Defined Benefit Pension Scheme Funding: What Members Need to Know

A defined benefit (DB) pension promises a specific income for life — calculated by reference to your salary and years of service, not the performance of an investment pot. That promise sounds reassuringly solid. But behind every DB promise sits a funding equation: the pension scheme must hold enough assets today, invested and growing, to meet all the future pension payments it has guaranteed.

When the assets are insufficient, the scheme has a deficit. When they are more than sufficient, the scheme has a surplus. The employer is ultimately responsible for making up shortfalls. For members of private sector DB schemes, the financial health of that employer — what actuaries and regulators call the "employer covenant" — is the most important single variable governing the security of the promised pension.

This guide explains how DB scheme funding works, what the key terms mean, and what the current landscape of scheme endgames looks like for members.

Important: This guide provides general information about defined benefit pension scheme funding. Individual scheme rules, employer circumstances, and regulatory positions vary significantly. The Pension Protection Fund provides a safety net for certain eligible schemes, but does so at capped benefit levels. Seek regulated advice before making any decisions about a DB pension, including transfer decisions.

---

How DB Scheme Funding Works

A DB pension scheme makes promises to its members: "You will receive 1/60th of your final salary for each year of service from the date you retire until the date you die, plus a spouse's pension on your death." Honouring these promises decades in the future requires the scheme to hold sufficient assets today.

An actuary appointed to the scheme calculates the present value of all future pension obligations — the total amount that, if invested now, would be sufficient (on certain assumptions about investment returns, inflation, and longevity) to meet every future pension payment the scheme has committed to make. This calculation is called the "technical provisions."

The assets of the scheme — predominantly gilts, corporate bonds, equities, and property — are then compared to the technical provisions to determine the funding level. If assets equal 90% of technical provisions, the scheme has a 10% deficit.

The Actuarial Valuation

UK private sector DB schemes must conduct an actuarial valuation every three years. The valuation is submitted to The Pensions Regulator (TPR). If the scheme is in deficit at the valuation date, the trustees (who are legally separate from and independent of the employer) must agree a recovery plan with the employer setting out how and over what period the deficit will be repaid.

Recovery plan periods can extend to 15 years for schemes where the employer covenant is strong. TPR expects shorter recovery plans where the employer is financially weaker or where the deficit is large relative to the employer's capacity to pay.

The valuation assumptions — particularly the discount rate used to calculate the present value of future liabilities — materially affect the funding figure. Two identical pension promises can show very different technical provision figures depending on the assumptions used. More prudent (lower) discount rates produce larger liability figures.

The Impact of Interest Rates

The most dramatic driver of DB funding levels in recent years has been the movement in long-term interest rates. When gilt yields rise, the present value of future pension liabilities falls — because those future payments are discounted at a higher rate. When gilt yields fall, the present value rises.

The rapid rise in UK gilt yields during 2022 dramatically improved DB funding levels across the board. Many schemes that were deeply in deficit for years moved into surplus in a matter of months. By 2024, aggregate UK DB pension funding was at its best level since the 1990s — a transformation that has accelerated the move towards buy-out and wind-up for many schemes.

---

The Deficit: What It Means for Members

A funding deficit means the scheme does not currently hold enough assets to pay all future pensions, based on the actuarial assumptions used. This does not mean that member pensions are immediately at risk — the employer is obliged to make up the deficit through regular deficit repair contributions.

However, a persistent or large deficit does create risk:

Employer insolvency risk: If the sponsoring employer becomes insolvent before the deficit is fully repaired, the scheme cannot compel the employer to make further contributions. The scheme may then need to enter the Pension Protection Fund (PPF). For pensioners who have reached normal pension age, benefits are generally paid in full; for deferred members (those who have not yet retired), PPF benefits are at 90% of the accrued pension. The PPF compensation cap that previously limited higher earners was removed after the Court of Appeal ruled it unlawful in Hughes v Board of the Pension Protection Fund (2021). PPF inflation increases may, however, be lower than the original scheme's, which can still reduce the long-term value of compensation for some members.

Benefit restrictions: In an ongoing scheme with a large deficit, the trustees have limited legal powers to reduce accrued benefits (what you have already earned is generally protected). However, future accrual (what you would earn in future years) can be changed, and many DB schemes have been closed to future accrual precisely because the cost of continuing to accrue benefits became unsustainable for the employer.

---

The Surplus: What Has Changed

For most of the 2000s and 2010s, UK DB scheme surpluses were unusual. Where surpluses did arise, a tax charge on surpluses returned to the employer (the authorised surplus payments charge) disincentivised employers from overfunding their schemes. That charge was reduced from 35% to 25% with effect from 6 April 2024, and subsequent reforms have sought to make surplus release easier — Employers historically preferred to reduce contributions once schemes were fully funded rather than build reserves.

