Defined benefit (DB) schemes could benefit from smaller deficits if changes are made to rules governing scheme surplus refunds, says BDO Stoy Hayward Investment Management.
In the white paper: Security in Retirement, the government stated they would be launching a “rolling deregulatory review” of pensions regulation which would form part of the Department for Work and Pensions simplification plan to be published later this year.
As a result, it said it may be possible to “remove, merge or simplify many of the layers of legal requirements introduced in and since the 1995 Pensions Act, and could include re-examining the provisions” on topics including payments to employers where surplus funds exist.
Although the white paper is vague on what the review will actually do, BDO Stoy Hayward Investment Management says a relaxation of the rules could benefit both employers and pension schemes as, at the moment, refunding a scheme surplus is almost unheard of.
Under current rules, should a pension fund actually have no deficit and then receive good returns on the investment, before an employer can take back the extra money it has to significantly improve the scheme benefits.
This means a scheme needs to grant Limited Price Indexation (LPI) pension increases on all the pension benefits, and the scheme has to effectively be in surplus on a buy-out basis. But even if these conditions are all satisfied, any refund payment is then taxed at 35%.
BDO Stoy Hayward Investment Management says employers are naturally reluctant, as a result, to make significant payments into schemes on the basis it could be “wasted money” as the scheme could be more than fully funded and the money is serving no purpose.
John Broome Saunders, actuarial director at BDO Stoy Hayward Investment Management, says employers suffer from “significant risk asymmetry”, because if scheme investments perform badly, the employer has to pick up the tab through larger contributions, whereas if funds do well and the scheme moves into surplus, the employer finds it very difficult to benefit from those good returns.
He adds while almost every DB scheme is in deficit and the prospect of a surplus refund may seem like a pipe-dream at present, any relaxation of the rules could significantly change employers' perceptions of scheme funding.
Contributions are seen very much as "one-way" cashflows, where once money is in a scheme, it will never come out, irrespective of actual investment or scheme experience.
Broome Saunders argues by allowing surplus refunds it gives employers far more incentive to fully fund schemes and look for better investment returns, because the employer will ultimately benefit from any good investment performance enjoyed by the scheme.
He says: “As a consequence, if employers are more enthusiastic about paying contributions, we could certainly see a reduction in aggregate deficits, although the changes wouldn't necessarily stop scheme closures, as ultimately these are now being driven by risk and remuneration considerations.”
While it is still uncertain what changes will be made, if any, as the “deregulatory review” has yet to be started, Broome Saunders says removing the need to improve scheme benefits before a surplus can be refunded, would clearly be beneficial.
In addition, he suggests another positive change would be to lower the tax charge to something far less penal, with perhaps a higher rate for very large surplus refunds - in relation to the size of promised benefits - to stop companies abusing schemes by using them as tax-free investment wrappers.
The government, in its DWP pensions white paper, says the next step for the review will be to establish a group of external stakeholders to help understand the current position, and identify particular areas where “quick wins” may be possible, such as changes which could be achieved by introducing secondary legislation or administrative action.
It also commits the review to “maintain momentum by mapping out a programme of simplification measures”, adding it would welcome proposals during the consultation period of the paper which ends on 11 September.
Broome Saunders points out: “Giving employers the potential to benefit from upside investment risk must be a positive move, not least because it should encourage employers to focus more clearly on pension scheme investment strategies designed to deliver significant long-term returns.”
If you have any comments you would like to add to this story or would like to speak to its author about a similar subject, telephone Nyree Stewart on 020 7968 4558 or email [email protected]IFAonline
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