Incentive exercises are increasingly used as part of a defined benefit (DB) pension scheme’s liability management. The exercises have also grown in popularity as a result of the introduction of defined contribution (DC) flexibilities, since members of DB private sector schemes stand to gain greater flexibility in retirement options by transferring their benefits to a DC scheme offering flexible access to benefits.

There are a number of important legal and regulatory issues when deciding to run a one-off incentive exercise, or introduce an at-retirement option. This briefing flags some of the key issues on which legal advice will be required when planning and implementing an incentive exercise.

Types of incentive exercise

From the scheme/sponsor’s point of view, incentive exercises have the benefit of permanently reducing or eliminating certain benefits from the scheme. They may be offered simply as a way of providing a further choice for certain members, or they may be offered with a longer term buy-in or buy-out solution in mind. They can be offered as a one-off event for a particular group of members at the relevant time, or they can be introduced as an option available to all members at the point of retirement.

There are a number of different types of incentive exercise:

Click here to view table.

Legal and regulatory issues

There are a number of legal and regulatory issues that need to be considered, and the precise issues that will be relevant will depend on the type of incentive exercise being implemented, the profile of the section of scheme membership to whom the exercise will be offered, and the offer terms. The key items on which legal advice will be necessary include the following:

  • Voluntary Industry Code of Good Practice (the Code). The Code applies to one-off incentive exercises and not at-retirement options. The Code also currently does not apply to WULS exercises, although the foreword to the Code does include a statement that the Incentive Exercises Monitoring Board will consult the pensions industry on this position in the course of 2016. Whilst compliance with the Code is technically voluntary, compliance is expected and is market practice. The Code is also supported by the Pensions Regulator, and the Pensions Ombudsman and Financial Ombudsman Service will have regard to the Code where appropriate.
  • Where the Code applies, the key principles of the Code require (among other things), either financial advice or guidance to be given to the relevant member (depending on the type of exercise), particular timing requirements as to the implementation of the exercise, and certain minimum standards for the relevant member communications.
  • The Code was updated in February 2016. For a summary of the changes made to the Code in this updated version, please see our briefing: Incentive Exercises – Update on change to Code of Good Practice.  
  • Trust deed and rules (power to offer the relevant exercise to members). The trust deed and rules of the relevant pension scheme will need to be checked to see whether or not they permit the relevant exercise to be offered to members. Where the rules do not so permit, an amendment will be required (and so the power of amendment will also need to be reviewed for any restrictions on amendments, and the balance of power), and the terms and scope of such amendment will need to be carefully considered. In addition, the impact of the exercise on other benefits may need to be considered (this is relevant to PIEs – e.g. should any five year guarantee under the rules be calculated from the pre- or post-PIE level of pension?)
  • Even where there is a relevant power, it will be important to follow any procedural requirements to ensure effective implementation – see below.  
  • Trust deed and rules (benefit issues). The trust deed and rules of the relevant pension scheme should also be checked to see whether the benefits in respect of those members taking up the exercise need to be amended. For example, in the context of a PIE, do the scheme rules include a five year guarantee? Does the drafting of the rules mean that the guarantee would take into account the pre- or post-PIE level of pension, and is that result intended?
  • Another issue that arises in relation to PIEs is whether or not it is intended for spouse and dependant pensions also to be subject to the PIE if the member accepts the offer. Legal views on whether or not the member’s consent is sufficient to bind the spouse and dependants with contingent benefits differ, and the analysis depends on the way in which the spouse and dependants’ benefits are expressed under the trust deed and rules.  
  • Statutory restrictions on changing benefits. For certain incentive exercises, statutory restrictions on amendments to benefits are also relevant (namely, sections 67 and 91 of the Pensions Act 1995). Where these are relevant, in order not to fall foul of the restrictions it will be necessary to confirm either that the circumstances fall into an exception from the statutory restrictions, or to follow a prescribed process for making the relevant amendment.  
  • Age discrimination. Is the design of the exercise age discriminatory? Is any age discriminatory element nevertheless objectively justifiable? For example, is it objectively justifiable to include over-80s into the exercise on an opt-in basis only?  
  • Data protection. The trustee will be asked to provide details relating to the members in scope for the incentive exercise to the employer and to the relevant financial adviser. The trustee will need to be comfortable that it is in compliance with its obligations as a “data controller” under Data Protection Act 1998.  
  • Statutory requirement to confirm financial advice has been taken. Where the incentive exercise involves a member transferring DB benefits worth more than £30,000 to a DC scheme in order to access their benefits flexibly, the member is required to confirm that they have taken financial advice in relation to the transfer. Where an employer has written to two or more members to encourage a transfer (as will be the case in an incentive exercise context), the employer must meet the cost of the advice.  
  • Tax. The usual tax regime will be relevant on an incentive exercise, e.g. the usual authorised payment restrictions, benefit crystallisation events and the requirement to transfer to a registered pension scheme. In addition though, questions may arise as to the tax treatment of the value of the financial advice that the member is provided with. For PIEs, the question arises as to whether or not a further benefit crystallisation event occurs on the option being taken up (and the level of the pension increasing as a result).
  • Getting the communications and member consent forms right. There is a delicate and important balance to be struck between drafting member communications so that they are technically correct and complete (and cover off all necessary legal points) but also understandable for the majority of the members who will receive them. In addition, it is crucial to effective implementation that the option forms that members sign are legally robust to ensure that member acceptance is binding.

The role of the company, trustee and legal advisors

Incentive exercises, as a part of the liability management toolkit, are largely employer-driven. However, that is not to say that scheme trustees have no involvement in the exercise. Trustees will usually be involved to the extent that their consent is needed for the scheme rules to be amended (or their consent is required under a permissive rule) to allow the offer to be made to members, and also in providing member information to the employer and to the financial adviser.

Legal advice plays a pivotal role in the design and implementation of incentive exercises. We envisage that legal advice is required, for example, in respect of the following:

  • Offer design stage
    • Does the offer design meet with legal requirements?
    • Does the offer design comply with Code requirements?
    • Does independent financial advice need to be offered?
    • Do the trust deed and rules permit the offer to be made?
  • Implementation process
    • Is a deed of amendment required to amend the trust deed and rules? What should its terms be?
    • Do the member communications meet the requirements of the Code (and any statutory requirements, if applicable)?
    • Are member option forms legally robust to ensure effective implementation?