When pension professionals hold the key to a nation’s fortunes

Pension professionals are used to making decisions that shape the financial security of scheme members. In the UK, those decisions may now have consequences that extend far beyond individual schemes, with trustees currently finding themselves holding one of the keys that could unlock the country’s wider economic fortunes.

The UK’s defined benefit (DB) pension universe now has surplus assets of more than £200bn, according to industry estimates. That is a major change. For much of the past two decades, DB pensions have been viewed mainly as a problem to be managed: a leaking roof to be fixed, not a store of value to be used. Today, the DB world is in surplus territory.

The implications of this are important for the country as a whole. New legislation means DB schemes can release surplus more easily, and surplus release would typically generate tax revenue of around 25%. This could become a meaningful source of capital for a government under pressure to fund competing priorities, whether they be defence, health, welfare or infrastructure.

Political leaders may see DB surplus as one of the few large pools of capital that could be unlocked without raising headline tax rates.

However, just because pension funds have the freedom to release surplus assets doesn’t mean they will do so. Trustees and advisers have to prioritise scheme members, not politicians.

Politicians seeking ways to support growth may therefore consider reshaping the incentives.

The rationale for DB surplus release

The Pensions Regulator estimates that around four in five UK DB schemes are now in surplus. Surplus assets have been estimated at more than £200bn on a ‘low-dependency’ basis by investment consultancy XPS Group, meaning these schemes are expected to pay members benefits without needing further support from their corporate sponsor.

The political rationale behind enabling and encouraging surplus release is therefore based on the assumption that members’ pensions can remain secure, while leading to a financial boost for members and corporate sponsors.

“Trustees are rightly cautious because the risk is asymmetric”

The government could also benefit. If £200bn of surplus capital were released, the associated tax receipts could be around £50bn, without an increase in headline tax rates. That is an opportunity large enough to attract political attention, and that figure sits alongside the wider economic benefit of releasing £150bn of capital to companies and individuals, and indirectly, the economy at large.

There is also a Gilt-market dimension. DB schemes are among the UK’s largest pools of long-term institutional capital. Many use Gilts to hedge their liabilities. If a scheme releases surplus and continues to run on, it is likely to remain a long-term holder of Gilts.

Put simply, surplus release could help turn a stockpile of prudently accumulated pension capital into tax revenue, corporate investment and member value. Without it, we believe the UK may face a Gilt market with fewer natural long-term buyers, and at the mercy of short-term capital flows.

There has been debate in the UK about whether government might direct investment by defined contribution schemes or local government pension schemes, but there has been no suggestion that DB trustees should release surplus for any reason other than the interests of their members.

However, the size of the opportunity could change the terms of the debate. Beyond the new legislation introduced this year, politicians have a clear incentive to make surplus release easier, safer and more attractive. The question is how they might do that without weakening the central principle of member security. Ultimately, trustees’ fiduciary duty to act in the best interests of members is clear, so this is a critical issue.

Trustees are rightly cautious because the risk is asymmetric. If surplus is released, and the sponsor later fails or the funding position deteriorates, the decision to release surplus could be criticised as not putting members’ needs first.

This is where political attention may turn to the Pension Protection Fund (PPF). Today, if a DB scheme is underfunded and the sponsor fails, the PPF provides important but partial protection for members.

If the PPF underpin were strengthened to cover benefits in full, it could provide trustees with a stronger final line of defence. Trustees would still need to invest prudently, and sponsors would still be expected to support schemes where required – minimising moral hazard risk. The PPF’s reserves are large, making such an approach affordable. 

In our view, this change could be critical in providing trustees with the confidence to release surplus assets where appropriate.

There is also extensive discussion in political circles around how to boost investment in UK productive assets. If the government increases PPF protection, it could reasonably charge a small levy for this. One incentive to encourage allocations to UK productive assets might be to link this levy with the level of investment.

Done well, this could be a genuine win-win all round. Members could retain retirement security with potentially enhanced pension benefits, funded by their share of surplus assets. Sponsors would benefit from additional capital that could be used to invest and grow. The Treasury could receive significant tax receipts. The Gilt market could keep a broader base of long-term domestic investors, and the UK economy could recycle capital built up through years of prudent pension funding.

The question is whether politicians design the rules so that the key turns without breaking the lock.

Jos Vermeulen is head of solution design at Insight Investment