What if the Surplus Management Framework is wrong?
I inverted each tenet to find out.
“Invert, always invert” - Charlie Munger
The quickest way to learn why a condition matters is to invert it and watch what happens. I did that to the Surplus Management Framework (SMF) TM, one tenet at a time. Each inversion leaves behind a cartoon. The cartoons are absurd. This is what real schemes drift towards when one or more of the tenets is quietly ignored.
Delete the boundary between Trapped and Distributable Surplus
There are two ways to have no boundary.
Option A: surplus stays trapped, forever. The scheme is 140% funded, the trustees are proud, and the sponsor is observing a fortress that it is not allowed to enter. Security is 99.9%. Not good enough. Trustees hold on. Anything short of total security is unacceptable.
Option B: it is all distributable, always, whatever happens. Pay it out on Monday. Discuss on Tuesday. Surplus is treated as a windfall bonus, with no thought for the member benefits it was protecting.
The boundary is what stops the scheme sliding to either end. It is a policy choice, but the boundary has to exist.
Ignore covenant
Covenant is unimportant, apparently. The sponsor is visibly wobbling, so push the surplus out and lean into the insolvency. The scheme arrives at the Pension Protection Fund with a story to tell.
Covenant is the measure of how much help stands behind the scheme if the assets disappoint. Ignore it and you release surplus at the precise moment the safety net is thinnest.
Ignore investment risk
Take as much risk as you want and release as much surplus as you want. It will all be fine. Risk of underperforming liabilities is ignored as unnecessary pessimism.
A scheme that holds more risk needs more capital behind it, so it can release less. Remove that link and the amount released has no relationship to the chance of needing the money back.
Ignore opportunity cost
The sponsor is happy for the scheme earn a low return on assets no longer needed to be held for security. The CFO's cost of capital is way in excess of the scheme expected return, but the scheme trustee board never asked. Holding onto assets in the scheme results in ~37% value destruction over a 10 year period.
Opportunity cost is rarely assessed, but has not stopped mattering. Surplus held in the scheme earns scheme returns, which given de-risking are usually much lower than the sponsor's return on capital employed. That gap is the sponsor's loss to delaying surplus release, and it is why schemes holding surplus for longer than needed is a costly decision, not a neutral default.
Delete Timing
Wait. Release no surplus. Hold everything in situ for 5, 10, 15 years. Pre-97 pensioners will live forever and absorb zero increases comfortably ad infinitum, and the scheme will hand something back when and if sponsor and trustees can eventually get comfortable.
Pensioners protesting outside Corporate HQ are less enthusiastic about this plan. Delay is not cost free to them. The cost of living keeps on going up. Every year of waiting is one where members living standards fall further behind.
What the cartoons teach
Each tenet is a constraint doing real work.
· The Boundary keeps the scheme from drifting to an extreme
· Covenant recognises the benefit of support standing behind the scheme
· Investment risk increases the cost of releasing surplus
· Opportunity cost is the sponsor's side of the status quo
· Timing decides when members can benefit from the upside
Remove any one tenet and the decision defaults to a cartoon: never release, release everything, release into insolvency, wait until value is totally destroyed or wait until members who could benefit most have stopped asking.
The Surplus Management FrameworkTM exists so that trustees and sponsors never have to choose between these cartoons.
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