The pensions industry in the UK continues to await the consultation on the use of surplus assets in defined benefit ("DB") consultation schemes that was promised in the 2023 Autumn Statement. The briefing note published at the time of the Autumn Statement said the DWP would launch its consultation "this winter", and with Spring fast approaching (albeit not fast enough, some might say) we're keeping our eyes peeled for the consultation to land at any moment.

 Meanwhile, on the other side of the Atlantic, DB schemes in the US seem to be devising creative solutions of their own to the use of scheme surpluses. A more relaxed regulatory environment and improved funding, further enhanced by recent increases in interest rates, have seen many US DB schemes develop a substantial funding surplus. Given that a repayment of surplus assets to the scheme sponsor would attract a 50% excise tax plus employer income tax, schemes and their sponsors are looking for ways to use these assets which would otherwise be trapped.

Of the possible solutions available, one appears to be the reopening (or, at least, no longer closing or freezing) of DB schemes. This is exactly what IBM has done. 

The IBM solution

Finding itself with a surplus of $3.6 billion, unable (under US pensions law) to access any of it to fund its contributions to its ongoing defined contribution ("DC") arrangements, and faced with a substantial tax bill for paying the surplus to the company, IBM decided instead to re-open its legacy DB plan after almost 20 years to allow current employees to earn new benefits. 

From 2024, instead of paying a 5% matching contribution from cash flow into employees' DC funds, IBM will give each employee a 5% credit in a cash balance plan within its re-opened legacy DB scheme, using the surplus assets. Under US law, a cash balance plan is classified as a type of DB arrangement, which means that there is no prohibition on using the surplus assets to fund new cash balance benefits. 

In reality, cash balance plans are hybrid arrangements which, on the face of it, operate in much the same way as a DC fund, with each employee paying into a savings "pot" in their name. However, in a cash balance plan, there is an element of "defined benefit" which can be provided in a number of ways. In the IBM plan, this is being given by way of a fixed rate of increase on the investments. The plan's governing documents have specified that a 6% "interest credit" will be given for the first two years, with interest linked to Treasury yields thereafter. At retirement, employees may choose to draw the value of their account as a cash sum, or use it to purchase an annuity.

It's a neat solution, enabling the company to access assets that would otherwise be out of reach, freeing up some cash flow by removing the need to fund DC contributions, and potentially benefiting its employees with an element of certainty on their retirement savings.  Employees may have mixed views on the arrangement, however: it removes a degree of flexibility, with employees no longer having a choice of contribution rate or investment fund, although they may still (if they wish) continue to pay into a DC arrangement of their own choosing, albeit without a matching contribution from their employer.

Is this the way forwards for schemes in surplus?

It's an interesting possibility. The Millman 2023 Corporate Pension Funding Study of the top 100 funded DB schemes in the US shows that 27 of them have closed plans with surplus assets with a combined total of more than $27 billion, indicating that other employers may well be considering their options. 

Employers will most likely want to weigh up the value of their DB surplus against the ongoing cost of its contributions to DC arrangements as a first step, as well as any other impact that utilising DB surplus rather than company cash flow for its pension obligations might have on its balance sheet. Future risks will also need to be considered: employers will want the flexibility of being able to change (or withdraw) any pension offering that has a DB element.  Relative benefits to its employees will also be a factor. 

And in the UK?

It's been clear since the Chancellor's Mansion House speech last July that the Government is keen to explore ways in which DB schemes can utilise (and grow) surplus assets, and we're looking forward to seeing the options that are presented in the forthcoming consultation.  Here in the UK, there is the possibility for trust-based occupational pension schemes to use surplus DB assets to fund DC benefits, but this is complicated: the scheme rules have to permit it and DC benefits have to be in the same trust as DB. We can see real opportunities for new flexibilities and tax incentives to allow DB schemes in surplus to use their assets to contribute towards future DB and DC pension savings, and to generate additional income for the employer to invest in UK assets, provided that an appropriate regulatory framework is established to protect scheme members.  

We explored some of these opportunities when we contributed to the XPS Pensions Group, Burges Salmon and Premier Miton report last year, which you can read about here. If you'd like to find out more, please get in touch with Richard Knight, Head of Pensions at Burges Salmon.