UK employers continue to move away from providing defined benefit pensions as liability reduction and de-risking exercises remain high up the agenda. A multitude of reasons exist for this trend, including the increasing cost to sponsoring companies of providing final salary benefits, increases in pension scheme underfunding coupled with greater employer contributions, the high level of uncertainty brought by a triennial revaluation using actuarial assumptions dependent on events outside the company’s control, such as mortality rates, and changes to accounting treatment and disclosure.
There are various options for employers looking to change or alter a defined benefit occupational pension scheme. At the most fundamental level, they may close the scheme, often providing a money purchase scheme for future pension provision. Alternative options include keeping the scheme open but altering the rate of accrual of benefits, replacing final salary benefits with career average or cash balance benefits, or increasing the rate of members’ contributions towards the scheme.
Future Pension Provision and Moving to Defined Contribution Arrangements
When proposing a move away from defined benefit pension provision, employers need to decide what to provide for their employees in relation to future service. Minimum statutory requirements set the pension provision which employers must offer all employees. At present, the Welfare Reform and Pensions Act 1999 requires that an employer designates a stakeholder arrangement. However, subject to potential political intervention, from 2012, under the Pensions Act 2008 and supporting legislation, employers will have an individual staging date from which they will need to automatically enrol eligible jobholders as active members of a qualifying scheme or the National Employment Savings Trust (NEST). Where a company has previously made defined benefit pension provision, typically a more substantive future pension provision than the statutory minimum will need to be offered.
Some major employers have caused headlines after deciding to close their defined benefit schemes completely, and offer defined contribution arrangements for future pension provision. When taking such a step, employers must decide whether the defined contribution arrangement will be an occupational or personal (contract-based) scheme, what the level of employer and employee contributions will be, as well as obtaining trustee consent (where required) to the closure of a defined benefit scheme to future accrual (see “Fiduciary Duties of the Trustees” below).
Pensions Law Issues
The company and the trustees need to consider the powers under the scheme trust documents, which may need to be exercised when implementing the restructuring proposal, and also any possible consequences which the proposal (typically termination of future accrual) may have under the scheme provisions and relevant legislation.
Amendment Power: Pension Scheme Rules and Statutory Restrictions
Closing a pension scheme to future accrual is typically achieved by amending the scheme rules. The ability to exercise the power of amendment may rest solely with the principal employer or the trustees, or with both parties jointly. When exercising scheme powers, it is always advisable to act precisely in accordance with those powers. In the context of a restructuring proposal, of particular concern would be any restrictions stated in the trust documents upon amendments which adversely affect members’ pension rights, and could therefore impact on the proposal.
This issue was considered in the case of Re Courage Group’s Pension Schemes ( 1 WLR 495). Looking at a restriction which stated that an amendment must not “reduce… the accrued pension of any employed member”, Mr Justice Millett decided that the “ordinary” meaning to be given to these words meant that the linkage of benefit earned by past service to final salary needed to be preserved. It follows that where, at least based on Courage, there is a Courage-type restriction upon the amendment power, future accrual can be terminated but the final salary linkage in relation to benefits for past service must be maintained.
An example of a more severe restriction came in the case of Lloyds Bank Pension Trust Corporation Limited v. Lloyds Bank Plc ( PLR 263). The restriction in the amendment power which was not limited by reference to benefits accrued up to the date of the proposed change, was found by the court to prohibit any change to past or future benefit (that is, that no amendment could be made which would stop future defined benefit accrual).
Considering these cases, a company should thoroughly check the scheme trust documents for any restrictions that mention “accrued rights” (or a similar term) in the context of amendments. Furthermore, the statutory protection for members’ subsisting rights under Section 67 of the Pensions Act 1995 (amended by the Pensions Act 2004) requires some thought. While Section 67 may not be relevant to the proposal, even where the amendment power is vested solely in the principal employer, the employer must notify the affected members of the proposed change and inform them of its impact. It must also seek the consent of the trustees if the amendment would or might be a ‘detrimental modification’.
