Background

Following a notable hike in interest rates in September 2022 (and onwards), there has been an unprecedented shift in the financial positions of defined benefit (DB) pension schemes. For the most part, the change is positive as many schemes are now in surplus. According to the PPF 7800 index, at the end of May 2024, around 91% of DB schemes were in surplus – with indications that surplus levels will continue to grow. As a result, trustees and employers are reviewing the endgame strategies for their DB schemes.

To date, most endgame strategies have focused on achieving buy-out with an insurer which fully de-risks the scheme by transferring all obligations to the insurer. More recently, consolidation within a superfund vehicle has also emerged as a potential endgame strategy.

Data from the consultancy, Lane Clark & Peacock (LCP), shows that the total volume of buy-ins and buy-outs completed in 2023 reached £49.1 billion, surpassing the previous record of £43.8 billion in 2019. Looking ahead, LCP projects that buy-in and buy-out transactions could total between £400 billion and £600 billion over the next decade. This shift towards insurance-based solutions is driven by the strong funding improvements mentioned above, which make buy-out more affordable.

However, the improvements in DB funding are also driving trustees and employers to think about running on their DB schemes as an alternative to buy-out in the short to medium term. Some of the issues that they will need to consider are discussed below.

Run-on: some relevant considerations

There are two main benefits to running on a scheme as an alternative to buying out:

• Cost efficiency: Buying out is expensive. Avoiding the need to make a one-time premium payment for the transfer of liabilities to an insurer should deliver immediate and longer-term savings.
• Potential to utilise surplus: Run-on enables schemes to retain, manage and utilise surplus more effectively, which can be of benefit to members and sponsoring employers.

In addition, the government's approach to pensions policy over the last couple of years has also made it easier for schemes to adopt a run-on strategy. In particular, regulatory changes have encouraged schemes to reassess suitable levels of risk, pursue asset diversification and reduce administrative costs.

It follows from the benefits of run-on mentioned above that a conceptually successful run-on relies on there being a material surplus in the future. Although this can be managed to a certain extent, there will always be economic uncertainty that could impact run-on strategies, such as changes in macroeconomic policies triggered by global political instability. Known or reasonably identifiable changes to geopolitics can be connected to the US, China and Russia (for very different reasons), but other unknown matters could emerge with other countries or regions. There are also those factors that are simply unpredictable, such as natural disasters and the general volatility of financial markets.

Because of this potential for surplus to be impacted by events that schemes are unable to control, schemes will need to build flexibility into their endgame strategies so that they can change their direction of travel if needed. For example, it would be sensible to have a reserve plan to move the endgame away from a run-on strategy if circumstances and events occurred which impacted on the certainty of there being a suitably sized surplus.

Practical takeaways for corporates considering run-on

Where sponsoring employers are considering running on a DB scheme, they will need to have a fair understanding of how much surplus can be generated in the future. To maximise the benefits of run-on, there needs to be certainty that there will be a material surplus and this will be affected by the strategies and frameworks a scheme has in place over the coming years. Employers will need and want to be actively involved in the implementation of those strategies and frameworks and therefore should be mindful of the additional time and effort this is likely to involve.

Another key consideration concerns what can be done with the surplus. There are a number of competing interests and an employer will not want to run on a DB scheme without there being a clear understanding between the employer and scheme trustees as to how that surplus is to be dealt with (i.e. who should benefit from it). To a certain extent, this will depend on the balance of powers within the scheme rules, but the position is also subject to legislation which currently makes it difficult for surplus to be returned to employers. However, there are proposals for changes to make this easier and, meanwhile, there are other mechanisms that can be used (such as escrow arrangements) to ringfence an employer's interest in surplus. Employers will need to ensure that they take appropriate advice and that they maintain a pragmatic, regular and continued dialogue with the trustees throughout any run-on period.

Whether a corporate entity wishes to continue managing a DB scheme through run-on will be dependent on their appetite to do so and the particular circumstances of their scheme. For some, who may have had difficulty with DB schemes in deficit over the last 20 years, the prospect (and potential risk) of continuing to manage the scheme may simply be unpalatable. However, there will undoubtedly be those schemes that will readily take advantage of the benefits run-on offers.

If you would like to discuss anything raised in this article in more detail, please do get in touch with a member of the Dentons Pensions team or your usual Dentons contact.