Special Edition - Pension Scheme Surplus

Hello and welcome to this special Aeon podcast where we'll be focusing on the issues of pension schemes surplus in the UK, active run on and what influence either might have on the share prices of listed companies who sponsor those pension schemes. I'm Louise Dale and today I'm joined by Abbott Hussein, who's the managing director and lead equity analyst for Palmio Libreum and John Harvey, who's a senior partner, Pentiary Actuary and Head of Run on and Alternative Solutions at Aeon. Abbott, John, welcome. Thanks Louise and thanks for inviting me. It's lovely to be here and this is an area of development that we're watching closely. Yeah, again hello everyone. On the course with what could be a really big change in the pensions industry and actually something really exciting and beneficial for the UK economy as a whole. So John, perhaps we can start with you and expand on that. Why is pension schemes surplus such a key issue at the moment? Sure, I'm going to start by sharing a few numbers just to kind of put all this into context. So for a helpful, the pensions regulator has recently published an analysis, the evolution of occupational defined benefits schemes 2025. It's only just been published but it's all based on data from 31st of March last year. And relative to the economy, there's about 4,700 pension schemes covering 9 million savers but collectively those schemes have 1.1 trillion pounds of assets. It's quite a huge number. And the regulator believes that around 83% of those schemes are in surplus and about 50% of those indeed have a surplus over and above the amount they'd need to secure the benefits and fall within insurer. Excess of surplus above insurance, they've estimated at something like 90 billion pounds. So there's quite a sizeable amount of surplus in the economy and you can measure that a number of different ways. There are even large estimates of the potential amount of surplus that pension schemes could have on all the measures as well. An issue that we need to face just to sort of give the story behind that. If you go back five, six years, we were talking really about pension deficits and not surfaces but as we've seen a very sharp increase in global investment yields and particular UK government bond yields, we've seen these surfaces just certainly appear over night in UK pension schemes and it's come to government's attention and we're seeing a lot of change within regulations to help give new options for pension schemes to distribute that surplus. So there's a really large opportunity there. I hope for those numbers illustrate and some new choices of pension schemes and employers of pension schemes in particular need to be thinking about. So turning to you, Abid, historically would equity analysts have even looked at pension scheme surpluses when you look at companies? Yeah, so I think let me pick up on the point that John made sort of historically these pension schemes were in deficit and so you'd have a negative value placed on the schemes particularly because there were deficits and sort of periodically they'll be the triangular review and we would be told that further cash injection would have been required into the scheme. So you have this negative historical context and it was almost a one-way valve as in money being injected in and it's not a two-way street and I think that's sort of the discussion for today that changes the perspective but I don't think as analysts and today their view has changed just quite yet. It's too early for them to start changing the view and turn positive on this and then secondly the information in the accounts have only given a partial picture on the surplus. The accounting surplus wasn't really the right number to be looking at and I think there's a sort of different number that the trustees will be considering and then yet again there'd be a third number if we were thinking about an insurance buyout and so there's this sort of lack of clarity which then sort of just lends itself to a default position of having a negative view and I think as we get more education and this becomes a two-way street in terms of cash gain in and possibly cash being extracted that the sentiment will start to change. That makes sense. So John what kind of strategies are companies currently thinking about to access surplus? There are a lot of different ways and indeed an increasing number of ways in which employers can access the pension scheme surplus. So perhaps the most common one historically has been by firstly ensuring the pension scheme and then any excess asset that you have left over after you've insured the pension scheme taking that as a refund generally with the trustees permission and paying tax on that currently at rate of 25% and then being able to take that onto the companies general cash reserves. Now the second option that is quite common is just simply subsidising the cost of benefits within the pension scheme and that could be subsidising existing final salary benefits what we think of as a contribution holiday but it could also be subsidising the contributions the employer would normally pay towards defined contribution accrual which in many cases is a much larger group of employees these days. The new option which is being brought into legislation, governments response to trying to encourage pension schemes to run on and invest in the UK economy and the government felt that actually giving companies a way to benefit from surplus would encourage this kind of behaviour. So they're introducing legislation to allow a lump sum to be paid out from a pension scheme in surplus to the pension scheme employer and again that would generally be with the consent of the trustees the pension scheme and it would be taken 25% but that's a new option which we expect to be fully available to companies from some point in 2027 and it's really creating a lot of excitement in the industry because it's a significant new flexibility. So okay Abid let's pick one of those if a company fully insures its pension scheme and releases the surplus that way I presume you and your colleagues are going to look favourably on that. Yeah look I think in short that