The straitened economic conditions of recent years have impacted on businesses across the aviation sector and the economy as a whole. One major issue has been the challenge of funding increasingly costly defined benefit (DB) pension schemes.

In a DB pension scheme, each member is promised a retirement pension based on a fixed formula, typically 1/60 x final pensionable salary x years of pensionable service. The scheme is valued by an actuary every three years. If the contributions paid in to the scheme by the employer and the members, adjusted for investment gains and losses, are judged by the actuary to be insufficient to pay the members’ accrued pensions, the employer will need to make increased contributions to make up the deficit.

A DB pension scheme must be distinguished from a  defined contribution (DC) pension scheme. In a DC scheme, each member has a personal account into which fixed contributions from the employer and the member are paid. The member’s pension depends on the value of his account at retirement, including any investment gains or losses: no promise is made as to the level of pension, and so no deficit can arise.

Amending the scheme

The simplest – but not necessarily the easiest – means of dealing with a deficit in a DB pension scheme is to amend the terms of the scheme so as to either (1) reduce the scheme’s future liabilities by cutting benefits or (2) increase the scheme’s future assets by increasing members’ contributions.

The law prevents employers from reducing DB benefits which members have already accrued, save in the unlikely event that their consent can be obtained to the reduction. This means that any reduction in benefits will have only future effect – for example, an amendment might provide that members’ pensionable salaries will be capped at a certain level going forward, or that benefits accrued over their future service will incorporate smaller cost of living increases. This would restrain the growth of the scheme’s future liabilities.

The most radical course of action, but one which has been taken by an increasing number of employers over the past decade, is to freeze the pension scheme to all future accrual of benefits. Affected employees would instead be offered access to a DC scheme with a lower contribution rate – in the case of employers which have passed their staging date for automatic enrolment, the scheme would need to satisfy the minimum standards laid down in the automatic enrolment legislation.

Any amendment to a DB scheme is likely to require the consent of the scheme’s trustees. Trustees are under legal duties to safeguard the interests of the scheme members, although this principle must be balanced against the employer’s right to determine its future remuneration policies. It is unusual for trustees to refuse point blank to agree to a proposed amendment, but they may  attach conditions to it: for example, they might seek the employer’s agreement to improve the scheme’s funding position, or even agree a “flightpath” whereby the scheme’s liabilities can, over time, be fully funded and bought out (see below).

The governing documentation of DB pension schemes can sometimes contain terms which restrict the employer’s ability to amend the scheme even where the trustees consent. Careful analysis may be needed of such terms. In addition, the affected employees’ contracts of employment may pose difficulties – for example, if the employer is seeking to raise the members’ contribution rate and the current rate is stated expressly in the contracts. In such a case, the employer would need to secure the employees’ individual consent to amend the terms of the contracts.

Finally, an employer which is proposing to cut its DB scheme benefits must undergo a statutory consultation process with the affected employees (or their trade unions or other representatives). The employees must be asked for their views, but they are not required to give their consent in order for the amendment to proceed. The consultation process must last at least 60 days: this can impact significantly on the timetable for implementing an amendment.

Incentive exercises

One form of DB liability management which has become increasingly popular in recent years involves the employer offering incentives to its DB scheme members in return for them agreeing to modify or give up their current DB entitlements.

Some examples of the deals which might be offered to members include:

  • Asking members to transfer their DB rights into a DC scheme in return for the employer making an additional lump sum payment into the DC scheme
  • Asking members to accept less generous rights to cost of living increases in retirement in return for a higher basic pension
  • Asking members to give up their rights to a spouse’s pension on their death in return for a higher basic pension

Whether such a deal would be in any given member’s best interests would depend entirely on that member’s individual circumstances. In order to ensure that members are not treated unfairly, the pensions industry has adopted a Code of Practice governing incentive exercises. This was  a voluntary step to forestall Government legislation in the area. The Code requires, amongst other things, that the members in question be given independent financial advice (paid for by the employer) before agreeing to modify their DB rights. While the Code is not legally binding, employers who are considering carrying out an incentive exercise would be well advised to work closely with their advisers to ensure that they do not incur unnecessary risks by failing  to comply with it.

De-risking

The most reliable way of divesting a DB scheme of risk is to transfer its liabilities to an insurance company. The insurance company will issue annuity policies to cover the liabilities, which will then become the insurance company’s problem. The difficulty is that the insurance company will need to be paid in order to compensate it for taking on this risk, and this cost will outstrip – often by a large margin – the “normal”, ongoing deficit of the scheme. This is because the insurance company will use conservative discount  rates in pricing the annuities and will add in margins to cover its own profits and capital adequacy requirements. An estimate of the cost of such annuities – known as the “buy-out” cost – will be provided by the actuary in each three-yearly valuation of a DB scheme.

A de-risking exercise of this sort can encompass the entirety of a scheme’s liabilities (a buy-out) or only a portion of them (a buy-in). In some cases, a kind of slow- motion buy-out can be accomplished as increasing portions of the scheme’s liabilities are subject to buy-ins as the scheme’s funding position progressively improves.

One development which may be of interest to smaller schemes is the advent of medically underwritten annuities. These products, which are suitable for schemes of up to 500 members, can offer the opportunity of buying bulk annuities from an insurance company at a relatively lower cost.

Conclusion

Therefore, while the funding of employers’ defined benefit pension schemes can give rise to serious challenges, there are several options available to help employers deal with them.