UK: The Legal Implications of Final Salary Scheme Deficits & the Move Away From Final Salary Provision

Last Updated: 31 March 2002

The publication of the annual NAPF survey for 2001 triggered a series of articles in both the national and pensions press on the move away from final salary to money purchase provision by employers. The survey found that out of 800 of the UK’s major employers, 46 had closed their final salary schemes to new entrants, compared to 18 in the previous year. Thirteen employers had switched from providing a final salary scheme to providing a money purchase scheme and a further seven had switched from a final salary scheme to a group personal pension plan.

The reasons for the move away from final salary to money purchase provision have been the subject of much discussion. In summary, increased costs have combined with longer life expectancy and decreased investment returns to reduce the funding levels in many schemes. The effect of the Pensions Act 1995 has also created a regulatory burden for schemes, not least in respect of compliance with the minimum funding requirement. The attraction of the fixed and certain costs of money purchase provision, as opposed to the variable and unknown costs associated with final salary schemes, is easy to understand. Furthermore, under the new accounting standard FRS17, a pension scheme’s surplus or deficit has to be reflected in the sponsoring employer’s balance sheet, which means greater transparency, but also greater volatility in the company accounts.

In this briefing we discuss some of the legal implications surrounding these issues, in particular:

  • The options for dealing with a funding deficit; and
  • Restructuring employees’ pension arrangements.

Dealing with a funding deficit in a final salary scheme

After the pension scheme surpluses of the 1980s and 1990s, many sponsoring employers and trustees are now finding that their schemes are in deficit, and are having to consider for the first time the effect of the funding deficit provisions that were brought into force under the Pensions Act 1995. We discuss below what the legal position is on pension scheme deficits, including recent changes.

Every three years (or more frequently if the scheme rules provide) the scheme actuary has to provide a full actuarial valuation of the fund. The valuation must be signed by the scheme actuary within one year of the effective date of the valuation. The trustees and the employer then have eight weeks from the date that the valuation was signed in which to reach agreement on the future level of employer contributions. Failing agreement, the trustees must decide an appropriate contribution rate, within the following four weeks, to ensure that the statutory minimum funding requirement (MFR) is met. The level of contributions over and above those required to meet the MFR will depend on the provisions of the scheme rules, which will usually provide that either the employer, the trustees and/or the actuary determines what additional contributions are required by the employer.

The amount and rates of the contributions are then set out in the scheme’s schedule of contributions. The actuary has to certify that the rates set out in the schedule are adequate. Where the scheme is fully funded, adequate means that the contributions should maintain full funding on the minimum funding requirement (MFR) basis throughout the period covered by the schedule. If the scheme is in deficit on an MFR basis, then adequate means that the contributions should be sufficient to bring the scheme up to the fully funded level by the end of the schedule period. The schedule period is 10 years where the scheme is under funded on the MFR basis either at the valuation date or the date that the actuary certifies the schedule of contributions. Prior to 19 March this year the schedule period was five years, or 5 April 2007 if later.

Different provisions apply where the scheme is less than 90% funded on the MFR basis (a serious shortfall). An employer may either secure the shortfall by making additional contributions to the scheme or follow a prescribed method which guarantees that the serious shortfall (ie the amount that the funding level falls below 90%) will be met in the event of the employer’s insolvency or if the scheme were to be wound up. A combination of these methods can be used.

Under the additional contributions method, payments totalling the serious shortfall must be made within three years of the date that the scheme actuary signs the minimum funding valuation. Prior to 19 March, this was one year, or 5 April 2003 if later. The payments can be made on a regular or one off basis. Under the prescribed method, the outstanding balance of the serious shortfall would be secured either by means of the relevant sum being paid into a designated escrow account, a letter of credit in favour of the trustees being put in place for the relevant amount or by granting the trustees a charge over unencumbered assets.

Changes to the position on funding

The Government intends to replace the MFR with a long-term, scheme specific, funding standard. Implementing these changes will require primary legislation and the Government is consulting further on this.

This means that eventually the "one size fits all" nature of the MFR will be replaced with funding and investment objectives that are linked to a scheme’s own liability structure rather than to some external benchmark.

In the meantime, the Government has introduced short-term amendments to the MFR regime with effect from 19 March 2002 (contained in the Occupational Pension Schemes (Minimum Funding Requirement and Miscellaneous Amendments) Regulations 2002). These amendments include:

1 The extension of the deficit correction periods as follows from 19 March 2002:

a seriously under-funded schemes have three years to bring the funding levels up to 90% on the MFR basis: previously the deficit correction period was one year or 5 April 2003 if later;

b under-funded schemes (including seriously under-funded schemes) must be brought up to 100% MFR funding within 10 years: previously the deficit correction period was five years or 5 April 2007 if later.

