Is now the time for a Defined Benefit Pension Windfall for your charity

In my long career advising both pension funds and charities on investment matters, I have witnessed times when the pension scheme has been a "win-win" vehicle for both Trustees and sponsors (back in the early 90s!) when generous defined benefits (DB) were provided. Early retirements were often granted, and sponsors often took contribution holidays. However, I have also seen times. Particularly during most of the 2000s, where pension schemes became a millstone round sponsors' necks with increased statutory indexation, longevity lengthening and interest rates falling all contributing to a massive ramping up in the cost of benefit provision.

This was particularly acute in the charity sector, especially for charities that had limited reserves to cushion the impact of low interest rates through much of the 2010s. This resulted in material "recovery plan" contributions being paid that put severe strain on finances and often led to the scheme's ultimate closure to future accrual. It is now extremely rare for charity employees to be receiving final salary related benefits.

However, the landscape has changed markedly in the last couple of years, with long-term interest rates normalising to levels not seen since the 2008 Global Financial Crisis. For defined benefit schemes these interest rate increases reduced materially the capitalised value of the liabilities, in many cases led to some charity-financed pension schemes being in a much better funding position - some have even flipped into a pension scheme surplus!

At the same time, running costs for many charities have continued to rise inexorably, with the new Chancellor's NI and living wage increases in the 2024 budget only the latest in added costs that will hit the sector. There are few charities in my experience that wouldn't value some additional revenue to help with either running costs or increasing their funding to charitable causes.

The question is - should charities take the opportunity to get rid of their legacy pension scheme via the insurance market, or could they actually use the scheme to extract value to the benefit of their wider stakeholders?

Pension scheme investment strategies have improved in their sophistication over the last 10-15 years, to such an extent that it is now possible to use the pension scheme's assets to hedge more accurately the liabilities they are due to pay out. This means that, if done carefully, and if the cost of running the scheme can also be covered, then the charity may be able to extract some surplus from the Scheme to further the good causes they are set up to help. For a scheme of say £50 million in size, say, delivering a net additional 0.5% per annum of return could deliver £250,000 each year to help the charity, and recent changes to the refund of surplus rules have made these refunds a bit more palatable, tax-wise. There are other potential options for this additional revenue stream, for example, using the funds to contribute to pension contributions for staff.

Furthermore, in the case of charities specifically, I believe there is also a strong case that the scheme beneficiaries (who will have worked at the charity) would also be supportive of some form of "surplus sharing" compared with the position in corporates where the shareholders would be the main beneficiaries.

The alternative is to crystallise the "premium" by paying an insurance company to take on the liabilities, which will could easily be a 10-15% premium over the liabilities in a "run on" scenario - a chunky premium to boost the profits of the insurance company!

What are the downsides?

• Longevity risk that cannot be completely hedged without an insurance company buy-in;
• Increasing running costs which may counteract any emerging benefit;
• Management time and complexity, although this can be mitigated by hiring professional trustees;
• Finally, the need for trustee agreement and confidence in the charity to underwrite the scheme insolvency risk.

Clearly, all these issues would need to be considered, but it may still be the case that for a charity that is keen to do more for their beneficiaries, the pension scheme could provide a welcome shot in the arm for these good causes. After all, the charity will likely have lumped many payments into the Scheme back in the 2010s - so could these now deliver an unexpected dividend for the next 5-10 years?

Personally, I think it is reasonable for a charity to at least consider this possibility - note that it is unlikely that pension Trustees (whose key focus is to administer the benefits to pension scheme beneficiaries) are likely to be proactive in taking this idea to their sponsor, and so it would be up to the Charity's board and finance team to take the lead on these discussions.

So to summarise, charities with reasonably well-funded pension schemes attached may at last be able to reap some benefits from the extra contributions they have paid over past years, and I am sure that all parties involved would support a well-considered approach to adding funding towards their charity's mission.