would be a clear yes and I think the the caveat is if the guarantees have been passed on to an insurer admittedly for a cost and then it means that surplus is genuine and then if that can be allocated elsewhere particularly in the business for reinvested for growth then that would be positive for for the equity stories. Pension scheme buyout can come with a P and L hit so should they be concerned about how analysts and the market look at that. So I think the if it's signposted if there's been some education around this beforehand I think the market would typically look through that one time negative hit to the P and L especially if it's been explained by the management that the volatility around the P and L going forward has reduced and the volatility around the balance sheet has reduced so if you know if we can exceed the benefits for for that then it shouldn't really be viewed as a negative from the market's perspective. Okay John insurance and wind up sound like good options so why would companies consider any of the other routes to surplus you mentioned earlier. So there could be a number of scheme specific issues that mean that one option or another is not attractive to a company or even not possible for a company but if we leave aside those very specific circumstances let me just talk about the general features which might lead you to choose one option over another and might mean insurance isn't the optimal choice. So the first issue might be speed of surplus release typically in an insurance process you only release surplus once you've been through that whole exercise winding up a pension scheme discharging all the benefits to members and transferring all the liabilities to an insurer and that can be a process that takes many years it can take two three four five years to complete that longer in some cases so by going down a different mechanic to pay out surface, it may be that companies can get hold of that surface more quickly. Secondly, you have the opportunity potentially to access a larger amount of surface, and that's because the new regulations that are coming in to pay out a lump sum look at a different measure of surface. They look at low dependency as a threshold for potentially paying that surface out rather than the cost of insurance, and that means that potentially companies can just access a bigger surface pool than they would if they were insuring. Then finally, continue to run the pentatogame asset scheme, means that you can continue generating more surface over time as your assets perform, and potentially that gives you an ongoing cash flow stream of future refunds over time. That can be very attractive, I think, for some employers. Abid, if companies get their surplus through a lump sum, would you still give credit to that, even if the pension scheme was still there? Look, I think that's a good question, and it really depends on the future risk of having to inject capital back into this scheme, and it depends on how that risk is monitored, how it's been communicated. I think if that's been monitored well, if the risk has been managed well, it should be viewed positively. That being said, there is a potential asymmetry here, even if it is viewed positively initially for the equity story, there could be a double negative here down the line, if there is a need to inject cash back into the scheme down the line. That really needs to be monitored carefully, I think. Yes, so I think this really is a key issue, which we come across a lot when we're consulting with our corporate clients. There is a real desire, I think, to avoid having to put cash back in, once the surplus has been released from a pension scheme, and we've spent a lot of time developing quite extensive tools to help manage the risk, help mitigate the risk, and I'm thinking they're not just investment risk, demographic risks as well, and really put the pension scheme in a position where it can be secure for the long term without needing any additional cash flow from the corporate sponsor. A lot of time has been invested certainly by Aon to make that work, but I think the tools are emerging that should give companies and their investors confidence that those structures exist. John, what about this idea of building up more surplus in the future? This is an idea we would call active run on at Aon, so the idea that you have a huge amount of value locked in these quite large asset pools, which sits in pension schemes in the UK. If you invest to grow the surplus through stable, regular outperformance above your liabilities, and that's a concept that's not unlike how an insurer would be seeking to run the assets on its balance sheet, then the idea is you can generate a stable, regular increase in your surplus, and that can translate into a regular cash flow stream to the employer. It could potentially be shared in some proportion with members of the pension scheme as well, some circumstances, and it could be done in a way therefore that benefits all the stakeholders of the pension scheme. So Abid, what do you think of the idea to run a pension scheme specifically to generate surplus, and then perhaps generate a regular stream of free cash flow for shareholders? It is a positive idea, and I can understand the logic behind it, and I think the success of it will really depend on how sophisticated this scheme is managing the risk and you touched upon the tools that already exist, and maybe some further development of additional tools to manage that, and then ultimately from a company's management perspective, from an analyst's perspective, this then actually becomes a strategic asset for the corporation. It becomes a capital allocation decision for the management, and then it's a question off, does the management team have the bandwidth? Do they have the expertise to monitor this, and if it is yes to all of those, then this makes a lot of sense to me, and if it's no, then that will be questioned. And so I think there's a framework around here that we can develop for this to make sense and for this to work. We talked about managing management having the skills to the surface. Is there a risk that the market might see this as a potential distraction, and