Employers are increasingly looking at contributing to a defined contribution (DC) or money purchase pension arrangement for employees. This can be a way of complying with the auto-enrolment duties being phased in under the Pensions Act 2008. In the private sector, employers have the choice as to whether such arrangements will be ‘trust based’ or ‘contract based’:
- trust based: established under trust as an occupational pension scheme (OPS); or
- contract based: an arrangement established as a personal pension (PP) under a contract with an external provider. The external provider is regulated under the financial services legislation and typically uses an insurance policy or a unit trust as the funding mechanism. This can be a self-invested personal pension (SIPP).
This briefing looks at the advantages and disadvantages from a legal perspective for an employer using one of the above two structures.
Differences between trust based and contract based DC arrangements
Trust based and contract based DC arrangements provide a similar end product – a savings pot for the employee to use to fund his or her own pension provision. Despite this similarity, these arrangements are regulated differently in many ways, although the differences are gradually becoming less significant. For example:
- the 2006 tax rules removed many differences in the tax treatment; and
- the government has said that it is looking at removing the two year vesting period allowed for an OPS but not PPs.
The differences are summarised in the table below. The main differences are:
- tax: the tax rules are now the same for both a PP and a DC OPS. There can be some difference on tax relief at source; and
- early leavers: an OPS may be better for an employer because members’ benefits only vest after two years pensionable service unless the scheme’s rules provide otherwise. Previously, early leavers were only entitled to a return of their own contributions if they left employment before two years of pensionable service (or such earlier date as provided for in the rules). As a result, the portion of their benefits attributable to employer contributions became available to be used for other purposes (eg to be used to meet expenses or contributions for other employees). Members in a PP are immediately vested in their benefits.
However, the pensions legislation changed in April 2006 so that leavers with less than two years’ pensionable service (but more than three months pensionable service) must be given the right to request a transfer of all their benefits (including employer contributions) to another plan. The potential savings for an employer in respect of early leavers is probably much reduced.
In addition, the government said (in September 2011) that it is looking at removing the two year vesting period currently allowed for OPS (but not currently allowed for PPs). However, draft legislation has not yet been prepared, nor a date set, for this proposed abolition of short service refunds.
- Trapped surplus offsets: the risk of trapped surplus in a defined benefit (DB) scheme can be reduced by attaching a DC section to the DB section of the scheme. If the rules are structured properly, any surplus in the DB section can be used to offset employer obligations to contribute to the DC section – Barclays Bank v Holmes (2000). This is not possible for a PP (or freestanding OPS).
- Trustees needed for an OPS: an OPS requires trustees to administer the scheme. The trustees will have a number of legal duties which may attract claims if it is alleged that they have not acted appropriately. An OPS will also need to comply with the member-nominated trustee (MNT) obligations. There are no trustees needed for a PP.
- Investment Monitoring: one of the duties trustees of an OPS have is to monitor the investments in the fund (either the investments selected by the employer or the investment menu offered to members) and, in particular, the default fund used for members who fail to make a choice (although the extent of any legal duty in this area is unclear). Trustees could potentially face claims in relation to their role in monitoring investments. The trustees carry out a useful monitoring role in an OPS – where no such role exists for a PP.
- More employer involvement in OPS: an OPS requires more employer involvement – eg appointing trustees. This can be desirable because, for example, there can be better branding and more oversight of investment/operations. However, this involvement could also cause some issues. These issues include the trustees looking for indemnities from the employer and the employer having statutory payment obligations under the 2005 Employer Debt Regulations (eg to pay the PPF levy amount (although this is small for DC benefits) or if a ‘criminal deficit’ (ie resulting from an offence involving dishonesty or an intent to defraud) arises).
- Costs and charges: the costs and charges of a PP will either be debited from member accounts or (if agreed by the employer) paid by the employer. Costs and charges of running an OPS are more likely to be paid directly by the employer. The actual amount of the charges will depend on factors such as the size of the scheme and the arrangement made with the provider.
- Political risk: there is probably more risk for an OPS of future legislation imposing further obligations on trustees or employers. For example, the Pensions Regulator issued a consultation in January 2013 on Regulating work-based defined contribution (DC) pension schemes. This consultation envisages, amongst other things, a code of practice for DC trustees.
- Financial services regulation: a PP is a financial services product that needs to be promoted and marketed in accordance with the rules of the Financial Services Authority (FSA), which are now administered by the Financial Conduct Authority/Prudential Regulation Authority (FCA/PRA) – eg any promotional literature needs to be approved by an authorised person. In contrast, an OPS is not governed by the financial services legislation (save that day to day investment decisions need to be taken by a registered person). In practice we would expect the PP provider to be on top of (and ensure compliance with) the FCA/PRA rules and requirements.
- Employer-related investment: an OPS needs to comply with the limits on employer-related investment (eg no loans to the employer and no more than 5 per cent of the fund invested in shares of the employer). A PP does not have such limits.
- Legislation: there are still some (marginal) differences in the legislation (eg on stakeholders and Tupe transfers).
- Age discrimination: there are more express exemptions for an OPS than a PP under age discrimination legislation. Age-related contribution rates and length of service exemptions apply to both an OPS and a PP. The express exemption related to closing a scheme (or section) to new entrants does not apply to a PP.
- Risk benefits: it is easier to incorporate risk benefits (eg a death in service lump sum or payments on incapacity) under an OPS than a PP. For example, if an employer wants to provide a lump sum benefit on death that is intended to top-up a member’s pot to a target amount, it is easier to have such an arrangement under an OPS.
- Branding: an OPS is easier to ‘brand’ as a benefit from the employer – but this may well be possible in a SIPP as well.
- Member bankruptcy: a member pension under an OPS may be less at risk from a claim by a trustee in bankruptcy than for a PP.
- Lien over funds: an OPS can include a lien in favour of the employer for any liability of the member to the employer arising out of a criminal, negligent or fraudulent act or omission by the member (s91, Pensions Act 1995). A PP cannot include such a charge or lien.
- Type: PP obligations will transfer on a business sale under the Transfer of Undertakings (Protection of Employment) Regulations 2006. OPS rights and liabilities do not transfer (save for any rights which are not ‘old age, invalidity or survivors’).
There continue to be some differences between a PP and an OPS for DC provision, although the gap is narrowing. The choice between providing DC benefits by using an OPS or a PP will depend on the employer’s individual circumstances (and risk appetite).
Click here to view overview table.