The overwhelming majority of defined benefit pension schemes are running deficits at present due to a combination of factors, including adverse performance of investment markets, longevity of pensioners and tighter regulatory controls. So what are the options available to companies operating such schemes?

When a defined benefit pension scheme has a deficit, tough decisions have to be taken. The sponsoring employer needs to decide whether or not it wants the scheme to continue and what is involved in making that happen. It may also wish to establish if the scheme’s documents allow it to terminate future contributions and effectively walk away from the deficit.

Separate actuarial and legal advice should be taken to inform the employer and scheme trustees of what might be done to restructure the scheme to enable its survival and to establish what options both parties have in this regard. Trustees and employers have different roles and responsibilities and they need to take separate advice.

The employer will need to reflect on the implications for the workforce of withdrawing the promise of a defined benefit pension as well as considering what alternative pension arrangements might be offered in the future. The employment law issues of making such a change must be examined in detail to ward off any claims by affected employees. And the position of employees, pensioners and those who have left service with accrued entitlements in the scheme must all be addressed.

Under the terms of the Pensions Act 1990, all pension schemes that are running deficits have to submit a funding proposal to the regulator, the Pensions Board. If a funding proposal is not submitted, either the scheme trustees will be directed to implement benefit reductions by the Pensions Board or, most likely, the scheme will be wound up. Funding proposals usually envisage that the employer and, increasingly, also the active members agree to pay extra contributions to the scheme to enable it to meet the Pensions Act’s funding standard by the end of the recovery period.

A funding proposal needs to be agreed between the scheme trustees and the employer. Its purpose is to explain how the funding deficit will be eliminated over an agreed recovery period. The terms of the proposal need to be signed off by the Pensions Board. Recovery periods can be anything from three to ten years, and in exceptional cases longer. The Pensions Board has recently extended the timetable by which funding proposals can be submitted and has added an additional five months to the process for schemes that are required to submit proposals by 31 December 2010.

Restructuring the scheme

These days, funding proposals are frequently formulated in conjunction with changes to the scheme’s benefit structure. The facts and circumstances of each defined benefit scheme are unique.

Common restructuring issues that we are advising on include: closing a scheme to new members, closing a scheme to future accrual (in other words, that future service with the employer will no longer accrue defined benefit pension benefits), reducing a scheme’s future service benefits (for example, reducing the accrual rate from 1/60 to 1/80), introducing or increasing employee contributions and reducing the amount of prospective pension increases.

Change in State pension age

The recently announced National Pensions Framework proposes increases to the age at which State pension may be drawn down. It is proposed that this will be 66 in 2014, increasing to 67 in 2021 and 68 in 2028. These proposals, which are likely to become law, have significant implications for defined benefit schemes and their sponsoring employers.

The Pensions Board is hoping that when a scheme’s funding proposal is being formulated, its terms will take account of these changes. The impact of higher ages at which State pension can be drawn down is still being considered by most employers who sponsor defined benefit schemes. It also raises employment issues, with the spectre of age discrimination lurking in the background.

Implementing benefit changes

An application may need to be made to the Pensions Board by the scheme trustees to seek a direction to reduce certain benefits. Provided various detailed conditions are met, the Board may direct the trustees to take action to accomplish these reductions.

A scheme’s documents may enable benefit changes to be implemented through the use of the scheme amendment power. Frequently, the amendment power may be problematic in this regard. It is important to note that trustees must always exercise their power of amendment in the best interests of the members as a whole and there can be issues for trustees where benefits are to be reduced. Employers need to be mindful of the trustees’ position when formulating their strategy for their pension scheme.

It can happen that the amendment terms of the pension scheme prohibit a particular restructuring which the trustees and the employer consider is appropriate to the business needs and interests of members. In those circumstances, it may be possible to achieve the required aims on the basis of getting the agreement of the affected members. Such a step is not to be taken likely. It will involve a large and ongoing communication process as well as consultation with affected individuals and their representatives.

What is emerging is that there are a number of employers who are interested in maintaining their defined benefit pension arrangement, even though this will carry an ongoing cost for them. Employees prefer having some type of defined benefit pension rather than none, and there is now more willingness on the part of active members either to accept benefit reductions or pay into the scheme.