Employers with defined benefit (DB) pension schemes focusing on insurance buyout must become more proactive to avoid the risk of trapped surplus, Hymans Robertson has warned.

In the latest update to its 2024 Corporate Valuation series, Hymans Robertson said that while improved funding levels present an opportunity for DB schemes, many do not have appropriate plans in place to ensure efficient use of any emerging surplus, which leads to “trapped surplus”.

Given this, it highlighted a number of key areas that pension scheme trustees and sponsors should review to help remove trapped surplus risk, including escrow arrangements, contribution mechanisms and the funding of future service contributions.

In particular, the firm recommended putting funding triggers in place so deficit reduction contributions turn off once the scheme is fully funded based on the ‘roll forward’ estimates provided by the scheme actuary.

It also suggested that it may be worthwhile introducing an escrow arrangement to avoid potential issues from a trapped surplus, giving trustees security that, in the case of any funding deterioration, the escrow can act as a cash injection, whilst also providing the employer with the flexibility and reassurance that, if not needed, any surplus funds won’t be trapped in the scheme.

Looking further ahead, the firm suggested that the Department for Work and Pensions' consultation on DB pension scheme surpluses could bring further "significant change" that benefits both members and employers.

It acknowledged, however, that it is likely that any changes will take time to implement, emphasising the importance of employer proactivity to ensure they have maximum flexibility.

Hymans Robertson senior actuarial consultant, Sachin Patel, said: "In isolation, improved funding levels are great news for DB pension schemes and even better news for members.

"However, with many sponsoring employers having paid deficit contributions for years, they may not have the appropriate plans in place to take advantage of a surprise emerging surplus.

“For those schemes where the employer’s long-term objective is to target a run-on strategy, the idea of a trapped surplus is less likely to be an issue.

"However, for those targeting an insurance buyout, and are reasonably close to reaching this, a 2024 valuation discussion is a welcome moment of reflection, particularly when viewed in tandem with the potential forthcoming legislative changes signposted by the DWP.

“We would urge employers with DB schemes and 2024 valuations to review their surplus framework as part of their negotiations.

"In our experience trustees are supportive of these discussions and recognise that the risk of trapped surplus. If this is not managed it could lead to unhelpful sponsor thinking and decision making. It is in everyone’s interests to solve this issue.”

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