UK: The Government’s Action Plan for Occupational Pensions

Last Updated: 25 June 2003

The Government published its intentions for reforming the law governing occupational pensions on 11 June, following the end of the December 2002 Green Paper’s consultation period. The Green Paper had been criticised for neither being radical nor concrete enough, particularly when compared to the Inland Revenue’s proposals for simplifying the tax regime for pension schemes. The new action plan seeks to address those criticisms with firm proposals on key issues. Andrew Smith, in the foreword to the action plan, states that "the package of measures strikes a balance between protection for members and easing burdens on companies running schemes."

We provide a brief bullet point summary of the proposals, and discuss the main points in more detail.

THE PROPOSALS TO PROTECT SCHEME MEMBERS

The majority of the Government’s proposals in this area are aimed at protecting members of defined benefit (final salary) schemes, where the scheme has gone into winding up and there are insufficient funds to meet the scheme’s liabilities in full. These proposals are in response to some recent, highly publicised cases of employers triggering a winding up of their under funded pension schemes. An example of this is Maersk, who took over as sponsoring employer of the Sealand Scheme in 1999. Maersk is winding up the scheme, which is fully funded on the Minimum Funding Requirement basis (MFR), but has a £3.5 million deficit on a full buy-out basis. As the scheme is fully funded on the MFR basis, under current legislation, Maersk will not be required to pay anything to the scheme, despite the fact that some member’s benefits could be reduced by as much as 60%.

There are also some important proposed changes to the pension protection given to employees who transfer employment as a result of a sale of a business and proposed changes to the law on the vesting of pension rights.

Protection on the winding up of a defined benefit scheme

The Pensions Protection Fund

The Government intends to set up a mandatory compensation scheme to protect private sector defined benefit scheme members where the employer becomes insolvent with unfunded liabilities in their pension scheme. The Government has paid particular attention to the experience in the US of running a pension compensation scheme in formulating its proposals.

Under the proposals, employers with defined benefits schemes will pay a flat-rate levy to the Protection Fund. Employers with under-funded schemes will have to pay an additional "risk-based" premium. Details on what basis such under-funding will be calculated are not included in the proposals, but could effectively become a default funding basis. It is also unclear whether the risk-based premium will take account of the financial strength of the employer concerned. If the US model is to be followed, then it seems unlikely that this will be the case.

The Protection Fund will pay:

  • a maximum of 100% of pensions in payment; and
  • 90% of the benefits of non-pensioners. The proposals do not state whether these maximum benefits will include increases to pensions in payment. Furthermore, the salary of high earners will be capped at between £40,000 and £60,000 for the purposes of calculating any entitlement payable from the compensation scheme.

It is not clear who will bear the ultimate risk if the Protection Fund itself gets into funding difficulties: the Government is silent on this in the action plan, but has stated (in its response to the Work and Pension Select Committee report) that it did not intend to act as the ultimate guarantor of such a scheme. This has been an issue in the US, where the Pension Benefit Guaranty Corporation’s (PBGC) deficit is substantial. It is understood, though not stated, that Congress would ultimately underwrite the compensation scheme. We have summarised some of the key characteristics of the PBGC in this briefing.

We have also provided a summary of the Financial Services Compensation Scheme set up in December 2001, which provides another possible model.

Solvent employers

The Government is proposing that where a scheme is being wound up and the employer is not in liquidation, any debt on the employer (resulting from the scheme being under-funded) will be calculated by reference to the cost of buying out all benefits in full with an insurance company.

Currently, solvent employers are only required to provide non-pensioner members with the cash equivalent transfer value of their benefits, calculated by reference to the Minimum Funding Requirement. This amount could fall substantially short of the actual cost of replicating the pension that would have been provided by the scheme. The Government has already introduced, in March last year, a requirement that the actual costs of providing annuities for pensioner members must be included in calculating any debt on the employer.

Draft Regulations setting out the new requirements were issued alongside the action plan. The Government intends to bring the Regulations into force later on this summer. As currently drafted, the new requirement will apply to schemes that have commenced winding up on or after 11 June 2003. Schemes that commenced winding up before that date will not be affected.

The action plan states that trustees will be able to agree a lower sum from the employer if the increased debt would put the employer at risk of insolvency and states that trustees will have to have regard to their fiduciary duties before exercising this power. This trustee power is not set out in the draft Regulations: presumably the Government is intending that trustees can rely on the principle established in Bradstock Group Pension Scheme Trustees Ltd v Bradstock Group Plc (2002) that trustees can compromise or otherwise deal with a statutory debt due to the scheme from the employer, where it is in the best financial interests of the beneficiaries to do so. Although the effect on the employer’s business may be a relevant factor, trustees will also have to bear in mind that their beneficiaries will include former, as well as current, employees.

