With recent interest by government into potential reform in this area, we thought we would take a deep dive into the current state of the DB schemes to understand the motivation and potential impact of proposed changes.
At first glance the latest Purple Book, published by the Pension Protection Fund (PPF) in 2024, and released annually, tells a positive story. Aggregate funding levels across DB schemes appear healthy, with the Section 179 funding ratio (s179) (Defined in FN1) standing at 123% and a surplus of £219 billion. In effect this means that the value of assets available are currently significantly in excess of the value of liabilities, giving rise to the recent notion that DB schemes are in surplus. Where this is slightly misleading, is that the basis for valuing liabilities when calculating this measure of surplus does not take into account the full scheme benefits current and future pension holders might be entitled to.
However, even the more conservative buy-out (FN2) basis shows schemes around 94% funded, numbers that would have seemed ambitious only a few years ago. In fact, for much of the last 20 years, on both a s179 and buy-out basis, DB schemes have been in deficit and in some years, significantly so.
Underlying much of the apparent improvement in recent years is the steep rise in gilt yields since 2021. This change, while favourable for scheme liabilities, was largely market-driven and in many cases not the result of deliberate strategy. Higher gilt yields translate into an increase in discount rates which has resulted in a sharp fall in the present value of liabilities, improving funding ratios across the board. The Purple Book includes sensitivity analysis which brings this to life, a 0.1% increase in gilt yields translates into a £2bn in the available surplus (which equates to approximately 1% of the current surplus). So even a small movement in yields has a large impact on current funding levels.
This effect could prove temporary. Should yields decline again, as they have at various points in recent history, schemes that have not taken steps to lock in gains, through hedging activity or risk transfer, may see their positions quickly erode. Although it is understood that the majority of schemes have taken measures in part or full to take advantage of the current situation through risk mitigation measures. In addition, life expectancy can swing the valuation of a DB schemes pension liabilities. If pension scheme members were to live two years longer than expected the average s179 liabilities would increase by £60bn or 6%.
Other material drivers of surplus movements lie on the asset side of a scheme’s balance sheet. These include potential volatility in equity prices—where a 2.5% rise would increase the net funding position by £5.5 billion, or roughly 2% of the current surplus.
In this context, the Government’s Pensions Reform Bill arrives at a pivotal moment. Among other things, the Bill looks to address the treatment of and potential access to scheme surpluses. The Bill includes a resolution-making power which will allow DB scheme trustees to modify their rules to permit payment of surplus to corporate sponsors, or to remove or relax restrictions in an existing power. Power to make any changes remains the discretion of the DB schemes trustees, who are invariably bound by a fiduciary duty to members of the scheme. A certified actuary will also be required to attest that the prescribed conditions are met in relation to the value of the scheme’s assets and the amount of its liabilities.
Where DB schemes are looking to release surpluses, it is expected that these will be returned to corporate sponsors of schemes for their own use or shared with Direct Contribution Schemes where there is an employer in common.
Beyond the 25% tax rate that is levied on any release of surplus, governments motivations appear to be driven by the need to spur investment into productive assets across the economy which has been limited recently by availability of capital. There is a common misconception that surpluses are not currently invested and are in effect “trapped” by current rules. However this is not quite correct. Current surpluses are invested alongside the broader composition of assets that their to support the schemes liabilities.
Whether the allocation of capital including any surplus is in productive assets is a separate question. What we do know is that over the last 20 years there has been a notable shift in the allocation of capital in DB schemes away from equites and into bonds. In fact, in 2006 61% of a DB schemes assets were comprised of equities, this has fallen to 16% in 2024. All the while allocation into bonds has increased from 28% in 2006 to close to 70% in 2024.
Now some of the movement can be explained by the maturity of DB schemes in the UK. The number of active schemes continues to decline, now sitting below 5,000, and most are closed to new members. The sector is increasingly mature: the vast majority of schemes have very few active members and limited time horizons. Around 80% of schemes have fewer than 1,000 members, and many of these lack the scale or governance capacity to pursue complex investment strategies or innovative risk transfer models.
The other effect these changes has on asset composition is that many members of these schemes will either be in the draw down phase or nearing it. In this context a reallocation away into bonds, which typically benefit from a more certain stream of cash flows from interest and principle repayment, makes sense.
That being said, the extent of the swing to bonds is arguably also explained by active decisions to move away from equities, where there is greater pricing and cashflow risk. The trade off of current trends is to arguably limit the potential for future outperformance and raises questions about the role DB schemes could or should play in longer-term investment policy, including UK growth and infrastructure agendas.
The release of surpluses is not likely to move the dial on equities but the injection of additional capital it would give corporate sponsors could provide businesses with the opportunity to increase capital expenditure budgets, which could improve efficiency which improves margins, and or spur expansion. Alternatively businesses may decide to distribute out any windfalls to shareholders as dividends or share buy backs. Either way the release of the surplus, would simply entail a reallocation of capital into another area of the economy broadly away from where it is currently invested in i.e. in bonds.
- s179 liabilities represent, broadly speaking, what would have to be paid to an insurance company to take on the payment of PPF levels of compensation (rather than full scheme benefits).
- The cost of insuring a pension scheme in the private market.