The reduction in the surplus charge, together with subsequent legislation to facilitate surplus extraction where a scheme is sufficiently well-funded (typically at or above a prescribed buyout-related funding threshold), is aimed at encouraging employers to keep running their DB schemes rather than buying them out. This is significant for larger sponsors with overfunded schemes.

For members, a well-funded surplus is positive: it indicates the scheme has significant capacity to absorb market shocks without falling into deficit, and reduces the employer's need to make additional contributions that might strain the business.

---

The Employer Covenant: Why It Matters Most

The employer covenant is the actuarial and regulatory term for the financial ability and willingness of the sponsoring employer to support the pension scheme now and in the future. It is assessed across three dimensions:

1. Financial strength: Does the employer have the cash flow to make regular contributions? Does it have sufficient assets to make additional contributions in a stress scenario?

2. Legal enforceability: Is the employer legally obliged to support the scheme? Can the trustees call on the full resources of the employer group, or only on the specific entity that is the scheme sponsor?

3. Longevity of the covenant: Will the employer exist — in its current form, with its current financial capacity — for long enough to fund the pension obligations, which may not be fully paid for 40+ years?

A FTSE 100 company with £10bn of annual revenue and an investment-grade credit rating provides a strong covenant. Its pension scheme might have a significant deficit and still be considered relatively secure, because the trustees and TPR can be confident the employer has the capacity to repair it over time.

A loss-making SME with high debt and declining revenues provides a weak covenant. Even a 95% funded scheme on such an employer is concerning — a market downturn that moves the scheme from 95% to 85% funded might create a deficit that the employer genuinely cannot repair.

TPR's guidance requires trustees to take the employer covenant into account when setting the funding target, the recovery plan length, and the investment strategy. Schemes with weak employer covenants should be more conservatively invested (less equity exposure) and should target faster deficit reduction.

---

Buy-In, Buy-Out, and Consolidation: The Endgame

The majority of UK DB schemes are closed to new members and to future accrual. They are in "run-off" — managing the existing obligations until all members are retired and have died, which may take 50+ years. Given the improved funding positions of 2022-2024, many employers are now pursuing endgame strategies:

Buy-In

A buy-in is a bulk annuity purchase from an insurance company. The pension scheme (which continues to exist) pays a premium to an insurer (Aviva, Legal & General, Just Group, Scottish Widows, PIC, etc.), and the insurer guarantees to pay the scheme an income matching its pension obligations. The members' pensions are still paid by the scheme — but the scheme now holds an insurance policy rather than a direct investment portfolio.

A buy-in reduces investment and longevity risk for the scheme but does not immediately affect members' day-to-day experience.

Buy-Out

A buy-out is the full transfer of pension obligations to an insurer. Each member's pension is secured individually with the insurer, the pension scheme is wound up, and TPR is notified. Members thereafter have their pension paid directly by the insurer as an individual policy.

Buy-outs are more expensive than buy-ins (the insurance pricing reflects the full regulatory capital cost of guaranteeing individual pensions permanently), but they eliminate the employer's ongoing pension liability entirely.

The UK bulk annuity market has been exceptionally active since 2022. Transaction volumes reached record levels as the combination of high interest rates (making buy-out affordable) and improved funding positions created a window for many schemes to achieve buy-out.

Superfund Consolidation

DB superfunds — commercial vehicles that take on multiple DB schemes from multiple unrelated employers — were authorised by TPR from 2024. Superfunds offer an alternative to buy-out for schemes that are not fully funded to buy-out level: the employer pays a "capital injection" and exits its pension obligations; the superfund takes over. Members' pensions continue to be paid by the superfund rather than an insurer.

The security provided by a superfund is lower than buy-out (it is not regulated as an insurer and does not benefit from FSCS protection), but higher than remaining with a weak employer covenant. Superfunds remain a niche option.

---

Comparing Private and Public Sector DB Schemes

Public sector DB schemes — the NHS, teachers, civil service, local government, police, armed forces — are "unfunded" pay-as-you-go schemes. There are no investment assets; pensions are paid from current government revenue. The "funding" risk for public sector schemes is effectively sovereign credit risk — the risk that the UK government cannot or will not pay its pension obligations.

For private sector DB members, the funding and covenant analysis described in this guide is directly relevant. Public sector members face different risks (including the political risk of benefit reform), but not the employer covenant and investment funding risk that private sector members face.

---

How Global Investments Can Help

Global Investments works with clients who hold private sector DB pensions to understand the funding and covenant position of their scheme and the implications for their broader financial planning.

For executives and senior employees in organisations with DB schemes, we can help you understand how to interpret the scheme's funding information (available in the annual trustees' report and accounts), assess whether your scheme's financial position warrants any planning action, and consider the interaction between DB benefits, DC pensions, and personal wealth.

We do not undertake actuarial valuations, but we can connect you with independent actuarial advisers where a detailed professional assessment of a specific scheme's position is required.

Contact us to discuss your defined benefit pension position.