Trustee and treasury teams responsible for the UK’s £1.2trn defined benefit (DB) corporate pension sector are weighing one of the most important decisions they’ve had to make in years.

Rising interest rates have made it cheaper for these schemes to meet the costs of their pension obligations. Recent figures from The Pensions Regulator (TPR) reveal that out of around 5,000 DB schemes in the UK, over 3,750 are now in surplus on a low dependency basis with a further 950 schemes approaching surplus.

Tipped into surplus for the first time in decades, DB funds must decide whether to wind the pension fund up. This involves handing it over to insurers who promise to pay employees’ retirement payments at a fixed level under so-called bulk annuity arrangements. Alternatively, they can run it on, continuing to operate the pension for the benefit of the business and wider economy.

“The dynamics shifted in 2022 with the onset of higher interest rates. Most pension funds are fully funded and in surplus after years of deficit,” explains Wayne Segers, Partner and Head Pensions Solutions at pensions consulting and administration business, XPS Pensions Group.

Segers says many of the trustees and treasury teams he speaks to have spent years struggling to put money into the pension to improve funding levels through decades of low interest rates. Now, the fact they can offload the liabilities to an insurer and dispose of the cash risk the pension fund has on the business should it slip back into deficit, is a source of relief.

Treasury and trustee teams also harbour painful memories of the damage corporate pension funds can wreck on a business in times of market volatility. In 2022, Liz Truss’s mini budget sent gilt markets into a tailspin. It affected many funds’ liability driven investment strategies, LDI, forcing them to rely on emergency bailouts from their corporate sponsor. “This still weighs on peoples’ minds,” he says.

Moreover, treasurers and trustees are also sceptical of government pressure that has emerged in line with their new largesse. The sector’s aggregate surplus is estimated at around £150bn, roughly 10% of total DB assets. Rather than offload to an insurer, the government has weighed in, encouraging companies to keep hold of the pension fund and invest the surplus for the wider economy in productive finance.

“Deciding to run the scheme on and invest the surplus requires a shift in mindset,” explains Segers. “Many treasurers and trustees are legitimately sceptical of the government drive to get pension funds to become source of investment and productive finance.” He observes that companies fall into two camps, with most likely to wind up. But around 20% are exploring running on. This is most prevalent amongst larger schemes which will be able to generate more returns from investing a larger surplus, he says.

The potential

Choosing to run on the pension in a well-managed, low-risk way, could benefit treasury by creating a source of funding to the business, and generating value for members. For example, low risk investment strategies (only targeting a small outperformance like an insurance company) could generate 1% of the value of the surplus. “A £100m pension fund could generate £1m on the surplus for the business or members. A £1bn scheme could generate £10m in surplus,” he suggests.

Returns from investing the surplus could be invested in the company or used to offset borrowing costs. Having a pension surplus on the books can support the corporate’s credit rating and become a source of funding or be used to offset borrowing costs especially as debt has become more expensive.

Holding onto the pension fund could also allow companies to offer discretionary benefits for members or increase inflation protection, supporting employee retention in competitive businesses.

He notes that treasury is perfectly qualified to apply the same financial controls it deploys to run the business to managing the surplus. Trustees just need a blueprint, or code of practice, around surplus extraction and guidance on how to best manage the assets. In terms of financial rigour, the company and trustees can do things like set clear investment plans for pension schemes, put in checks and balances and rules around monitoring and assessment, he suggests.

“For many years schemes have been a drain on liquidity but now there is an opportunity. Well-managed, a pension fund in surplus can be a positive source of cash for the business rather than a drain,” he concludes.