It appears from the draft Regulations that the proposed new funding obligation on the employer will apply even where the trustees have the power to trigger the winding up. There will be cases where trustees have that power, and the Government also intends to give trustees the power to wind up the scheme where the employer contribution levels cannot be agreed (discussed later on in this briefing). Trustees will need to consider whether it would be in the best interests of the members to trigger a winding up in these circumstances.

A further issue is that "insolvent" in the draft regulations merely means that a company has entered into liquidation, including a members’ voluntary liquidation, where the company would not need to be insolvent at all.

Changes to the priority order

In advance of the Protection Fund being put in place, Regulations will require that where there are insufficient assets to meet all liabilities on the winding up of a defined benefit scheme, the assets are shared out "as fairly as possible between active and pensioner scheme members". Draft Regulations will be issued for consultation this summer, and the Government expects to bring them into force in the Autumn.

The degree of protection provided for non–pensioner members on a winding up will reflect the length of time a member has been contributing to the scheme, i.e. those who have been in pensionable service for the longest will receive the greatest protection.

Priority will also be given to the rights of non-pensioner members over the future indexation of pensions in payment. This requirement was due to be introduced with effect from 6 April 2007, in any event.

The Government has not stated the date from which the new priority order will apply. Presumably it could not be made to apply to schemes already in winding up, although it is possible that they will back date the change to schemes commencing winding up on or after 11 June.

Other protection for occupational pension scheme members

Other measures put forward by the Government include:

New statutory trustee duty

Legislation will be introduced that will require trustees to be familiar with the issues or have the relevant knowledge across the full range of their responsibilities, not just their investment duties, as previously proposed in the Myners Report.

The new Pensions Regulator will provide guidance in the form of a Code of Practice setting out how trustees will satisfy this requirement: it is likely to encompass training, qualifications and experience.

Extension of TUPE Regulations

The Government is intending to provide protection for employees who benefit from employer contributions to a pension scheme prior to a TUPE transfer occurring. Currently the TUPE Regulations exclude any obligation to provide old age, invalidity and survivors’ benefits under an occupational pension scheme from being automatically transferred to a purchaser.

Where the seller of the business contributes to an occupational pension scheme (whether defined contribution or defined benefit) in respect of the transferring employees, then the Government is proposing that the new employer will also be required to contribute to a pension scheme. The new employer will be required to match employee contributions up to a maximum of 6% of salary to a stakeholder scheme.

Extended protection for early leavers

Currently pension rights do not have to vest until an employee has been a member of a scheme for 2 years. If an employee leaves during that period then they will be entitled to a refund of their contributions (less tax). The Green Paper proposed that pension rights should vest immediately, but this idea has been abandoned. Instead, the Government is proposing that employees who have been scheme members for at least three months, but who leave during the vesting period, will have to be offered the choice of a refund of contributions (less tax) or a cash equivalent transfer value.

The action plan does not state whether trustees will have the power to transfer the cash equivalent transfer value to a stakeholder scheme without the member’s consent, in the event that the member does not specify their choice of receiving scheme.

Restriction on return of surplus to employers

The Government will restrict the ability of companies to take money out of a scheme which is in surplus on its own funding basis, unless the scheme is funded to a level sufficient to allow for the full buy-out of all benefits. This is consistent with the new proposal for solvent employers to guarantee benefits on a full buy-out basis on a winding up.

A new pensions regulator and new codes of practice

The new regulator, to replace Opra, will focus on tackling fraud, bad governance and poor administration, and will encourage best practice through an increased education and guidance role. The Government wants to move the regulator away from monitoring and penalising minor breaches of regulation, and become more risk orientated.

The Government also intends to restructure and simplify pensions legislation. Legislation will, where appropriate, be accompanied by "Codes of Practice" rather than detailed Regulations. The Codes of Practice would be issued by the Regulator. Only breaches of the legislation would be sanctionable, although the Codes would have evidential value in determining whether a breach of the legislative provision had occurred.

PROPOSALS TO SIMPLIFY PENSION PROVISION

The Government’s aim is to simplify and enable greater flexibility in pension provision. It remains to be seen how effective the proposals will be at encouraging occupational pension provision. It is a widely held view that the Government will need to introduce further measures such as additional tax incentives or compulsory pension provision if this aim is to be achieved.

The key proposals set out in the action plan are the reduction in the LPI cap for pensions in payment from 5% to 2.5%, the continued commitment to replacing the MFR and a weakening of the statutory restriction on amending occupational pension schemes.

