The majority of defined benefit schemes are in deficit on some basis. For most schemes the bulk of the deficit relates to past service benefits. Recently employers have looked for innovative ways to reduce past service liabilities. Most of the deficit reduction methods include some form of inducement to encourage members to consent to the proposal.
The Regulator accepts that deficit reduction schemes which include inducements are legal. However, it has issued guidance outlining how employers, trustees and members should deal with inducement offers.
HMRC has issued an announcement to clarify the tax and National Insurance (NI) position of inducement payments. In a change from its previous view, HMRC now considers that such payments are subject to both income tax and NI.
This briefing note considers both the Regulator’s guidance and HMRC’s announcement.
What are typical deficit reduction schemes?
Employers have been exploring different ways they can reduce past service liabilities. Examples of proposals are:
- Offer deferreds an enhancement of their transfer value to transfer out of the scheme. The enhancement is paid by the employer either as a stand alone lump sum or as an uplift to the transfer value. This has been the most common approach.
- Offer pensioners the option to receive a cash lump sum or additional flat rate pension in lieu of non-statutory increases on their pensions in payment.
What is an inducement?
According to both the Regulator and HMRC, an inducement tends to be a monetary offer to members and will usually involve:
- An enhancement to a transfer value,
- A direct cash payment to the member, or
- A combination of the above.
Inducements: the employer’s perspective
The guidance acknowledges that employers generally offer inducements because they represent a financial saving for the employer in terms of liability management. In addition, other motivating factors include avoiding volatility in future contributions, administration cost savings and achieving changes in scheme design.
Inducements: the trustees’ perspective The guidance lists the following things which trustees need to be aware of or consider where inducement offers are concerned:
• Question or challenge the employer about the appropriateness of an inducement offer when they become aware that the employer is considering one.
• Be aware that members will have to make complicated financial decisions. Trustees should be sure that members are given all the information they might reasonably need to make an informed choice. In particular trustees should check that the offer emphasises the importance of independent financial advice. Ideally this advice should be paid for by the employer.
• Consider if the requirements concerning the modification of past service rights are relevant. If so, trustees should ensure that all the requirements have been complied with.
• Be aware that the employer is likely to request member details. Trustees will need to consider whether or not to make these available. They may wish to take legal and financial advice on their exposure under Data Protection Act principles before providing the information to the employer.
• Where the trustees become aware that the employer has made an inducement offer which they were not aware of and consider may not be in members’ best interests, they should consider issuing their own announcement to members to highlight the risks surrounding the offer.
Inducements: the member’s perspective
The member is faced with a difficult decision when trying to decide whether or not to take up an inducement offer. It is important for the member to take an overall view of the value of the inducement offer and the financial risks involved.
The guidance gives the following examples of things the member will probably need to consider in relation to an inducement to transfer:
- Whether the transfer value offered represents good value for scheme benefits.
- The type and likely amount of benefits the transfer value will secure under the receiving scheme and the likelihood of those benefits being provided.
- The value to the member of the cash inducement.
The guidance also makes it clear that the member’s attitude to risk is an important consideration. A member may be faced with moving from a low-risk defined benefit environment where much of the investment risk is borne by the employer, to a high investment risk defined contribution environment where the member bears all of the risk.
The guidance also strongly recommends that the member takes independent financial advice.
How should employers deal with inducement offers?
Employers are likely to need to involve the trustees before issuing an inducement offer to members. One important reason for this is that it is the trustees, not the employer, who hold member details. Whether trustees are going to have any other involvement will depend on the nature of the inducement offer. The guidance comments that trustees are unlikely to agree to pay enhanced transfer values if there is no associated payment into the scheme to cover the cost of the enhancement. In such a case the employer and trustees will need to negotiate the level of the additional funding.
The communication of the inducement offer to members needs to be clearly expressed. The guidance states that the communication should at least:
- Explain the nature of the benefits being given up in exchange for the inducement.
- Explain where a transfer out is involved:
- That the receiving scheme may not provide the same level of benefits.
- The risks inherent in and the guarantees offered by the member’s scheme including, employer insolvency, wind-up legislation protection and the Pension Protection Fund. An indication of the likely cost of replicating Pension Protection Fund compensation levels should be provided.
- Explain, where a rule change leading to benefit reduction is involved, the likely cost of making good the benefit.
- Recommend that the member takes independent financial advice.
- Explain that there may be tax implications if the inducement payment is accepted.
