resolution was passed, then any return of surplus rule became unusable. So for an unknown number of DB schemes, return of surplus is simply out of the question.

The legislative framework further complicates return of surplus. A scheme must be more than fully funded on a buy-out basis, and the surplus return must leave it that way. This is a very high threshold and in some ways an odd one, given that trustees are increasingly being encouraged to “run on” rather than buy out. Perhaps a more appropriate threshold would be based on a less stringent measure of liabilities. The “low dependency funding basis” – which recently became the official long-term target for all DB schemes under new funding regulations – would seem a natural choice.

Another complication is a requirement that trustees must be satisfied that returning surplus is in the members' interests. In other words, not taking into account the employer's beneficial interest under the trust. This test is notoriously difficult to meet. If a scheme is well enough funded, you might argue that returning surplus would be neutral with regards member interests, but when could it positively be in their interests? Trustees could seek court approval, but this would take time and money, and the outcome would by no means be certain. A new legal test is required here. Perhaps something along the lines of a return of surplus not causing a material detriment to members at the time it is made.

All this explains why mandatory return of surplus is on the agenda, and hints at some of the complexity involved in the reforms. It will be interesting to see how the Government proposes to navigate this crucial area when the Pension Schemes Bill is published. Many schemes will have paused their end game planning to see what the Bill will bring.