Further details on scheme specific funding

Details of the proposed scheme specific funding requirement, to replace the minimum funding requirement, were set out in the Green Paper. These have been confirmed in the action plan as follows:

  • Scheme trustees will be required to draw up a Statement of Funding Principles.
  • Trustees will be required to obtain a full actuarial valuation of their scheme at least every three years.
  • Following the valuation, the trustees will be required to put a schedule of contributions in place.
  • Where trustees and employers cannot reach agreement on issues fundamental to the funding of the scheme, the trustees will have the power, as a last resort, to freeze or wind up the scheme.
  • Trustees will be required to send information about the funding of the scheme to scheme members each year.
  • The scheme actuary’s duty of care to scheme members will be clarified.

The Government, in due course, will also have to implement the EU Directive on the activities and supervision of institutions for occupational retirement provision which covers scheme funding, and it is not clear whether the requirements of the Directive and the Government’s proposals for a scheme specific funding standard are entirely consistent.

It appears that the proposed new funding obligations on a solvent employer discussed earlier in this briefing, will apply even where the trustees trigger the winding up following a disagreement with the employer over funding levels. This will substantially increase trustees’ bargaining position over employer contribution rates.

Changes to the indexation requirements

The Government will reduce the 5% LPI cap introduced by the Pensions Act 1995, to 2.5%. This means that employers will have to increase pensions in payment, relating to service from the date of the change, by the annual increase in the retail prices index, up to a maximum of 2.5%.

The proposed change will make the LPI cap applicable to pension increases inconsistent with the statutory revaluation of deferred pensions, which, it seems, will remain capped at 5%.

Changes to the restriction on amending schemes and a requirement to consult

The Government intends to amend the restriction in section 67 of the Pensions Act 1995. Section 67 prevents changes being made to the rules of an occupational pension scheme that would reduce a member’s accrued pension rights without the member’s consent. However, the Government intends to introduce a new requirement to consult with employees about changes.

Under the proposals, schemes will be able to be amended, even if the amendment affects members’ accrued rights if:

  • There is power in the scheme rules to make the change.
  • The change does not involve converting defined benefit rights into defined contribution rights.
  • The trustees approve the change.
  • The total actuarial value of the members’ accrued rights at the point of any change is maintained.
  • Pensions in payment are not reduced.
  • Members are consulted before the change is made.

This will make it easier for employers to simplify scheme benefit structures. For example, the power could be used to allow the scheme to increase all pensions in payment post April 1997 in line with the reduced LPI cap, as long as the total actuarial value of the members’ accrued rights at the point of change is maintained. It could also facilitate redesigning a scheme’s benefit structure, for example from final salary to career average, although clearly the Government intends to prevent any relaxation in section 67 requirements being used to convert from defined benefit to defined contribution.

Employers will be required to consult with scheme members before making changes to pension schemes. The action plan does not give details of whether this duty to consult will extend to pensioner or deferred members where their benefits will be affected by the proposed change.

Further details of the proposed new requirement to consult are likely to be given by the Government when it publishes its consultation on how to implement the EU Information and Consultation Directive. This Directive requires that information and consultation has to take place at an appropriate time and at the relevant level of management. Normally it will be done via employee representatives, defined according to national law and practice. The representatives, having received the appropriate information, may meet the employer, present their opinion and receive a reasoned response.

Depending on how the Directive is implemented, the consultation process may potentially make it more onerous for employers to introduce changes to scheme benefits.

Member-nominated trustees

As set out in the Green Paper, the Government has confirmed that it intends to legislate that schemes should have at least one-third member-nominated trustees, but it does not intend to prescribe in legislation how schemes must arrive at that outcome. There is likely to be a Code of Practice on the procedure for selecting member-nominated trustees.

Additional voluntary contributions

The Government intends to simplify the tax rules to allow occupational schemes to choose whether or not to offer arrangements for additional voluntary contributions. Currently the Government requires occupational pension schemes to provide an AVC facility.

Contracting-out

The Government is continuing to explore options on the simplification of the administration of guaranteed minimum pensions.

However, the Government has confirmed that it will proceed with some of the simplification proposals put forward in the Green Paper, including:

  • A relaxation of restrictions on contracted-out rights forming part of the tax free lump sum; and
  • A relaxation of restrictions preventing contracted-out rights being paid at the same time as other benefits.

The action plan is silent on whether the Government intends to reform the reference scheme test, although it does state that it does not intend to remove the requirement to provide a spouse’s benefit, as proposed in the Pickering Report.

Further simplification

The Government has stated that it also intends to:

  • Rationalise the way schemes communicate with members;
  • Simplify the internal dispute resolution procedure rules;
  • Clarify the jurisdiction of the Pensions Ombudsman so that cases of maladministration by a pension scheme falls clearly within his remit;
  • Simplify the treatment of pensions on divorce by abolishing safeguarded rights and aligning normal benefit age.

