The UK’s defined benefit (DB) pensions lifeboat, the Pension Protection Fund (PPF) currently has a funding surplus of around £13bn (the PPF Surplus). In this article we consider what could, and what should happen to that funding surplus, both in the immediate future and in the longer term. This is considered against the backdrop of a contracting DB market, where the number of DB schemes (and thus the pool of PPF eligible schemes) is reducing, where schemes are currently for the most part very well funded and many are being bought out and wound up. Is the endgame for the PPF already now visible, albeit in the distant future, and what happens to any surplus remaining when we get there?
Background and context
The PPF is often described as the UK’s pension scheme lifeboat – in its own words, its duty is “to protect people with a defined benefit pension when an employer becomes insolvent”. The PPF manages £32bn of assets for its 292,000 members. It is funded in part by ‘levy payers’ (i.e. PPF eligible DB pension schemes), whose contributions depend on a combination of the size of the scheme (the ‘scheme based levy’) and the risk of the scheme needing assistance from the PPF (the ‘risk-based levy’). The remaining funding comes from the assets of the distressed schemes that transfer into the PPF, assets recovered from insolvent employers, and the investment returns the scheme earns on its assets.
The PPF Surplus has arisen because, according to the PPF’s most recent annual report, as at 31 March 2024 the fund held over £1.68 for every £1 of liabilities it represents (around £32bn of assets versus around £19bn of liabilities). So the PPF is currently significantly over-funded. At the same time, the DB market is contracting and the number of schemes eligible for this lifeboat is shrinking. On 20 February 2024, the Pensions Regulator (TPR) published its Annual landscape report on DB and hybrid schemes. Amongst other compelling statistics, the report revealed that:
- the total number of DB and hybrid schemes has reduced by 2% from 5,378 in 2022 to 5,297;
- the percentage of schemes closed to future accrual (excluding those in wind-up) has risen from 70% to 72%
- the number of schemes with 100% or greater technical provisions funding levels increased from 2,565 to 3,620; and
- the total deficit (of schemes in deficit) reduced from £63.610bn to £27.673bn.
Against this context of a market made up of a smaller number of larger, better funded DB schemes, we consider the position of the PPF and the options for dealing with the PPF Surplus.
PPF Surplus in the spotlight
This has been a hot topic over the past couple of years. The Work & Pensions Committee (WPC) report on defined benefit pension schemes published in March 2024 said the following:
“The PPF is now fairly confident that it is secure and able to meet future claims from its existing funds, with £12 billion in reserves. This is a significant achievement which we applaud. It means there is the opportunity to consider how both levy payers and scheme members can benefit from this. DWP should legislate to give the PPF more flexibility to reduce its levy to zero, knowing it can increase it again if needed. It should also legislate to improve PPF compensation levels.”
The funding position of the PPF today is clearly very strong – actuarial valuations reveal it has far more assets than it needs to meet its liabilities. Partly this is due to a successful investment strategy and partly due to collecting more in levies than it needs. The PPF is very aware of its current over-funded status. However, as flagged in the WPC report quote above, and as we’ve discussed in previous articles (in September 2023 and October 2024), it feels constrained by the law as it currently stands and unable to reduce the levy on eligible schemes any further. This is because of the legal restrictions on the amount by which the levy can be increased annually – s177(5) of the Pensions Act 2004 says that the extent to which the levy can be increased from year to year is limited to a maximum of 25% of the previous year’s levy. The PPF feels it cannot risk dropping the levy any lower than the £100m it charged in the last levy year and is proposing to collect again in the forthcoming 2025/26 levy year as set out in the consultation.
The PPF has been lobbying the DWP for statutory change. In its 2024/25 levy determination it made clear that, but for the legal requirement to charge a levy and the restrictions on how much it can be increased each year, the PPF Board would have anticipated being in a position to move to charging no levy at all given its strong funding position. In this year’s levy consultation, the PPF advised that it is proposing to maintain the levy at £100m (the lowest ever set), reflecting the “continued improvement” in its own funding position as well as the DB market more generally, as well as the need to “retain the ability to raise a material levy in future in the event of a funding shock”. At the same time, it said that it will “continue to work with Government to seek the changes that would allow us to safely reduce the levy further”.
