UK: Pensions Crisis - What Employers Can do About Final Salary Schemes

Hardly a week now passes without some reference in the press to the sorry state of British pension provision. Stakeholder pensions have hardly been a great success with 90% of stakeholder schemes offered by employers having no members. At the other end of the spectrum, final salary schemes are closing their doors to new entrants and some employers are considering the abandonment of the final salary concept altogether.

The reason for abandoning final salary can easily be identified – expense. Schemes were established on the expectation that the fund would grow during a member’s life by investment in shares which could be expected to increase in value over the years. Yet over the last three years, and so far this year, share prices have fallen.

When members retired, adequate pensions could be secured by direct investments in ‘gilts’ (government fixed-interest securities) or by purchasing annuities which would be secured by gilts. With interest rates half what they were ten years ago, it follows that the cost of a given income flow is roughly double what it was.

Taken together, the result is deficit in most final salary pension schemes. The position is made worse by legislation introduced in 1992 which forces the employer to make up the deficit, and by new accounting standards which focus attention on the extent of deficit.

The medical profession has done its bit too. Every year life expectancy increases, and with it the duration of the pension to be funded.

Small wonder that employers are asking whether the final salary concept can be abandoned. Arguably, now is the time to change, with employees concerned about unemployment and perhaps more willing (or less unwilling) to accept change.

Extraordinary though it may seem, the best way of eliminating final salary pensions is by a business transfer, provided the transfer can be justified as being for commercial reasons. The reason is that the Transfer of Undertakings (Protection of Employment) Regulations 1981 (‘TUPE’) fail to protect future pension accrual in final salary schemes on a business transfer and the government has not decided how to remedy this. Accrued rights up to the time of transfer remain secured in the transferor’s scheme.

Leaving aside the effect on morale, the concern if an employer withdraws final salary pension rights is the risk of staff alleging constructive unfair dismissal and seeking compensation. On the other hand, there may be ways of withdrawing final salary pension benefits without substantial claims.

First, if staff contracts permit pensions to be withdrawn, there is no breach of contract and no unfair dismissal. Unfortunately, contracts are rarely clear-cut. The power to withdraw may be in the booklet or even buried in the Trust Deed. Has adequate notice been given of the contract term? Quite possibly not. In addition, withdrawal might be a breach of the employer’s duty of trust and confidence, in particular where there is an expectation that the scheme will continue. Therefore, unless your staff contracts are unusually specific, it would be unwise to rely on a contractual power to withdraw pension rights.

A better route would be to assume that pensions are a contractual right, and announce to staff that current contracts will terminate in say six or twelve months’ time and be replaced by new contracts. The long period of notice should mean there is no breach of the existing contract and may take some of the heat out of the change. Staff would not therefore be entitled to walk out alleging unfair dismissal.

Even so, the termination of a contract with notice and the substitution of a new contract with altered pension rights is still a dismissal. So, to minimise claims the new contract would need to provide money purchase benefits actuarially estimated to be equivalent to final salary benefits. Thus there would be no immediate loss to staff and therefore no claim for compensation. However, the employer would avoid further increases in contribution rates if, for example, life expectancy were to increase or stock markets fall. On the other hand, while increases would be avoided, the employer would be locked into the current contribution rates which are fairly high in historical terms.

Possibly the new contract could go further and provide for 1% reductions in pension contributions over a period of years until old final salary scheme members and new entrants to money purchase schemes are treated equally in terms of contributions. This would not entirely eliminate the risk that staff might claim unfair dismissal compensation for the automatic reductions as an Employment Tribunal has looked up to ten years ahead in assessing pension loss. Yet given the uncertainties, staff may well hesitate before taking action. If claims were to be brought, employers would at least know within three months of the new contracts being introduced, and could back-track if needed. Employers would still have made the main switch from final salary and stopped their pension commitments increasing further.

There are other aspects of pension provision change to consider as well as those mentioned in this article, but they do not affect the point that the climate may now be right for the abandonment of final salary schemes.