Escrow is not a pension contribution. Treat it differently.

Corporate sponsors of UK defined benefit schemes have spent the past few years watching their funding positions improve - sometimes dramatically. Elevated gilt yields have done much of the work. But alongside a scheme now sitting in surplus, a significant number of sponsors also have an escrow arrangement that has quietly been accumulating.

The instinct is to treat both as part of the same pension story. This is worth examining.

The combined capital stack

The Surplus Management Framework TM (SMF) distinguishes between Trapped Surplus - the portion of scheme assets that must be retained as a risk buffer - and Distributable Surplus, which can be returned to the sponsor without compromising member security. The key input is the sponsor's covenant: a stronger covenant means a smaller required buffer, and therefore a larger distributable pool.

Where escrow sits alongside the scheme, the same logic applies - but the unit of analysis changes. The relevant question is no longer about scheme assets in isolation. It becomes: what is the minimum combined level of scheme assets and escrow required to adequately protect member benefits? Capital above that threshold - wherever it sits - is "surplus" to the protection requirement (no pun intended).

Three zones, one release pathway

Working through this combined stack produces three distinct zones:

Zone 1 is the Required Protection Stack. Scheme assets plus escrow, up to the level genuinely needed to secure benefits given the scheme's risk profile and the sponsor's covenant. Nothing here should move.

Zone 2 is Distributable Escrow - escrow that sits above Zone 1, providing insignificant protection to members. This can be returned to the sponsor. There is no Pension Schemes Act (PSA) 2026 surplus release authorisation process. There is no 25% extraction tax. The governance requirement is a trustee comfort exercise: demonstrating that the remaining combined stack is adequate. That is a tractable conversation.

Zone 3 is Distributable Scheme Surplus - what remains once Zone 2 has been exhausted and scheme assets alone still exceed the protection threshold. This is the formal PSA 2026 route, with the associated authorisation requirements and tax cost (currently anticipated to be available to all schemes from 2027).

The sequencing matters

Zone 2 before Zone 3 is the dominant strategy. It is lower friction, carries no tax cost, and does not require the full surplus extraction machinery. Sponsors who move straight to discussing PSA 2026 distributions without first examining their escrow position may be leaving the easier money on the table.

There is also a dynamic element. The Zone 1 boundary is not fixed. As covenant quality improves - evidenced formally rather than assumed - the required buffer shrinks and more escrow migrates from Zone 1 to Zone 2. Investment de-risking works the same way: a more liability-matched portfolio reduces the risk buffer requirement, widening Zone 2 capacity. Active management of both levers accelerates the release pathway.

The cost of inaction

Escrow sitting in Zone 2 is typically earning a low, cash-like return. It is not in the business. It is not reducing leverage. A trustee board that has not been presented with a formal analysis of the combined protection stack has, in effect, been asked to hold capital it cannot quantify a use for. That is not good governance on either side of the table.

The reframe is simple. Releasing Zone 2 escrow is a recognition that the scheme is now adequately protected without it.

The question is whether the right amount is being retained. For sponsors who are not running this analysis, the answer is most likely to be no.

About SMF

The Surplus Management Framework (SMF) is a proprietary purpose-built governance tool built to support the decisions that matter - integrating funding, investment and covenant risks into a single, coherent framework.

The SMF helps to transform surplus distribution from a potentially contentious negotiation into a structured, straightforward, risk-based decision furthering the interests of all scheme stakeholders.

Contact us to find out more.