2 Previously trustees had to ensure that the scheme actuary recertified the schedule of contributions as adequate on an annual basis. From 19 March this requirement is removed for schemes that are over 100% funded on the MFR basis.

In line with a recommendation from the Faculty and Institute of Actuaries, the Government has also approved a change to the MFR equity Market Value Adjustment. With effect from 7 March, the level of the central dividend yield used to determine the Market Value Adjustments for the purposes of calculating the MFR is reduced from 3.25% to 3%.

There have also been changes to the debt on the employer regulations on a winding up which are described later on in this briefing.

Opra’s powers

It is worth noting that the Occupational Pensions Regulatory Authority (Opra) has the power to grant, on request, an extension to the normal time allowed for making up an MFR shortfall. When applying for an MFR extension, the employer will need to satisfy Opra that:

1 the grounds for an extension exist (Opra give the examples of the under-performance of certain assets compared to the MFR indices, loss through fraud, or an increase of liabilities not under the employer’s control);

2 the employer’s business is likely to continue to operate; and

3 to correct the deficit within normal MFR timescales would have a significant adverse impact on the employer’s profitability.

Since 1997, Opra has had only 15 applications for an extension, only three of which have so far been considered by the Opra board, and only one of which has been granted. However, Opra have stated that if they receive large numbers of applications for extensions to the time limits for complying with the MFR, they may exercise their power to grant extensions to any scheme that meets certain conditions defined by Opra. They have also announced that they may decide to grant extensions without insisting on all the documents, information and evidence that would normally be required. However, Opra stresses that these steps will not result in a"blanket" exemption: schemes will still have to apply for an exemption. Opra has not yet introduced these powers and, in any event, these powers have been overtaken to some extent by the amendments extending the deficit correction periods.

The employer’s options in relation to reducing the costs of final salary provision

Those employers who currently sponsor a final salary scheme may be seeking ways to reduce the cost of providing pension benefits to their employees for the future. There are various steps that the employer can take, for example:

1 Close the final salary scheme to new entrants and switch to money purchase provision for new employees;

2 Reduce benefits for future service and/or increase members’ contributions;

3 Close the final salary scheme to future accrual and switch to money purchase provision for future service for all employees;

4 Wind up the existing final salary scheme.

Whatever options the employer decides to take, effective member communication will be an important part of the exercise. Employers will need to be careful that they do not make any statements about future benefit levels that could either be construed as forming the basis of a contract between the member and the employer or that could form the basis of a claim for negligent misrepresentation. There have been two recent cases on communications with members: Moores (Wallisdown) Limited v. Pensions Ombudsman and Hagen v. ICI. Moores (Wallisdown) Limited v. Pensions Ombudsman related to the closure of a final salary scheme and its replacement with a money purchase scheme. Members were told in a letter that the aim of the new scheme was to provide the same level of pension as that provided under the final salary scheme, although this was stated as "not being guaranteed". The judge held that there was not a binding promise as to the benefits to be provided under the new scheme. In Hagen v. ICI, the judge held that ICI had breached its duty of care in making statements to employees, by negligently misstating the position in relation to pension benefits on a business transfer.

1. Closing the final salary scheme to new members and switching to money purchase provision for new employees

The employer could decide to close the scheme to future members but continue to pay contributions to allow existing members to keep accruing benefits on a final salary basis. A final salary element would remain, and with it the potential for an open ended commitment for the employer, albeit that the scale of that commitment will be reduced.

One issue to bear in mind here is whether to allow those employees who have not yet joined the scheme but are waiting to do so to become members. This point will arise if the scheme’s eligibility provisions provide that employees can only join the scheme after having been in employment for a certain period of time, for example, after 12 months. Whether these employees have to be admitted to the final salary scheme will depend on the terms of the employees’ contract and what they were told at the time of joining the company, and employers will need to take advice on this as the employee may be able to establish breach of contract or misrepresentation. In order to avoid any claims it would be safer for the employer to allow all such employees to join the scheme.

Where employers have decided to switch to money purchase provision for new employees, they will have to consider whether to do this via an occupational pension scheme or contribute to a personal pension scheme or set up a stakeholder scheme. Under law, employers are only required to provide access to a registered stakeholder scheme, unless they or all of their employees are exempt (if you would like to be sent further details of stakeholder provision then please e-mail Olivia Steven at olivia.steven@herbertsmith.com).

