DB Surplus Consultation & Public Consolidator: Exploring the Potential 

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Hi, I'm James Brundrett, Head of Intellectual Capital for Mercer's investment business in the UK. I'm joined today by Leanne Johnston, the head of our funding and benefits business. Now with 75% of DB schemes now in surplus, and that surplus worth a whopping 225 billion of assets, the government has launched a recent consultation on the use of that surplus, and it's also announced its intention to launch a public consolidation vehicle.

We'll take the next few minutes to walk you through the key highlights of this consultation and what it might mean for you either as a corporate representative or a trustee of a defined benefit pension scheme.

The consultation builds on the mansion house speech, and the government's overall desire for UK pension schemes, both DB and DC, to invest in productive assets, i.e. Assets which invest in UK companies and businesses. The government has stated that the objectives of the consultation are three things.

Number one, support schemes to invest for surplus in productive assets by making it easier to share scheme surplus with employers and members. Second, remove practical barriers to actually extracting that surplus and third, remove behavioral barriers by bringing surplus extraction in line with trustee duties.

Now whether you think the government will be successful or not in encouraging defined benefit pension schemes to invest in productive assets like private equity, it's hard not to recognize the size and value of that DB surplus here in the UK with 3,750 of the 5,000 schemes in surplus already, and that surplus exceeding 225 billion of assets.

And HMRC has done a study that shows that only 180 million has been extracted in the last five years, and that's probably because until recently, a significant proportion of that so-called surplus has been used to be paid to insurance companies as DB schemes have passed over their assets and liabilities to insurer to take on.

So we certainly welcome the government's efforts if it means more pension fund members as well as their sponsors get to share the benefits of that surplus assets into the future.

But of course, the critical thing here is to make sure, first and foremost, the security of member benefits are protected. And the government has acknowledged this by stating that surplus should only be extracted where it's safe to do so. So there are a number of things the consultation is looking at.

First, a statutory override to the balance of powers in trust deed and rules to allow trustees and sponsors to actually pay out a surplus. Second, they're thinking about lowering the bar on when a surplus can actually be paid so having some form of eligible funding criteria such as being funded, fully funded on an excess of a low dependency target.

This is a concept which has just recently been introduced with the new DB funding regime, and that low dependency target would have a fixed margin possibly with a variation based on investment risk and/or covenant strength. Third, they're looking at use of a PPF underpin to guarantee 100% of liabilities, albeit this will come at an additional levy. They've also asked for any other alternative suggestions.

So let's talk about the public consolidator that the government's thinking about launching. It's been noted that in the consultation, that they're not looking to compete with other consolidators. They're looking to take up the schemes that might not be attractive to other consolidators, so probably hoovering up the smaller schemes.

Although the consultation does say it will target anything under $10 billion in assets which is clearly quite a large scheme. Interestingly, it will take on under-funded schemes as long as there's scheduled deficit contributions to get to full funding at which point the sponsor can walk away from the from-- from the scheme, and the PPF takes it on.

The underwriting of the risk here is through a limited government guarantee or through the PPF reserve. So it is limited that, and so in worst case, could potentially fail, but the kind of pricing that it will offer will be cheaper than buyout. So it could be some competition for other consolidators, even though the claim is-- that's not going to be the intention.

And the market size that they think they can target here is 120 billion of assets on 2,500 schemes, so half of the-- half of the schemes that are out there.

So what are the implications for trustees and sponsors of this consultation? Whilst this is still a consultation, it's clear that there is definitely some momentum building on this, and it does potentially change the future landscape of DB funding. Arguably, any strategic objective decisions that trustees and sponsors have already made should now be revisited in the context of announcements.

Managing schemes to address the issues of surplus are not new and there a number of options open to sponsors and trustees to make sure the economic value is shared in a sensible way. However, this consultation goes much further and challenges some of the norms that we have in the industry by asking us to look at ways of running on schemes for longer with higher ambitions and possibly higher levels of investment risk in order to grow schemes and surpluses so that we can share in the proceeds.

Now we're was still a very long way from getting the-- receiving the final detail after this consultation and finding out the new rules of the road, but we can start having the discussions now on how these proposed changes might influence future decisions around investment objectives, around investment risk and return and whether today's decisions still look sensible.

One thing is for sure, we should not lose sight of the need and fundamental right to deliver on pension promises.

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Thank you for listening and please do get in touch if you have any questions or would like to discuss these issues further. Thank you.