For the last 20 years or so, the holy grail for most defined benefit (DB) schemes has been to reach full funding on a buy-out basis in order to secure benefits with an insurer (referred to as a buy-in or buy-out, depending on the extent to which the insurer takes on liabilities). Frequently in the past, employers were aiming to get the DB liability off their balance sheet and many employers have poured contributions into schemes in efforts to achieve that.

However, in the last couple of years, with rising interest rates, much seems to have changed. Many DB schemes now have a surplus and, even if that is only a surplus on an ongoing basis rather than being able to meet the costs of a buy-out, it is still a much more positive picture than has existed for a long time.

This financial shift has prompted a strategic rethink, with more trustees and employers reconsidering the traditional endgame strategy and looking at alternatives including running their scheme on, partly in order to make the most of any surplus. Whilst many employers and trustees may have already committed to buy-in or buy-out, from the content of consultations ahead of the imminent Pension Schemes Bill, we can expect to see provision for facilitating the release of surplus from ongoing schemes and that may be music to some employers' ears.

What does run-on look like?

Run-on is simply a term for continuing to operate a scheme as it becomes self-sufficient. Self-sufficiency for a scheme means that the trustees use their investment strategy to maintain assets at a level where benefits can be paid as needed, without requiring funding from the employer. Run-on can continue until there are no more benefits to pay, or it may be a partial solution combined with a buy-in or buy-out further down the line.

Obviously, the ongoing costs of administration and governance will need to be taken into account in considering whether to run on and one of the key elements in running on is setting an appropriate investment strategy and managing investments, including any volatility in the market. Understanding cash flow needs and implementing a strategy to hedge against volatility are both crucial issues, as are factors such as longevity and macro-economic impacts, including pandemics and global conflicts.

A decision to run-on should be one that is taken consciously with full consideration of the impact and ongoing management of these issues and with input from professional advisers.

Is run-on and release of surplus a good idea?

Run-on may be helpful to schemes that have issues with data and/or with their scheme rules and administrative practice being misaligned. Insurers will typically not take on such schemes without charging a significant additional premium and/or carving out certain risks. Running-on allows those issues to be dealt with over a longer period and possibly even for less cost if the potential risks identified do not crystallise.

As noted, one of the main attractions of running-on that appeals to employers in a period of generally high returns is the prospect of the scheme generating surplus. However, in practice, trustees are unlikely to agree any surplus return unless members also benefit from surplus and we would expect that to be a key component of any discussion.

Some of the government's stated aims in making it easier to release surplus (and therefore making it more likely that schemes will run on) raise interesting questions. The government believes that pension schemes which run on will invest in UK productive assets. However, it is the scheme trustees who control the investment of assets and whether trustees will increase their investment in UK productive assets is yet to be seen. Trustees could do this at the moment but many have chosen to invest elsewhere, presumably on the basis of advice.

The government also takes the view that allowing employers to extract surplus will result in them investing further in the UK economy, but it seems equally likely that employers may take the opportunity to pay higher dividends to shareholders.

Unsurprisingly, the insurance industry has warned of risks with running on and that any decision to do so should be approached with caution, citing the certainty gained through a buy-out. We agree that, as set out above, there are many considerations to be weighed up, but are conscious that these views may be influenced by the loss the insurance market would experience if more employers and trustees implement run-on strategies. Equally, there have been questions asked over the capacity of the insurance industry to take on pension scheme liabilities, especially for those schemes in the middle to smaller end of the market, as well as concerns about concentration risk.

More interesting are the reported views of pension scheme members, many of whom are very concerned about the proposals to allow surplus to be taken out of ongoing schemes and who say they place more trust in their trustees than in politicians. This underlines the importance of trustees taking advice and carrying out proper due diligence where any proposal is made by the employer. The safeguards that should be inherent in trustee decision-making, given that their first duty is to discharge the purpose of the trust (i.e. ensure that members receive the benefits due to them), should not be eroded by any legislative change.

So, are we seeing a sea-change in attitudes?

It seems that many employers are, not surprisingly, waiting for the new Pension Schemes Bill and are weighing up the wider global issues before making decisions. If new provisions relating to surplus are introduced, it will take time to see tangible changes as trustees and employers navigate through the detail of any new requirements. Employers may also be wary of whether the potential for surplus can be realised in actuality, particularly given recent volatility in the markets following the new trading tariffs imposed by the US government, and the possible longer-term consequences.