- Specify the amount of the inducement.
- Explain the nature of the inducement payment.
- Explain if the amount of the inducement is affected by member choice, for example if the member can choose to accept a cash payment instead of receiving an enhanced transfer value.
- Explain how long the offer will be open.
- Explain why the employer is making the offer.
- Make it clear that the member does not have to accept the offer. The communication might also comment that there is very little consumer protection available to the member for this type of transaction.
How should trustees deal with inducement offers?
The guidance comments that trustees have a responsibility to act in the best interests of scheme members. As a result they should consider whether it is appropriate for them to question or challenge the appropriateness of any inducement offer.
The trustees should also check the employer’s communication material to members to ensure that it covers the matters mentioned above. Where any matter is missing, trustees should inform the employer. The trustees should consider issuing their own communication to members to ensure that the key messages are got across. However, the guidance emphasises that trustees need to take care that they do not give financial advice to members if they are not authorised to do so.
Finally the guidance reiterates that the trustees should bear in mind any data protection issues before they agree to release members personal information.
How should a member deal with an inducement offer?
The guidance suggests that a member should consider checking with the trustees to see both if they are aware of the inducement offer and if the employer had consulted them before the offer was made. The member should take the trustees’ response into consideration when making a decision on the offer.
How is an inducement taxed?
HMRC has changed its position on the way on which inducement payments are taxed. HMRC’s original view was, generally, there would be no income tax or NI liability. However, HMRC has taken further legal advice and has concluded that where cash payments are made to members to encourage them to agree to forgo future pension rights or transfer to another scheme, the payment will be subject to income tax and NI.
HMRC has confirmed that the revised tax position does not apply to payments which enhance a transfer value. These payments are included in the sum paid from one scheme to another and are not paid into the member’s hands.
What is the tax position in relation to transactions which have already been entered into?
The HMRC announcement confirms that they are aware of transactions which have been entered into on the basis of the previous advice. HMRC confirms that it will not seek to impose tax/NI in the following circumstances unless either the tax payer assumed that tax was payable or HMRC confirmed that tax/NI was due:
- Where the inducement payments have already been paid before the date of the announcement.
- Where HMRC has confirmed that the inducement payments are not taxable or liable for NI and the employer has made an offer to members before 24 January 2007 but no inducement payments have yet been made. This will only apply where there has been no material change to the employer’s offer.
- Where an employer has made an offer to members before 24 January 2007 and can show that they relied on HMRC’s former view.
- However, HMRC confirms that tax/NI will be due where:
- An employer has made an offer to members before 24 January 2007 but is unable to demonstrate that it relied on HMRC’s former view.
- An employer has not made an offer to members before 24 January 2007.
Deficit reduction exercises involving inducement offers have become more prevalent as employers have struggled to manage scheme deficits. At the same time the DWP has made various disapproving comments about these exercises. With that in mind it is not altogether surprising both that the Regulator has issued guidance (which, incidentally, had not previously been issued in draft) and HMRC has reconsidered its view. HMRC was able to do this because the tax/NI position before the announcement was not entirely clear even though, in our experience, local tax offices had been willing to confirm that no tax/NI was payable. The Regulator’s guidance and the change in HMRC position do not mean that employers will not try to implement inducement offers in the future. However, employers will need to take care that they follow the Regulator’s guidance closely (we have advised clients who have already undertaken these exercises). At the same time the tax clarification means that:
- An inducement offer will now look less attractive to members because they will suffer a tax hit on the lump sum they receive, or
- In order to maintain the attractiveness of an offer, the employer will have to consider increasing the inducement so that the net position for members is at least as good as what it would have been had HMRC not changed its view, or
- The employer should consider structuring the incentive as an enhancement to the member’s transfer value rather than as a lump sum payment direct to the member so that there would be no tax/NI immediately payable. Instead tax would be due when the pension eventually comes into payment.
Employers who have already made inducement payments may rest easy that the payments made will not be subject to tax/NI. However, where the payments have not been made it is crucial for employers to check whether or not they will now be subject to tax/NI.
It is interesting that the Regulator’s guidance states only that members should take independent financial advice. It does not explain exactly what type of advice members should be taking. Any independent financial adviser provided/recommended to members should be appropriately qualified to give the necessary advice. An employer which pays for advice to members needs to take care to structure payment to the adviser to avoid suggestions that the adviser is being “paid” to get members to accept inducement offers.