Mansion House Reforms and the Generation of DB Surplus

In 2023, the UK Government announced its intention to act to unlock barriers to investment in productive private assets such as UK private equity. This was first announced in the Chancellor’s “Mansion House” speech and elaborated upon in the 2023 Autumn Statement delivered in November 2023. Taking for example the implication stated for Local Government Pension Schemes, the guidance percentage allocation to private equity will move to 10% - which if acted upon would imply a £30bn allocation to productive private assets from that source alone. The measures point to interesting developments ahead for DC and DB pensions, and likely further innovation to come down the line.

Here we look specifically at implications for DB schemes of investing to generate distributable surpluses in future.

Why ‘Fund’ at all?

The funding of DB plans is there by design to enhance the security of members' benefits. This financial backing provides a level of comfort that members will receive their entitled benefits when they fall due, and provides support additional to the sponsor covenant. This is because the DB assets back the DB liabilities -any amount of asset in the Scheme is better than nothing, and a larger amount is better from a security of member benefit standpoint (all other things held equal).

Surplus is in the eye of the beholder

The question of the generation and re-distribution of surplus introduces intricate challenges. One consideration is the timing of when a surplus is deemed to be sufficient to enable its payment away, but perhaps a bigger consideration is what basis is used to determine the surplus. For example there are likely to be material differences between the surplus calculated on a Cash Equivalent Transfer Value (CETV) basis and the surplus relative to the cost of insuring pensions in full at any particular point in time. Generally, because of the difference in the levels of prudence, the surplus on an insurance buyout basis will be smaller (or even negative) even at a point in time when the CETV basis shows a healthy surplus.

It could be argued that if a DB scheme has an intention to invest to generate and distribute surpluses, that its long term funding target should move towards run-off / self-sufficiency – and absent a transaction such as an insurance buyout being aimed for, horizons for investment may well lengthen (potentially justifying the allocation to less liquid assets).

Surplus distribution will be a balancing act

Exploring the use of surplus assets for other purposes requires a delicate balance between various considerations. The potential for sharing surplus with members or returning capital to sponsors brings forth questions of the balance between providing additional benefits to members, returning assets to the sponsor (possibly for reinvestment and growth in the business), and maintaining an adequate level of security for the liabilities that remain due.

The decision to make early surplus payments out of scheme assets in future needs to be weighed against the potential resultant increase in reliance on sponsor covenant. A pertinent question moving forward is what is the optimal level of DB assets to strike the right balance between providing immediate value to recipients of the transfer and maintaining an acceptable level of long-term security for the remaining scheme members.

We will keep a watchful eye on future developments in this area!