Some employers have chosen to provide access to a stakeholder scheme for new employees, to which the employer contributes either a set percentage, or matches employee contributions up to a specified amount. The individual stakeholder or personal pension arrangement will "belong" to the employee and the only duty that the employer will have in relation to it is to contribute to it at the contractual rate and comply with the statutory time limits and record keeping requirements in respect of paying contributions to the pension provider.

Alternatively, the employer may seek to continue to provide occupational pension benefits for its employees, but in the form of a money purchase arrangement (under a money purchase scheme the employer is only required to contribute at the rate specified in the scheme’s documentation, and meet the cost of running the scheme, if the scheme’s rules so provide). In this case the employer will either seek to set up a separate money purchase scheme, or amend the existing final salary scheme by introducing a new money purchase section into it.

If the employer wishes to set up a new money purchase scheme, it will need to ensure that it has allowed sufficient time to have the scheme rules drafted, Inland Revenue approval obtained and have followed the contracting-out requirements, where appropriate. It will also be necessary to ensure compliance with the applicable Pensions Act 1995 requirements within the specified time limits, for example the member-nominated trustee and internal dispute resolution procedure requirements.

Another possibility is to amend the existing final salary scheme to allow for a new section providing money purchase benefits.

One potential benefit for the employer here is that if the final salary section ever went into surplus, such a surplus could be used to fund the employer’s contributions in the money purchase section, as long as the trust deed and rules of the scheme were appropriately worded. One scheme, as opposed to two schemes, will also have administrative savings, for example only one board of trustees will be required as opposed to two. Trustees will have to carefully consider their fiduciary duties in agreeing to any proposed amendment to the final salary scheme’s trust deed and rules to allow for the introduction of a money purchase section. Trustees may need to take independent legal advice, and will need to be satisfied that they have acted in the members’ best interests, particularly if the final salary scheme has a surplus and it is proposed to allow the surplus to be used to offset the employer’s liability to pay contributions to the new moneypurchase section.

2. Reducing accrual and/or increasing member contributions

Employers could consider maintaining the final salary promise, but reduce the cost of final salary provision by either increasing employee contribution rates or reducing future accrual rates, eg from sixtieths to eightieths of pensionable pay. This will involve making an amendment to the scheme. The scheme’s power of amendment, and any restrictions contained in it, will have to be carefully considered.

Under section 67 of the Pension Act 1995 an amendment that adversely affects scheme members’ accrued rights cannot be made without the members’ consents: any reduction in accrual without member consent has to be limited to future service.

Where the employer is considering reducing accrual or increasing member contributions, the following considerations will need to be taken into account:

a The employer will need to check that no members have contractual guarantees in respect of the level of benefit to be provided. If they do then their consent will be required to vary their contract of employment. Likewise, if the member’s contract states that they will contribute to the scheme at a specific rate then the member’s consent will be required to any alteration in that rate.

b Even if there are no express terms in the employee’s contract, an adverse change to the employee’s pension benefits that is made unilaterally could amount to a breach of the employer’s implied duty of good faith towards its employees. In the context of pensions, this duty has been applied to employers in relation to the exercise of their powers under the pension scheme. Essentially it prevents employers from using their powers and discretions under schemes in an improper way. Recent cases have confirmed, however, that employers can take into account their own interests (including financial and commercial interests) when exercising discretions and powers under pension schemes without breaching this duty. In any event, it would usually be advisable for employers to consult with affected employees, and, if appropriate, recognised trade unions, well in advance of the implementation of any changes to avoid any possible claims for breach of the duty of good faith or constructive dismissal.

c Employers will need to check the wording of the scheme application form to determine whether the employee agreed to a flexible or fixed contribution rate at the time of joining the scheme. If the employee consented to a fixed contribution rate only, and then the employer deducts pension contributions at a higher rate than that agreed, the employer could be making unlawful deductions from the employee’s wages under section 13 of the Employment Rights Act 1996. In such circumstances it would be necessary to obtain the employee’s written agreement to deduct the higher rate of contribution from pay. If the employee refuses to consent in writing to the higher contributions then it may be possible for the employee to be treated as having elected to leave the scheme.

d In situations where their consent is required to a scheme amendment, trustees will need to consider very carefully their fiduciary duties before agreeing to the employer’s proposals. Trustees will need to take independent legal advice, and will need to be satisfied that they have acted in the members’ best interests. Acting in the members’ best interests does not mean refusing all the employer’s proposals on the basis that the members’ future pension accrual may be reduced. Trustees may take the view that the level of benefits for future service is primarily a matter between the employer and its employees, to be agreed as a part of the employment relationship.

e A further issue where the employer is reducing the accrual rate for future service is whether to maintain the link to final salary for the purposes of calculating the benefit in respect of service to the date of the amendment.