However, there was a glimmer of hope before Christmas when the PPF published a statement advising that “following positive engagement with stakeholders as part of their consultation on the 2025/26 levy rules”, the publication of the final determination has been deferred to the end of January. Does this mean that we may see this year’s levy reduced further? Perhaps on the promise of forthcoming legislative change. We await this update with interest.
A note of caution
Of the substantial surplus the PPF holds today, the 2023/24 annual report says the following:
“Our reported reserves of £13 billion are held to cover future risks to the PPF, including longevity and claims risks. Whilst our reported reserves exceed the combined deficit of the schemes we protect, the deficit of the schemes in deficit is sensitive to interest rates and inflation if those schemes remain only partially hedged for interest rate and/or inflation risk. Falling rates and/ or rising inflation expectations could therefore result in an increase in the deficit of schemies in deficit. While the current reduction in deficits in the scheme universe lowers the current risk of significant claims on the PPF, the future outlook will hinge on how schemes choose to balance their exposure between LDI strategies and return-seeking strategies.”
And there’s no doubt that the PPF is right to exercise caution and maintain a strategic reserve to protect against future volatility, as well as against the unforeseen. And to a certain extent, assessing scheme funding levels is more an art than science. This was highlighted recently in December 2024 when the PPF revised its estimate of the funding levels for UK DB schemes in 2023 downwards to the not inconsiderable tune of £283bn. This means that in 2023 on average DB schemes across the UK were 90% funded on a buy out basis, rather than the 112% funded as previously estimated by the PPF. Given the PPF’s overfunded position, there is industry optimism that this revised estimate should not lead to any increase in this year’s proposed levy. However, it is an illustration of how quickly the funding position of a scheme can change.
Options for using the surplus
All that said, there’s little doubt that, with the PPF Surplus estimated at £13bn, the PPF currently has more money than it anticipates that it needs. As discussed above, of course all DB schemes should look to retain a buffer over and above full funding levels to protect against market shocks (such as the September 2022 LDI crisis) and the PPF is no different – it is alive to the risk of future economic changes changing the level of risk to the PPF. However, the lifeboat has now reached the stage where it is more than 150% funded, surely a surplus surplus? And of course, what if the surplus continues to grow? With the PPF currently constrained from lowering levy collections any further (albeit with legislative assistance – hopefully – on the horizon) if investments continue to generate returns the existing PPF Surplus may well increase even further. So what options does the PPF have?
As lawyers we naturally turn first to the legislation for guidance as to what ought to happen in the event that the PPF finds itself with a significant surplus. But there is limited assistance to be found, surprising perhaps given that, in the context of a contracting DB marketplace and very few DB schemes remaining open (barring a resurgence in the DB market), the PPF lifeboat was only ever going to be needed for a finite period.
We’ve identified four options for use of the PPF Surplus that may be considered – some more immediate and some further into the future, at the stage the PPF reaches its end game (as private sector DB schemes wind up, as the “rescues” slow (and eventually end) and the PPF’s membership becomes finite). There are four options that might be considered for how to use the PPF Surplus:
- Increase compensation for members and their dependants
The compensation paid to members under the PPF will not always be the same as the benefits they would have received under their employer’s pension scheme, and in some circumstances can be quite significantly less. For example, members who are below normal pension age at the PPF assessment date, receive broadly 90% of their pension. Under schedule 7 of the Pensions Act 2004, the PPF has some flexibility to alter the benefits that members and their dependants are entitled to – for example to reduce the cap on the rate of pension increases or revaluation – however, the scope to make upward adjustments is limited. More fundamental changes would require the Government to legislate. As an example, if given the necessary legal powers, the PPF could consider:
- removing or limiting the existing 10% reduction for those receiving compensation from the PPF but who are below normal pension age as at the PPF assessment date;
- increasing benefits so that they are uprated in-line with inflation (which could even be back-dated to factor in the recent high inflation environment); and/or
- providing more generous GMP equalisation outcomes.
