Defined Benefit Surplus Management: Staying on track with a U-turn 

Recent developments in the DB landscape are prompting schemes to rethink how they manage funding and investments. Stronger funding positions, changing market expectations and new regulatory guidance are reshaping the balance between harvesting growth and controlling risk.

Meanwhile, surplus management is no longer just about preparing for buyout. Instead, it has become a standalone strategic consideration.

In this environment, trustees and sponsors need to strike the right balance between growth and risk as schemes move from deficit to full funding and into surplus. The “U-shaped” framework can help schemes maintain the right balance between growth and risk, by offering a structured way to think about how growth exposure should evolve as funding improves, and surpluses build.

At the same time, flexibility is crucial as each scheme’s objectives, covenant and goals are unique, therefore strategies must adapt accordingly.

The “U-shaped” framework describes the optimal allocation between growth and defensive investments across the DB scheme’s journey. It provides a way to think about how much of a scheme’s assets should be invested in higher-return growth assets, such as equities, alternative credit and alternatives, at different funding stages, from deficit through to full funding and surplus.

When a scheme is in deficit, a relatively high growth allocation maybe be necessary to improve funding. As funding strengthens, the scheme can gradually de-risk, reducing growth exposure and increasing its allocation to liability-hedging or more stable assets. Once a scheme reaches full funding and begins to build a surplus, growth allocations can be increased again to capture upside potential, as the surplus provides a buffer to absorb market volatility and downside risk.

When a scheme is in deficit, the focus is naturally on improving funding efficiently, which typically requires a meaningful allocation to growth assets.

At this stage, schemes are likely to hold more than 20% in growth, supported by a full – or at least high – hedge of funded liabilities to manage interest rate and inflation risks.

The investment framework should be designed to diversify growth exposure while maintaining liability hedging discipline. A diversified portfolio reduces concentration risk, while liability hedging helps stabilise funding levels against market shocks.

This is the point at which the downward leg of the U begins: as funding improves, dynamic de-risking allows growth exposure to be reduced gradually and systematically, locking in gains rather than risking a slide back into deficit and increasing certainty of reaching Low Dependency.

The pace of that reduction will depend on the journey plan and the strength of the sponsor covenant, which remains a critical backstop. Balancing these factors helps ensure that deficit repair is efficient but not reckless, setting the scheme on a controlled path toward full funding.

Reaching full funding is a milestone, but it also raises one of the most important questions in the “U-shaped” framework: how low should the growth allocation go and how sharp should the dip be?

At this point in the funding journey, schemes typically hold 20% or less in growth assets, and some may already be fully invested in a Cashflow Driven Investment (CDI) strategy (consisting largely of bond assets) with liabilities fully hedged and a dynamic discount rate that aligns liability valuation with the bond assets held.

The key decision is whether to derisk to 0% growth or maintain a small allocation in growth. A zero-growth approach may be appropriate when minimising volatility is a priority, the sponsor covenant is a concern, or buyout is imminent and achievable without relying on investment returns.

However, choosing this path can create a much steeper “U” if the scheme later continues to run on and aims to rebuild surplus.

For many schemes, maintaining a small growth allocation of around 10–20% is the more pragmatic option. It allows for a shallower “U,” supports targeting funding levels beyond 100% and ensures flexibility whether the endgame is buyout or managing surplus.  Liability-hedging assets can be evolved at the same time to better match cashflows while gaining diversified exposure to credit and government bonds. 

When a scheme moves into surplus, the investment focus can shift somewhat from funding protection to surplus management. Growth allocations are typically modest - often below 20% - during this stage and many schemes are fully invested in CDI, with liabilities fully hedged. Where buyout is the end goal, hedging may be refined and/or increased to match insurer pricing more closely.

A framework often involves allocating 10% of total assets into diversified growth with liquidity tailored to support either buyout or surplus-use goals. The remaining assets are held in CDI, with expected returns calibrated to the scheme’s low-risk funding basis and appetite for volatility.  As the surplus grows the allocation of assets invested in growth assets will naturally grow in % terms.

Dynamic monitoring remains important. Trustees should consider implementing a surplus management framework that tracks funding levels, any agreed surplus use triggers, and adjusts for changes in discount rates, particularly if the surplus is intended for use prior to scheme wind-up.

This approach balances the need to protect the scheme’s funded position while allowing controlled exposure to growth opportunities, ensuring that surplus is managed strategically rather than as a byproduct of funding success.

The “U-shaped” framework provides an effective guide for managing growth allocations across the DB journey, but it is not a rigid rule because each scheme’s approach should depend on its individual objectives, covenant and goals.

Dynamic monitoring of surplus, triggers and market assumptions ensures strategies remain aligned as circumstances evolve. These regular reviews are essential, and Mercer can support trustees and sponsors in navigating these decisions with confidence.

By taking a strategic approach to surplus management, schemes can optimise both member outcomes and sponsor value, making it a central consideration rather than an afterthought.