The financial appeal of run-on is clear. Rather than hand over the surplus to an insurance company, continuing the scheme could be a way to recoup some of the investment not just for the company but also to improve the benefits of members.

As Hymans Robertson head of corporate defined benefit (DB) endgame strategy Sachin Patel explains: “More clients are considering the feasibility of run-on than there were a year ago.”

“While this has been the initial appeal of run-on, the rational has evolved. Schemes are thinking about how surpluses could be shared not just with sponsors but also with DB and DC members as well as current employees,” says Patel.

In some cases, employers and trustees have agreed to a run-on framework where no surpluses will be returned to the company but will instead share the benefits with DB and defined contribution (DC) scheme members, he adds.

For example, he says that some trustees who have awarded discretionary increases to members in the past may feel there is an expectation this will happen again.

But in other cases, there might be no history of member increases while large sums have been committed to the scheme by the employer. As a result, the sponsoring company believes it has a right to some or all the surplus return, adds Kitson.

Kitson explains: “We are starting to see the emergence of a model where surpluses are shared between the company, DB members and to top up incremental DC contributions.”

Size matters

Run-on is not, however, suitable for every scheme. Aon head of alternative endgames John Harvey says: “This suits a large, well-funded scheme with a strong sponsor.”

Around 90% of the £1.5trn in defined benefit schemes is held by around 1,000 schemes.

Insight Investment head of solution design Jos Vermeulen says: “If you look at the strength of the sponsors of those 1,000 schemes, the largest ones also have the strongest sponsors.”

In a survey Aon ran of its clients earlier this year, four-fifths of schemes with assets of less than £100m wanted to buyout as soon as they can, says Harvey.

Around 30% of schemes with assets of more than £100m up to a £1bn say they will run-on for a while. For schemes above £1bn, this moves up to around 40%, he adds.

Harvey notes: “Run-on only works if the benefits can be provided in a highly secured way to members which leads you to having a strong sponsor covenant.”

That’s a sponsor covenant which would score on the old regulator scale of ‘tending to strong’ − equivalent to a BB credit rating. “You could go ahead with run-on with a lower rating, but you would need extra forms of support,” he adds.

Is there optimal scheme size for run-on?

Despite the results of Aon’s survey of its clients, there is a range of opinions of what size, if any, is best for run on.

Indeed, while size does often dictate a schemes interest in run-on, this is not always the case, as EY’s Kitson explains: “We have found interest in run-on from a range of different sized schemes and corporates.”

While the smaller funds might generate less overall surplus, if there are also a small number of members this can translate into a significant uplift to benefits can be significant, he adds.

“A small scheme might well be attached to a small employer which would also welcome the benefits of a meaningful surplus gained from run-on,” says Kitson.

Taking these considerations into account, run-on makes sense for schemes which are around £100m to £150m. “Below this amount, the running costs will eat up all of the surpluses which could be generated,” says Kitson.

Capital Cranfield professional trustee Darren Masters agrees: “It is not currently realistic for a scheme of below £100m to consider run on as an alternative to buyout. Some are saying £200m is the cut-off point – but we are yet to determine the perfect size.”

It is, however, more likely that a small company sponsoring a small scheme will have a weaker covenant than a larger one and this needs to be taken into consideration, says Kitson.

“A scheme with a weak covenant is not excluded from run-on, however, they would just need a higher buffer before passing on a surplus or third-party capital which would underwrite this risk for a share of the profits,” he adds.

Insight Investment’s Vermeulen notes: “There is a chance the PPF may act as a public consolidator and just absorb these schemes which are, for example, £100m and smaller.”

DB trauma

Even if a scheme does have these attributes, it is not guaranteed it will want to run-on. “The appetite for run-on depends, in part, on how much DB trauma has been inflicted,” says Aon’s Harvey.

“The last 20 years of private sector DB scheme funding has been a rollercoaster ride with mostly bad news,” adds Masters.

If the last two decades has been a constant demand of cash from the scheme sponsor, volatile accounting deficits and a gyrating value of investments, buyout is a compelling option, says Capital Cranfield’s Masters.

Some companies might also feel run-on would dilute their focus. “The company might decide managing scheme is not a core business and does not want to operate an investment firm,” says Harvey.

“The financial sophistication of the corporate is a relevant consideration – the company might lack the expertise and skills in its Treasury team or finance department,” says Masters.

For overseas business running subsidiaries in the UK, getting to grips with the intricacies and complexities of the pensions system here can be a challenge, he adds.

Those organisations which have had to make large contributions to keep the scheme afloat in the past can be so traumatised by this that they want to get to buyout as soon as possible. “There is a danger, however, of living in the past,” says Harvey.

When the scheme is well-funded, the corporate is no longer paying contributions and unlikely to do so in the future and investment risk is at the right level, the corporate is now in a strong position.

“Clients who were adamant ten years ago they would definitely insure now feel they are in a very different situation,” says Harvey. Some clients are also keen to recoup some of the investment they have made to the pension scheme, he adds.

Cultural attitudes are also an important factor in a company deciding whether to go for buyout or run-on.

“Some schemes want to run-on not because they are motivated financially to do so but for other reasons, such as it being a part of their paternalistic attitude towards their current and previous employees,” says Hymans Robertson’s Patel.

If a scheme does decide to embrace run-on, it needs to be clear about its objectives. “The scheme should be operated as a separate entity which does not require company management time or resource,” says Kitson.

That clarity should encompass which trustees will run the scheme, which outsourced providers will be used as well as when and how the surpluses will be shared and whom will benefit from these profits, he adds.

Democratisation via the PPF

Run-on could be a viable option for many more schemes if the PPF were able to provide protection of all members benefits.

Redington managing director Nick Horsfall says: “This would make it easier for trustees to consider run on as a possibility as there would be an accepted good quality floor for members’ benefits provided by an entity with a very strong financial profile.”

That would make the choice between run-on and buyout a straight decision of whether to hand over the surplus to an insurer or share it between the corporate, scheme members and a levy for the PPF.

Insight Investment’s Vermeulen says: “An earlier government consultation suggested providing an opt-in model of PPF protection to facilitate run-on for more schemes but that voluntary model led to some conservation assumptions which ended up with levy of 0.6%.”

That effectively nixed these plans as this levy was too expensive.

“If, however, you made it a universal rather than opt-in plan – with the proviso that the 100% guarantee would not apply if a scheme took on too much risk – this would lead to a much lower levy,” says Vermeulen.

Making it universal mutualises the risk across the large and small pools, making run-on an option for smaller schemes as their size means they pose limited risk to the whole system.

“If you take these steps and take account of the much lower risk pension schemes are now running, then it would be possible to provide a low, single-digit basis points which is a cost-effective risk premium,” says Vermeulen.

This would not, however, get rid of sponsor covenant to the scheme but it would remove the concern trustees have that unless they buy-out they have not fulfilled their fiduciary duty, he adds.

Charlotte Moore is a freelance journalist