3. Closing the final salary scheme to future accrual and switching to money purchase provision for all employees

An employer could either exercise an existing power or seek to amend the scheme (if there is no existing power) to stop future accrual under the scheme, while retaining the liability in respect of accrued rights. The employer would continue to be liable to make contributions to the scheme in respect of accrued rights and would still have to correct any funding deficiency within the statutory time limits. The final salary promise would not continue for future service, thus containing the employer’s funding commitment. There may also be contractual issues here in respect of existing members of the final salary scheme, and the points made in section 2 above will apply.

The employer would have the options discussed in section 1 in relation to providing money purchase benefits for future accrual, including seeking to amend the existing scheme to introduce a money purchase section.The employer may also want to consider encouraging members of the final salary scheme/section to transfer their past service entitlement to the money purchase scheme/section by offering them an enhanced transfer value.

4. Winding up the final salary scheme

The employer could decide to remove the final salary commitment by terminating its liability to contribute to the scheme altogether. The wording of the relevant provisions in the scheme’s trust deed and rules will need to be carefully considered. In most schemes an employer exercising its right to terminate contributions will trigger an immediate winding up, unless the trustees exercise the power to continue the scheme as a closed scheme indefinitely.

If the trustees decide to wind up the scheme, or a winding up has been automatically triggered, the trustees will have to realise the scheme’s assets and apply them in accordance with the requirements of the law and the scheme’s rules. Under the Pensions Act 1995, the trustees can require the sponsoring employer to make up any funding shortfall on a winding up to the extent that the funding has fallen below the MFR. Trustees have the power to set the date on which this debt crystallises.

On a winding up members could be offered a transfer of their accrued benefits to any new money purchase arrangement that the employer may provide (as discussed in section 1 above), or members could opt to transfer the benefit to an individual personal pension of their choice. The employer may also want to consider paying for enhanced transfer values to any new money purchase scheme set up by it.

Usually the default option, if the member does not opt to take a transfer, is that the benefits must be bought out with an annuity policy. Annuity policies are expensive, which means that a scheme may find itself in deficit on a winding up even though it has met the MFR.

Furthermore, the recent regulations amending the MFR, which are effective from 19 March, provide for stricter conditions for calculating the "debt on the employer" on a voluntary wind up than those that previously applied. The new conditions are that the costs of the winding up and the actual costs of providing annuities for pensioner members must be included for the purposes of calculating any debt on the sponsoring employers. However, the increase to any potential debt resulting from the increased cost of purchasing annuities will be off set, at least to some extent, by the reduction in the dividend yield assumption from 3.25% to 3%, mentioned earlier in this briefing.

The recent New Zealand case of McClelland v. Unisys New Zealand Limited should also be noted. In this case the trustees had the power to determine the employer contribution rates to the final salary scheme. The scheme was in deficit when the employer gave one month’s notice that it was going to terminate its contributions to the scheme. Winding up automatically followed a cessation of employer contributions. The trustees required Unisys to make up the NZ$1.9 million deficit that had led to the notice from Unisys. The actuary told the trustees that a further NZ$1 million would be needed to fund the accrued benefits. The judge held that the trustees had the power to require Unisys to contribute to make up the deficit in full (including the additional NZ$1 million) even after the notice to terminate contributions had been given.

Are there any other options?

On the whole final salary schemes cost more because they provide a more valuable, risk free benefit to the employee. Many employers have sought to reduce costs rather than simply limit their exposure when changing the pension provision, which can only mean lower benefits for scheme members. A widespread move by employers away from final salary provision to money purchase provision could therefore add to the problem of inadequate pension provision. However, the employer clearly needs to take account of the costs and risks of an open-ended final salary commitment.

Some commentators have put forward a third option: a "career average salary" scheme or hybrid scheme. Under such a scheme the member would accrue a pension benefit that would be a fraction, for example one eightieth, of his total gross earnings each year. That benefit would then be revalued by the retail prices index up to retirement age. For example, if a member is in a scheme for twenty years then one eightieth will be earned in each of those years and at retirement each of those eightieths will be revalued up to the retirement date. This type of scheme could be combined with a money purchase underpin. For example, the employer could pay a fixed amount into the scheme, with the contributions increasing with age. Any surplus would belong to the members and would provide additional money purchase benefits.

Developing a new scheme design will be complex and input from experts at an early stage will be essential. However, we think that it is important to be aware that there are other possibilities that do not necessarily fit neatly into the final salary/money purchase dichotomy.

© Herbert Smith 2002

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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