Option (b) is currently a hot topic, in particular in relation to pre 1997 benefits which receive no increases under the PPF’s compensation rules. It was raised by the WPC under the previous government and new WPC Chair Debbie Abrahams has picked up the baton and wrote to the Secretary of State for Work and Pensions, Liz Kendall, in November 2024 to ask for an update on timescales in relation to a number of matters, including a response to the WPC’s recommendation (made in its report on Defined Benefit Pension Schemes) that the Government should legislate for the PPF to provide indexation in respect of pre 1997 rights, where the rules of the original scheme provide for that. That report said, ““We heard that for PPF members, the priority was indexation of pre-1997 benefits, which have had a disproportionate impact on women and older scheme members. This should be the first step, before other improvements are considered.”. The PPF has estimated the cost of providing increases on pre 1997 benefits (in line with CPI and capped at 2.5%) at around £2.6bn.
Increasing compensation for PPF members certainly has its equitable merits where their benefits have been cut back due to employer insolvency but should that still be the case where the PPF “lifeboat” now finds itself in surplus? However, one drawback to any change is that it would need to be implemented via regulations; and any proposed back-dating would no doubt be subject to much scrutiny and debate.
- Return payments to levy payers
Whenever the funding of the PPF has been a concern, it has always turned to levy payers in the first instance to build a buffer – the levy is set on an annual basis, allowing the PPF to take account of its own funding levels when assessing how much it needs to collect. One argument might be that it is logical for those levy payers, from whom the PPF has sought extra monies when funding levels have been strained, to be the beneficiaries when the PPF now finds itself with a surplus. Arguably, the PPF levy is, in effect, another form of taxation; and should there ever be a governmental surplus, it would be likely that taxpayers (i.e. the DB schemes that have been paying the PPF levy) would expect to see some of their hard-earned taxes paid back to them. As an example, the WPC report highlights that the Railways Pension Scheme has paid around £600m in levies to the PPF since it was established – the equivalent of more than £1,700 for each of its 350,000 current members.
Such an approach would also align with the governmental policy currently being pushed to return more to employers for them to be able to invest and grow (see below) – with the hope that this would result in some ‘trickle-up’ and ‘trickle-down’ benefits for the economy.
However, refunds to levy payers has its complexities. In particular, we note the following practical issues:
- Who receives the refund? Would this be current PPF levy payers, levy payers since the PPF Surplus became so material, or all those who have ever been levy payers? (And what about those schemes who have recently wound-up or whose employers have since entered insolvency?).
- How much? Whilst one would imagine the answer to this to be simple (i.e. something related to the sum that was paid in), this fails to take into account the impact of inflation, especially should the refund be applied historically (for example, a scheme that paid in £1,000,000 in 2010 may feel that they are due the c£1,600,000~ that it may be worth today when inflation is taken into account).
- Taxation issues? For example, would and should employers be liable to a “return of surplus” tax charge in the same way as sponsors receiving a refund of surplus from a DB scheme are? When and how would any such tax be payable – instantly or in the scheme’s end of year account? The levy payments would also have impacted the tax paid in each tax year, so how does this get accounted for?
So whilst the approach would be welcomed by levy payers, one could see why working out the complexities may not be attractive for a new Government with a full legislative agenda.
- Invest into a new consolidator vehicle for solvent employers’ schemes
Part of the Mansion House reforms package initiated by the previous Government included proposals to establish a public sector consolidator (PSC) vehicle. In measures consulted on during the first part of 2024, the Government set out plans for that PSC to be administered by the PPF and to “provide an alternative endgame solution for DB schemes unattractive to commercial consolidation providers”. The consultation focused mainly on the proposed design of the PSC, including structure and eligibility, as well as member benefits and funding.
