Legal Review: Surplus to requirements – what to do in a wind-up

Samantha Brown and Dan Saunders explain the complexities around managing surplus

clock • 4 min read
Herbert Smith Freehills' Dan Saunders and Samantha Brown

Herbert Smith Freehills' Dan Saunders and Samantha Brown

An increasing number of defined benefit (DB) schemes are approaching or engaged in a winding-up process that expect to have 'buyout surplus'.

In that context, trustees, employers and their advisers are spending ever more time considering how any surplus might be distributed. It is equally an area on which many members are becoming increasingly vocal.

Irrespective of in principle views, how a surplus is dealt with will principally turn on what the scheme rules provide for. Often, trustees will need to consider whether to exercise a discretionary power to uplift member benefits, sometimes exercisable only with the consent of the sponsoring employer, and sometimes not. Of course, any decision to return surplus to the employer must also be reported to The Pensions Regulator (TPR) and the party making such decision may also need to factor in TPR's views.

What should be front and centre of decision-makers' minds?

Firstly, insurers will only insure guaranteed benefits, so the necessary corollary of gaining the security provided by an annuity is that members can no longer benefit from potential future augmentations, as if the scheme was ongoing.

Whilst it must be 'right' that trustees consider the loss of such future discretionary benefits, they should not forget that having accepted, in principle, that buying out benefits is in the interests of members, they must be taken to have accepted that the benefit of doing so outweighs the loss of potential future augmentations.

That is not to say that the insured benefits cannot exceed the benefits guaranteed under the rules, but it is a helpful starting point. Further, schemes were set up with this outcome in mind, so it cannot be said to be inconsistent with the purpose of the scheme to take a step which results in the loss of a discretionary benefit.

Secondly, trustees and employers will want to consider whether a history of awarding discretionary benefits or of making statements about having such an intention supports the use of any surplus to uplift benefits. Care needs to be taken to distinguish between a belief that is genuinely and reasonably held by most members and the representations and recollections of some individuals. Since recollections often change over time and are influenced by multiple external factors, this process will usually require a careful consideration of the relevant documentation.

Thirdly, employers and trustees need to consider the 'moral case' for an uplift in benefits. In any balance of costs arrangement, the surplus may have arisen as a result of overpayments by the employer: if the trustee and employer knew then what they know now, what would have been the basis for agreeing historic employer contributions at a level that created a surplus on buy-out? However, the case against an uplift is stronger where the scheme is non-contributory or where the surplus can be shown to have arisen during a period when members were no longer contributing to the scheme.

Lastly, the question of whether there is a 'case' for using some or all of the surplus to uplift benefits cannot be considered in a vacuum: what is the proposed benefit improvement that might be achieved through use of the surplus? Whilst it is not necessary to treat all members the same, the trustee will want to ensure that members are treated fairly. For example, is an improved escalation rate – which will tend to favour younger members over older members and may benefit some categories of members over others – the 'right' way to go?

Whilst it's a nice problem to have, experience tells us that a surplus on winding up can be an area of significant tension between members, trustees and employers. A complex issue requiring a multifaceted approach, it usually benefits from early engagement between trustee and employer. Given that public discourse has often failed to recognise that complexity – describing a surplus in terms that suggest it is "fixed" or is "owned by" either an employer or members as of right (something not helped by changes to the way in which surpluses are recorded in company accounts) – clear communication to members is also key.

It should be noted that, once the trustee or employer has committed to a course of action, it may be difficult to persuade that party to change direction. Whilst any decision can be challenged through the courts, it is on a very narrow basis only: namely, did the decision-maker consider the factors that it ought to have considered and/or did it reach a perverse decision. The courts will not otherwise overturn a decision which it might consider to be unmeritorious.

Samantha Brown is joint managing partner of the EPI (employment, pensions and incentives) practice and Dan Saunders is of counsel and pensions litigator at Herbert Smith Freehills

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