that the insurance markets might be a better way to run liabilities over the long term? I think that's the initial reaction, if it's a sort of two ways of dimensioning this, if it's a very large pension scheme relative to the market cap, then there will be questions off, does the management team have the bandwidth? Are they in, is the company in the business of manufacturing widgets, and suddenly now having to manage this financial, sophisticated pension scheme, and how much time is that taken away from managing widgets, so to speak? And so there's a sort of size and complexity issue, and if that is addressed, if they have the right advisors, then it's not really about the insurance landscape versus the corporate landscape, if those things can be addressed. That being said, I think the insurance space does have a tried and tested model in the sense around the governance, around the regulation, around the capital allocation, around the assets, around the liabilities. And so if that model is being largely replicated in a non-insurance space, I have no issues with that, and I don't think the insurers would have any issues, and I think the question then becomes, is there some sort of tax arbitrage, capital arbitrage, and then there might be some benefits from that perspective, but it really distills down to, is the governance, is the regulation, and the capital framework, the right one? I think that's a really good point, but actually if I can jump in there, so there are definitely differences in regulation and capital requirements between the pension regime and the insurance regime, so some of those, I think, make it advantageous to potentially run some pension risk outside of the insurance industry, because you can use an employer's balance sheet to strengthen to support the pension scheme, rather than necessary having to put aside and ring fence large pools of capital to satisfy the insurance regime. And there are tax benefits as well, so I think the pension scheme itself and everything that happens within the pension scheme wrapper has very favorable tax treatment in the UK, and that's an advantage as well. So some of these sort of fringe benefits do mean that there are advantages, even if everything else is identical, I think, to continuing to run a pension scheme, and kind of, I see it almost as leveraging the strength of the corporate balance sheet to deliver things more efficiently. Reeve, this has been a really interesting discussion, but perhaps if we move a little bit back from individual company decision making and discuss the impact on the wider economy, Abid, what are your initial reflections on that? So, for me, I think the key is that we've always, when I say we, I mean sort of the broader analyst community and the regulator and the government, to some extent, have encouraged the insurers to invest in productive assets and productive UK assets and to invest back into the communities, I think, I think actually the government could have gone further in that regards. So my one ask of the industry, of the regulators, of the government here would be whether it's in an insurance framework, whether it's in a pension scheme framework, on whether it's in a corporate framework, I would encourage us all to think about investing back into the communities, investing back into the UK economy and investing into UK productive assets. Yeah, and Louise, perhaps if I could jump in as well, and Abid, for the record, I think completely agree with all the points you've just made. I think there's a real opportunity here to use Pensions Games and the large parts of assets we've got to support wider investment in the UK and you know I think there's some direct benefit to just paying up surface as well you know to the extent that we can get that into back into UK PLC and allow some internal reinvestment that is a positive benefit to the economy too. And again coming back to the data from the regulator that I talked about earlier at the moment we're seeing maybe ten billion a year of surface being distributed largely through that insurance mechanism I was talking about but the regulator is projecting that could increase quite markedly in the coming years till maybe nearly 40 billion in 2027 when the new regulations come online so the real step up and the amount of surface which would be released from Pensions Games and they're projecting that more than 120 billion could be paid out over the coming years. So some significant amounts of surface that could be paid and I guess the final point to mention as well again an area very close to my heart that is also a benefit for the UK Treasury as well so is it good for taxpayers because those surfaces that are paid out do you know help get tax taken up and help support our wider public sector as well which I'm sure won't surprise anyone listening to the podcast is very much in need of tax boost at the moment. Thanks John. Abbott do you have any final thoughts? Yeah I just want to touch upon just build upon what you just said John and that is the the tax take I think if that goes up that's great for the Treasury but I also think the if the corporations are allowed to access the surplus and reinvest it into the businesses into UK PLC that's going to be fantastic for the economy it will create a positive multiplier effect and so I think there are some real potential positives from this. And if I can have a close thought as well we've been focusing very much because it's the subject of the podcast on the impact on the employer there will also be some benefits on the members of pension schemes as well. I can see that as surfaces paid out members will also most likely get some additional benefits and and that's going to be positive as well for you know wide the wide sections of the British population that actually still have DB pension schemes and so positives all round but I think good for the Treasury good for the economy good for employers and good for members. Abbott John thank you so much for your time and what has been a really interesting discussion. If you would like more information or would like to have any comments please email us at talk to us at aion.com. Thank you very much for your time.