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Survey Report

Pension scheme surplus on buyout

Chapter six of the 2021 de-risking report

Pensions Corporate Consulting|Pensions Risk Solutions|Pension Board and Trustee Consulting|Pensions Technology

By Costas Yiasoumi | January 19, 2021

The number of pension schemes with buyout surpluses or close to having a buyout surplus has more than tripled over the last five years1. Whilst a surplus is a nice problem to have, Costas Yiasoumi considers the additional issues and considerations when it comes to transacting a bulk annuity for such schemes.

Of course a scheme with a buyout surplus does not have to buyout. There is nothing in legislation that says such a scheme needs to buyout and neither does the Pensions Regulator say that. Based on the specific circumstances there may be very good reasons not to undertake a bulk annuity transaction of any type, and to instead continue running the scheme on.

However, in circumstances in which a buyout is deemed the way forwards, our seven top tips based on the issues and considerations we've come across when advising clients are:

Get legal advice, early

It goes without saying that it's crucial to obtain legal advice on ownership of any buyout surplus. Must it be used for member enhancements, must it be paid to the company (net of tax), and who decides? Who has the power to trigger wind-up? The balance of powers within the scheme will be critical here and there may be a need for discussions and negotiations between the trustees and the company.

Without getting this tackled early, there is the potential for delays, missed opportunities and inefficiencies along the way.

Avoid an ‘accidental’ surplus

Many trustee boards have been surprised to find they have a buyout surplus and could have completed a buyout some months or years ago. It's really important to obtain tailored buyout estimates that indicate the likely outcome of a competitively run and well negotiated bulk annuity purchase process, based on actual market conditions and insurer appetites. A scheme actuary’s estimates for funding purposes are exactly that, for funding purposes, not for gauging and planning the outcome of an actual transaction.

Tailored estimates should be obtained sufficiently early and before full buyout funding is attained so that the trustees can plan ahead.

Engage the company early

The natural assumption is that the sponsor will welcome the trustees undertaking a buyout, even more so where it could receive some of the surplus. However, that will not always be the case. It's critical to engage the company so it can mitigate unintended consequences. For example, a buyout may cause significant and unwelcome swings in the company’s published financial statements. Although trustees should act in the best interests of members, the company’s views are important and its goodwill vital when it comes to the exercise of specific scheme powers and in areas such as post winding-up indemnities.

Buy-in or buyout?

Most buyouts start with a full buy-in covering all the members. After a period of data cleansing and other tidying up this buy-in is converted into individual annuity policies for each member – the buyout – after which the scheme is wound up. A common question from trustees is whether it is in members’ interests to forgo this final step. Instead the trustees would continue to hold the full buy-in policy as a matching asset that will precisely pay the trustees the pensions due to members each month. The point is that in the event of the insurer ever defaulting and for some reason the Financial Services Compensation Scheme not covering this, then the trustees would still have the sponsor to fall back upon, therefore offering an extra layer of security to members. There is no right or wrong answer here. Quite often it can come down to the balance of powers within the scheme, the sponsor covenant and the trustees’ appetite to continue running the scheme in such circumstances.

The likelihood of an insurer defaulting is considered very remote but, nevertheless, where a sponsor is particularly strong it can be a pertinent question to tackle early.

Don’t set the bar too low

The existence of a surplus shouldn’t change the approach to negotiation – which should be robust and aim to get the best possible pricing. The end recipients of the surplus, whether that is the members or the company, will benefit directly from improved insurer pricing. An experienced transaction adviser will know when pricing has been optimised, and not stop negotiating before this point.

Deal with surplus enhancements smartly

When members are entitled to some or all of any surplus, the question arises of how to allocate that surplus. For example, should that be by topping up members’ defined benefits on an equal percentage type basis or equal pound amount per member, insuring enhanced pension increases or some other method? This will require detailed legal advice on the duties of the trustee and requirements of the scheme rules, careful engagement with the insurer, documentation in the insurance contract and considerations covered such as whether the insurer can hold the price for the surplus component even if it is not allocated for some years.

Joint working group (JWG)

No top seven list would be complete without mention of a JWG. The role of the company has been mentioned several times above. The company and its advisers are a helpful sounding board and ally in any complex transaction. A regular JWG will ensure effective communication, collaboration, speed of decision making and momentum in any buyout process.

By following our seven top tips (and more!) trustee boards and companies can ensure that a surplus remains a nice problem to have and becomes a pleasant one to tackle.

Footnote: 1. Source: PPF Purple Books 2020 and 2015.

Next chapter - Spotlight on bulk annuity insurers and Environmental, Social and Governance


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