DB surplus advice risks destroying 37% of value

Here is how.

When a business evaluates any capital project, the rule is simple: discount future cashflows at the company's cost of capital. If the return falls short of that hurdle, the project destroys value - even if it generates cash in absolute terms.

That logic is applied rigorously to every factory, every acquisition, every piece of capital equipment a business deploys.

It is almost never applied to the pension surplus.

Right now, schemes are sitting on substantial surplus earning - say - 5%pa inside the scheme. 

The sponsor's cost of capital is, say, 10%. Every year that surplus sits unreleased, the sponsor is allocating capital at half their hurdle rate.

Retention of surplus beyond need is not a neutral decision. It is potentially value destruction. 

Quiet, systematic, at scale.

The standard run-on advice model treats the entire surplus as a single pool to be grown at the scheme's rate of return - with projections focused on how large that pool might become over time.

What portion could be distributed in the near term?

Largely unaddressed. 

The fact that some surplus must remain in the scheme to protect members is real and valid. But treating all surplus as if it should sit in place, compounding at 5%, when part of it could be in the sponsor's hands earning 10% - that is not prudence. 

On a £50m surplus, over 10 years, the present value loss from this approach amounts to £18.6m - 37% of the original surplus. A loss not driven by bad markets or bad luck, but by asking the wrong question.

The model approach underpinning this?

A rebadged Journey Plan - by construction blind to opportunity cost. It will never tell you that holding surplus for longer than necessary is wrong, because it was never designed to address that question.

I have written a short paper setting out the logic in full.

The conclusions are not flattering to the status quo.

If you are a trustee, a CFO or a finance director with an impending surplus management challenge, get in touch and I'll share more.