“A blessing or a curse – food for thought for CFOs responsible for a Defined Benefit pension scheme” – New analysis from LCP

For many years, the challenge of funding Defined Benefit pension schemes was a ‘millstone around the necks’ of many sponsor companies. Large and volatile deficits created headaches for employers, and the cost of passing their scheme to an insurance company (through a ‘buy-out’ transaction) was often prohibitive.

However, new LCP analysis from the On Point paper - Understanding the economics: Examining the financial case for running on a DB pension scheme beyond buy-out affordability – takes a dispassionate step back to look at the economics of a well-funded DB pension scheme today.

LCP’s analysis shows that the economic value of a long-term run-on could be substantial. For example, a £1bn scheme running for over 20 years is expected to have a positive value ranging from £100m to £250m, depending on the investment approach. This demonstrates the potential for well-managed DB schemes to significantly benefit both their sponsors and members, in the right circumstances where the sponsor can carry the downside risk.

The key to this new viewpoint is a dramatic turnaround in scheme funding, which has radically changed the situation. The latest Government figures show that the UK’s £1.2 trillion of DB schemes now hold approximately £160 billion in collective surpluses relative to the amount required to meet member benefits, even on a ‘low dependency’ basis. And importantly, these surpluses are far more robust than in the past, with better protection against changes in interest rates, inflation and lower investment risk.

With the Government’s draft 2025 Pensions Schemes Bill making it easier for well-funded schemes to pay surplus funds to sponsors, the pensions industry is reflecting on whether DB schemes should run on, transfer the scheme to an insurance company, or indeed a mix of both.

The analysis demonstrates that £160bn of paper surpluses could turn into real value for members, sponsors and through that the UK economy.

However, of course, some caution is required:

• For the upper-end estimates, higher-returning investment strategies are a key lever for increasing value, but stakeholders may need to be prepared to ‘ride out’ market volatility or pay contributions in adverse scenarios. Our analysis shows maintaining a modest allocation to growth assets is likely to be ‘worth it’ in most situations, but additional protections for members may be needed if more risk is taken.
• For smaller schemes, the value will be lower, and fixed costs will be proportionately higher. This may mean a run-on approach is less relevant for schemes below £100m, with schemes upwards of £200m in size encouraged to consider what the analysis could look like for them to help inform decision-making.

Commenting, report author and LCP Partner Steve Hodder said: “For many years, the challenges of funding a Defined Benefit pension scheme have kept the nation’s Finance Directors awake at night. But FDs now have real food for thought – could surplus sharing arrangements with trustees lead to a “DB curse” becoming a “DB blessing”?

“The paradigm shift is that the typical DB scheme is no longer underfunded and invested in risky assets, and so the chances of positive outcomes are much improved. Of course, risks remain, but our analysis suggests that most well-funded schemes are much more likely to be an asset than a liability over the long term.

“Whilst the most appropriate strategy will differ from case to case, the option of running on a well-funded scheme for the benefit of members and sponsors deserves to be high on the list of options to consider.”