Further Consequences: Employer Contributions, Winding Up and Section 75
Other provisions in the trust scheme documents that the company should consider when proposing a cessation of accrual include the employer contribution and winding-up rules. The company should check the employer contribution rule to determine whether the trustees can unilaterally increase the employer’s contributions to the scheme, with a view to securing the future of the scheme. If the trustees do have such a power, there will need to be discussions, and potentially negotiation, with the trustees. The company should also check whether cessation of accrual is a prescribed winding-up trigger. Typically, the relevant provisions may permit the winding-up of the scheme to be triggered, either by the principal company, automatically upon cessation of accrual, or alternatively, by the trustees. Caution must be exercised by the company, since triggering the winding-up of the scheme will give rise to a statutory debt (equal to the deficit calculated on a buy-out basis) payable by the employers to the pension scheme under the provisions of Section 75 of the Pensions Act 1995.
The winding-up of a pension scheme is one of three employer debt triggers under Section 75. For a single employer scheme, no statutory debt should arise on the cessation of accrual, provided that implementation of the proposal would not cause the winding up of the scheme, or the insolvency of the sponsoring employer. For participating companies of a multi-employer scheme, in addition to a debt becoming due on their insolvency or winding up of the scheme, the legislation provides for a debt to arise upon the occurrence of an ’employment cessation event’ (Section 75A and supporting legislation). An employment cessation event will occur where a participating employer ceases to employ any active members of the scheme, at a time when at least one other employer (who does not solely have defined contribution liabilities to the scheme) continues to employ active members. To avoid any employer incurring liability for a debt under section 75, in the case of a multi-employer scheme closing to future accrual, the company should ensure that all participating employers cease accrual simultaneously.
Fiduciary Duties of the Trustees
Trustees have an important role to play in the implementation of any proposal to alter or restrict pension accrual, particularly where their consent is required to exercise the power of amendment. The company will want to ensure that the trustees are satisfied that they are acting in members’ interests in agreeing to the change and are also acting consistently with their duties as trustees. The trustees’ fiduciary duties require them to have regard to the interests (which usually means the financial interests) of all their members, act within the scheme’s trust documentation, and adhere to any statutory or regulatory requirements imposed upon the scheme.
Where the company proposes to restrict or terminate final salary accrual, the trustees may be concerned as to whether giving their agreement to the proposal would amount to acting in the members’ best interests. The narrow view is that to act in members’ interests, generally, the trustees must not support any proposal or rule changes which would reduce members’ present or future benefits under the scheme. Whilst the legal position is not entirely settled and the analysis may vary depending on the circumstances, trustees should be able to agree to changes in respect of future service benefits.
Given that the trustees are aware of the difficult commercial background against which many companies are operating, it could be difficult for them to argue for continuation of the scheme without change (in the absence of any technical restrictions). Considering these points alongside an employer’s duty of trust and confidence (discussed below), the company should prepare, and be willing to disclose the business case supporting why it is not financially viable for the scheme to continue without implementing its proposal to alter or close the scheme.
Employment Law Issues
As mentioned at the outset of this article, there are a range of employment law issues that companies should be aware of when considering proposals to change or close defined benefit schemes. The issues will only be briefly considered here and warrant specialist legal advice in themselves.
As a first key issue, the company will need to find out whether the affected employees have a contractual right to a defined benefit pension. This will require the analysis of various documentation, including the employment contracts, the terms of the scheme, scheme members’ booklets, employee handbooks, any forms provided to and signed by employees when they joined the scheme, and any documents executed or provided when any previous changes were made. Further, the company should consider if some employees are on different contractual terms, since standard terms and conditions often change over time. Even if there is no express contractual right to a defined benefit pension, the company should be aware that the employees could, as a result of custom and practice, rely upon an acquired contractual right to the benefit. Often, the relevant employees will have some form of contractual right to a pension benefit and the key questions will be what that right amounts to and whether there is an express right for the company to implement its proposal.
