Significant market and interest rate movements over recent years have seen funding positions improve for many defined benefit pension plans across the UK, and in a lot of cases this has resulted in pension plans finding themselves with an unexpected surplus. If sponsors and trustees are not anticipating a surplus, this can lead to uncertainty as to how the surplus should be dealt with.

Once money has been paid into a pension plan it becomes subject to the terms and conditions of the plan. These terms may limit the sponsor’s ability to recover surplus money beyond the amount required ultimately to secure the plan liabilities in the insurance market, leading to a situation of “trapped surplus”.

So what can sponsors and trustees of pension plans do to guard against the risk of trapped surpluses, and how should they approach surpluses that do arise?

What Should UK Pension Plans Do Before They Are In Surplus?

There are a number of preventative steps that UK pension plans can take to mitigate the risk of trapped surpluses and reduce the possibility of any resulting uncertainty over the application of surplus between sponsors and trustees. In particular, pension plans should be in frequent contact with their actuarial and investment advisors to monitor the funding position. When the pension plan is approaching 100% funded, the sponsor and trustees may wish to consider alternative funding arrangements – for example, sponsor deficit reduction contributions being paid into an escrow account and only released to the pension plan when certain triggers are met.

This process is especially important for any pension plans that are considering buying-in their benefits with an insurer. Sponsors and trustees should be clear well in advance of any buy-in/buy-out transaction what will happen to any surplus and who has the power.

How Should UK Pension Plans Deal With Surpluses?

There were several relevant case law decisions during the 1990s which set out a number of principles for pension plans to bear in mind when considering the distribution of their surplus. However, these cases should be treated with caution rather than definitive guidance given the time that has passed and given the cases often focused upon circumstances arising from incomplete documentation or other governance uncertainties.

Surpluses can be used in one or more of a number of ways, including:

• To augment member benefits
• Returned to the sponsor
• To pay plan expenses

The preferred option for dealing with surpluses can be very situation-specific and will often depend on a number of factors. Sponsors and trustees will therefore need to consider and consult their advisers regarding:

• What the pension plan deed and rules say about distribution of surplus
• Whether the surplus has arisen in an ongoing or winding-up situation
• The size of the surplus
• The source of the surplus – has it arisen from overfunding from the sponsor, or from high levels of member contributions?
• The tax-efficiency of potential solutions, for example any tax charges that would be imposed if the surplus is returned to the sponsor
• Any statutory requirements to notify plan members regarding the use of the surplus

Next Steps For UK Pension Plans

Unfortunately, there is no one-size-fits-all approach to dealing with surpluses. Sponsors and trustees of UK pension plans should therefore start thinking about surpluses as soon as possible, especially if the plan’s benefits are due to be secured with an insurer. Given the complexities surrounding the different approaches to surpluses, sponsors and trustees should involve their advisers at an early stage of proceedings.