ADDITIONAL PROPOSALS

Flexible retirement

The Government has again stated that it intends to maintain the State Pension Age at 65. It has also confirmed that it intends to introduce new flexibility to tax rules to promote flexible retirement allowing employees to carry on working while drawing a pension. It also intends to increase the earliest age from which a pension may be taken from age 50 to age 55 by 2010. The Government has also stated that it intends to raise the normal pension age in public service schemes.

Member information

The Government will legislate to require defined benefit schemes to issue annual benefit statements showing both the amount of pension a member has built up and the likely amount that they will receive when they retire.

Implementation

Even though this is the second time many of the proposals have been put forward by the Government, they are still fairly broad brush: further clarification and detail will be required. The Government is aiming to introduce the reforms in the main with effect from April 2005, in line with the new proposed implementation date for the simplification of the pensions tax regime. However, Regulations amending the employer debt requirements are likely to come into force later on in the summer, and will apply to schemes winding up at that date, but not those that commenced winding up before 11 June 2003. Regulations changing the priority order on a winding up are likely to be issued this Autumn.

Summary of the action plan

The main proposed changes are to:

  • introduce a new pensions protection fund which would guarantee members a specified minimum level of pension when the sponsoring employer becomes insolvent
  • require solvent employers who choose to wind up their pension schemes to meet their pension promise in full
  • revise the priority order for the distribution of assets on a winding up, to give better protection to non-pensioner members
  • introduce a statutory duty for trustees to be familiar with relevant issues
  • provide pension protection on TUPE transfers
  • provide extended protection for scheme members who leave during the vesting period
  • introduce a new pensions regulator to focus on fraud and bad governance
  • simplify section 67 of the Pensions Act 1995 and introduce a requirement for employers to consult before making changes to a pension scheme
  • reduce the LPI cap for increases to pensions in payment from 5% to 2.5%

Further details are also provided in the action plan on the scheme specific funding proposals to replace the statutory minimum funding requirement and the simplification of contracting out of the state second tier pension.

The US Pension Benefit Guaranty Corporation (PBGC)

PBGC is a federal agency created by the Employee Retirement Income Security Act 1974. It provides insurance for pensions in payment and accrued benefits where a defined benefit pension scheme has inadequate funds to pay benefits on a winding up.

In order for a scheme to call upon PBGC, the sponsoring employer has to be insolvent or it has to prove to the bankruptcy court or to PBGC that it would become insolvent if it were required properly to fund its pension scheme.

Where PBGC is called on to guarantee benefits, it will take over the running of the pension scheme, as trustee, and pay benefits, up to the legal limits, using scheme assets and PBGC’s guarantee.

The benefits guaranteed by PBGC are currently limited to $43,977.24 per annum for a single life annuity at age 65. The guaranteed amount is lower where a member receives benefits before age 65. The guaranteed amount does not take account of increases in the cost of living.

The costs of PBGC are met by an annual levy of $19 per pension scheme member. Under-funded schemes make a further payment of $9 per $1,000 under-funded, based on a standard basis. There are detailed Regulations to prevent companies "dumping" their under-funded schemes on PBGC, and these are currently being tightened.

There is no explicit Government financial backing for PBGC, which currently has a substantial deficit, but there is an implicit understanding that Congress would bail out PBGC if necessary (Congress sets the premium rates).

PBGC’s current funding difficulties have been worsened by the termination of the four LTV pension plans with a deficit of over $2 billion, and 80,000 members.

The UK Financial Services Compensation Scheme

The Scheme was set up in December 2001 by the Financial Services and Markets Act 2000. It provides compensation, for example, for holders of insurance policies where an insurance company is in such serious financial difficulties that it may not be able to honour its contracts of insurance. The Scheme is independent of the Financial Services Authority, but accountable to it as required by legislation.

The scheme may assist by providing financial assistance to the insurers concerned, by transferring policies to another insurer, or by paying compensation to eligible policyholders.

The level of compensation paid from the Scheme differs for different types of financial product. For life assurance policies, the scheme pays the first £2,000 and thereafter 90% of the remaining loss to the policyholder.

The scheme is funded by levies on participating firms. The levy is aimed at funding the setting up and administrative costs of the Scheme, as well as the compensation payments. Both levies are subject to maximum limits.

The amount levied for compensation is an estimate of the compensation costs the scheme expects to pay in the twelve months following the levy date.

The Scheme is set up as a private company, limited by guarantee, and is not underwritten by the Government.

© Herbert Smith 2003

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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