Where an employee has a contractual right to a defined benefit pension, the company may consider the following mechanisms to implement the proposed benefit changes:
- Unilaterally exercising a contractual right to remove the benefit. An employer may be able to impose changes unilaterally through either an express right reserved to the employer in the employment contract, or alternatively, where the language is clear, a more general right to change the employment terms and conditions.
- Varying the employment contract with the employee’s consent. If an employer can gain employee consent to the change then provided that the appropriate consultation procedures (see “Procedural Matters and Consultation” below) are undertaken, there is unlikely to be material legal risks. Practically speaking, this may only be viable where a small number of employees remain as active members of the scheme, because 100% acceptance from the employees may be required to achieve the employer’s objectives.
- Variation of the employment contract by implied agreement. An employer may attempt to rely on the absence of an objection from the employee in order to imply the employee’s agreement to the amendment. This unilateral option could leave an employer exposed to claims for a breach of contract where it did not have a contractual right to make the changes, or the employee has chosen to work ‘under protest’ by making it clear that he does not accept the change, but is nevertheless a potentially viable option.
- Dismissal and re-engagement on new employment terms. If an employer concludes that the proposed pension change is not permitted under the employment contract, an alternative may be to terminate existing contracts and offer re-employment on new terms that include the new pensions benefits. A major issue is that the contractual termination will constitute a dismissal for employment law purposes, meaning that the appropriate dismissal procedures must be followed, and depending on the numbers, collective consultation under Section 188 of Trade Union Relations (Consolidation) Act 1992 may be required.
Procedural Matters and Consultation
Even if the employment contract does not preclude the possibility of changing or closing the defined benefit scheme, an employer should take care not to breach its duty of trust and confidence, which is an implied term in every employment contract. A level of uncertainty surrounds this concept, but it is thought that it will not prevent the removal of a non-contractual benefit, provided that the employer has a sound business reason for the change, and that it follows a fair and reasonable process in implementing that change. To minimise the risk of breaching its implied duty (and gain employee consent), an employer may consider, amongst other things, leaving as long a period as possible between the initial announcement and implementing the proposed change, to give the employees time to make alternative pension arrangements, and clearly identifying the business reasons for the change during the communication and consultation period discussed in the next paragraph.
Typically, employers will also have to comply with the statutory consultation requirements under the Occupational and Personal Pension Schemes (Consultation by Employers and Miscellaneous Amendment) Regulations 2006 (SI 2006/349) (‘Pensions Regulations’). The Pensions Regulations provide that no employer or trustee may decide to make a ‘listed change’ unless each employer of affected members has consulted with the affected members or their representatives about the proposed change. The ‘listed changes’ include ceasing further benefit accrual by existing members or members of a particular description, requiring member contributions where previously not required, increasing the level of member contributions, changing the benefits of a defined benefit scheme to pure money purchase benefits, and changing the basis of future benefit accrual, in whole or in part.
The consultation must continue for at least 60 days before the effective date of the proposed change and the employer must provide affected employees and their representatives (if any) with a written notice that details the change, allows for feedback and specifies the deadline for receiving comments and the consultation period closing date. If responses are received during the consultation, these must be considered by the employer before making any decision regarding the change. The consultation is complete if no responses are received before the end of the consultation period.
One further practical consideration where a company proposes to close its defined benefit scheme to future accrual, or make similar changes, is the impact that such change may have upon employee and industrial relations. This should be weighed against the potential benefit to the employer in making the change. Full engagement with both the trustees and the employees (including professional advisers) is vital to ensuring the successful implementation of any scheme alteration.
PLC Magazine Article ‘Altering Pension Schemes – Managing the change effectively’ by John Evason, Robert West, Chris Garrett and Mark Solomon.
Managing Risk and Liability Reductions – The Legal Issues # 2976702.06 (Annual B&M Pensions Seminar 2010).
Changing Pension Benefits – The Legal Issues #3186739.01 (Annual B&M Pensions Seminar 2010).
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