The PSC design proposals considered the question of PPF reserves. It was suggested that a proportion of these could be used to underwrite the PSC – in the form of a loan or investment from the PPF to the PSC, in return for which the PPF could be remunerated. However it was recognised by the DWP that there were challenges with this approach – both at a policy level (PPF reserves exist to protect the PPF’s current and future members, as well as its levy payers – if the reserves were called on by the PSC this would weaken the PPF’s financial position) and at a practical one (the funds available will be limited to the amount the PPF could reasonably spare to underwrite the PSC – if take up of the PSC is high, this could quickly become insufficient).
The PPF has published its response to the consultation and expressed broad support for the PSC proposals. However, it does not favour the use of PPF reserves to underwrite a consolidator vehicle – citing factors including the impact on and position of levy payers and members, as well as the PPF’s plans to move to a zero levy (when legislative change allows), meaning that the remaining surplus available would be insufficient to support the PSC if it grows to any scale.
It is interesting to note that the PPF also commented that “it is important to have specified at the outset what would happen to any surplus that might arise” – an indirect reference perhaps to the lack of any such specification for the application of the PPF’s surplus and the challenges that poses.
So far the new Labour Government has kept its cards close to its chest when it comes to what sort of reforms might be in store for DB pension schemes but, given the focus on consolidation in the DC market, it would not be surprising to see the PSC proposals resurrected in the coming year.
- Direct to the Government?
Looking further ahead to the long term horizon it is possible to envisage a scenario where the PPF Surplus could balloon even more dramatically at the same time that the number of schemes the PPF is protecting shrinks dramatically, as they secure benefits and / or consolidate and ultimately wind up. And where the remaining schemes are significantly derisked and well funded, the risk to the PPF (and the likelihood of the surplus buffer being required for compensation if a scheme enters the PPF) diminishes, meaning there is ultimately less reason to maintain such a large buffer.
As the PPF’s ultimate end point comes closer into sight, and if there is still a very large or even larger surplus at that stage, it is feasible to imagine that the government of the day might then seek to release the trapped surplus and deploy it towards national interests such as reaching net zero, investing in infrastructure and so on. What members in receipt of PPF compensation (particularly those whose scheme benefits have been cut back) or sponsors of schemes that have paid significant levies might make of that should it arise, and whether they would have any grounds to challenge such a distribution, is an interesting question to ponder.
What next?
As we’ve already mentioned, whilst the change of Government has seen no let up in momentum for the Mansion House reforms from the DC perspective, proposals for reform in the DB space appear to have stalled at this stage (though we understand some update may be expected in the Chancellor’s growth speech on 29 January 2025). Phase one of the new Government’s pensions review focused on investments for DC schemes and the LGPS, and the interim response published in November 2024 was accompanied by consultations proposing significant consolidation of DC schemes and LGPS funds.
Those proposed reforms are all focused around stimulating growth in the UK economy, underpinned by the rationale that larger schemes are better able to invest in a broader range of assets (including UK equities and infrastructure) and to benefit from economies of scale. So what, if anything, can we extrapolate from this, in terms of what Prime Minister Keir Starmer and the new ministerial team at the DWP may have in store for DB schemes in general, and the PPF in particular? If growth is the target and bigger is better, will we see the PSC proposals resurrected this year? And if so, will the “surplus surplus” in the PPF be in the crosshairs for providing a security buffer in place of the transferring employer covenant as was mooted in the consultation earlier in 2024? Or will the increasing engagement from the WPC and others put pressure on the Government to intervene with legislative change to allow the PPF flexibility to use some of the PPF Surplus to uplift members’ benefits? And what about levy payers – can they read anything into the deferring of this year’s 2025/26 determination to the end of January?
We will be watching developments in this area with great interest over the coming months.
This article was written by Callum Duckmanton and Louise Pettit