Putting DB Surplus to Work: A Shifting Landscape

The conversation in defined benefit pensions has changed. For years, the dominant question was how to close the deficit. Now, for a growing number of schemes, the question is what to do with the surplus.

Higher gilt yields and strong investment performance have transformed the funding picture for many DB schemes remarkably quickly. Where trustees and sponsors were once locked in long-term deficit repair plans, they are increasingly turning their attention to value sharing and, in some cases, value extraction. At our recent sponsor forum on Putting Surplus to Use, the mood reflected exactly this shift.

The latest LawDeb Sponsor Forum saw us welcome those with responsibility for their corporate pension schemes to hear from our experts and to share insights into their own journeys.

What the Room Was Thinking

We polled attendees on what was highest on their agenda when it came to surplus. Whilst a relatively small sample size, slightly skewed towards larger, more sophisticated schemes, the spread of answers is revealing in itself.

Poll: What's highest on your agenda?

Approach	Share of respondents
Extraction of surplus by employer pre-buyout	33%
Use of surplus within the trust	25%
"Surplus? What surplus?"	25%
Extraction of surplus by employer post-buyout	17%

The striking thing here is not any single number but the breadth of responses. A third of attendees were already thinking about extracting surplus before buyout. A quarter were focused on using surplus within the scheme rather than extracting it at all. Another quarter were not yet in surplus and were more focused on avoiding or minimising one arising. And a smaller group were still looking at post-buyout extraction.

The takeaway is not that one approach is winning. It is that there is no longer a single dominant playbook. Schemes are at different stages, with different objectives, different governing documents and different sponsor relationships, and they are responding accordingly.

What the poll perhaps tells us most clearly is that the era of the default "march to insurance and release whatever is left at wind-up" approach is starting to look dated. Sponsors and trustees are now actively exploring more varied and more immediate ways of putting surplus to work, including, for example, the recent Stagecoach sponsor swap transaction, which illustrated just how innovative these structures can be.

The Current Regime: A High Bar

Before looking at what is coming, it is worth understanding where we are today. The existing rules for ongoing surplus release are restrictive. To release surplus to an employer on a continuing basis, a scheme needs to be fully funded on a buyout basis, the trust deed and rules must expressly permit it (and many do not), and any release must be shown to be in the best interests of members. These are high hurdles.

The practical effect has been that most schemes have historically had to complete a buyout or wind up before sponsors could access surplus. There are exceptions -- Aberdeen and Schroders are among the examples sometimes cited and one of our own trustees have experience of this -- but cases have been relatively rare.

Using Surplus Within the Scheme

Extraction is not the only option. Many schemes are finding productive uses for surplus without it ever leaving the trust. This can be tax effective and include:

• Paying scheme running expenses from the fund rather than the employer
• Funding future accrual where the scheme remains open
• Making contributions to a DC section
• Granting discretionary increases to members
• Covering the cost of ill-health early retirements

These uses can deliver genuine benefit -- to members, to sponsors, or both -- without the regulatory complexity of a formal surplus release. For schemes where extraction is not yet feasible or appropriate, this may be the most practical near-term route.

Minimising Surplus Before It Arises

For schemes not yet in surplus, a different question arises: is a large surplus actually desirable? Not necessarily. Surplus trapped in a scheme is capital that cannot easily be recovered, and for sponsors with other calls on their cash, that matters.

Techniques for managing the position before a surplus crystallises include funding scheme expenses from the scheme, escrow arrangements, and contingent payment mechanisms. These allow sponsors to retain flexibility while keeping the scheme on a secure footing.  Derisking investments may also be considered where neither trustee not sponsor is targeting surplus.

A New Regime on the Horizon

The forthcoming changes to surplus legislation are expected to significantly ease the current restrictions, with the new regime anticipated to be in place from April 2027.

The key changes include:

• A lower funding threshold. The new threshold for surplus release will be based on a low dependency measure -- typically a discount rate of gilts plus 0.25% to 0.50%, rather than the (traditionally) more demanding buyout measure used today. That said, the Pensions Regulator is encouraging schemes to consider holding a buffer above that level, and the line between low dependency and current buyout pricing has blurred somewhat, with some full buy-ins now being achieved at implied returns above gilts plus 0.50%.
• Greater trustee flexibility on rules. Trustees will have the power to amend scheme rules to permit surplus release, removing one of the current blockers for many schemes.
• Removal of the "best interests" requirement. The current requirement to demonstrate that a release is in members' best interests is being dropped, though trustees' overriding duty to protect accrued benefits remains.

• No mandation on use. The draft Regulations do not prescribe how surplus must be used, though the Regulator's expectation is that it will be shared between the employer and members. A new form of authorised lump sum payment to members is included in the draft Regulations. The detail is still being consulted on and further Regulator guidance is expected.

The Process Will Still Be Demanding

Easier does not mean simple. The process for surplus release under the new regime is expected to be prescriptive. Trustees and sponsors should expect requirements including an actuarial assessment, consultation with the employer, at least three months' notice to members, an actuarial certificate confirming the surplus on a low dependency basis and that the scheme is likely to remain in surplus for three years, payment within five days of the certificate, and notification to the Regulator.

And of course surplus creation requires careful consideration around the investment strategy that will get you there.  And if that means re-risking it might point to discussions around alternative security...

This is not a light-touch process, and preparation will matter.

No Safe Harbour, and That Is Appropriate

One point worth emphasising: the new regime is not expected to provide a "safe harbour." The onus will remain on trustees to safeguard accrued benefits, which is as it should be. Nobody, trustees, sponsors or advisers,  wants to see a scheme tip back into deficit after a surplus release.

There is also a broader legal backdrop to bear in mind. The criminal offence introduced under the Pension Schemes Act 2021 for conduct that risks accrued benefits applies to sponsors and advisers as well as trustees. This is not a risk to take lightly.

Getting Safe Release Right

What "safe" looks like will vary by scheme. But common considerations include:

Asset and liability confidence. Trustees will want to be confident in the valuation of assets, particularly illiquid holdings where valuations might not be realistic or could be stale, and satisfied that there are no historic errors lurking in the liability calculation.

A meaningful buffer. Many schemes are choosing to hold a buffer above the low dependency threshold to cover unhedged risks such as longevity (unless hedged with longevity swaps), unknown liabilities and any deterioration in insurer pricing.

Covenant monitoring. The strength of the employer covenant is central to any release. Trustees will need a robust monitoring framework and appropriate protections, clawback provisions and contingent security are likely to feature prominently.

Structural safeguards. Break provisions, top-up triggers, and capping or smoothing of surplus payments are all tools trustees may wish to consider, depending on circumstances.

Actions for Trustees and Sponsors

If surplus is on the agenda, or likely to be, now is the time to get prepared. Key steps include:

• Considering a joint working group between trustees and sponsor to ensure a joined-up approach
• Agreeing objectives and priorities with trustees and sponsor, including how surplus would be used
• Thoroughly understanding the funding position, including asset valuations and liability certainty
• Developing a surplus policy covering how surplus will be shared and the guardrails in place
• Reviewing governance processes, including how conflicts of interest will be managed

The theme emerging from forum discussions is consistent: engage constructively, but cautiously. Surplus is an opportunity, but it carries responsibilities. The schemes that handle it well will be those that have done the preparation, built the right frameworks and approached the question with both ambition and care.

The regulatory landscape continues to evolve. Draft Regulations are under consultation and further Pensions Regulator guidance is expected ahead of the anticipated April 2027 implementation date. Watch this space.