The governance of money purchase pension schemes is one of the biggest challenges facing the pensions industry currently. The Pensions Regulator, for example, has made its expectations very clear, not least through its requirement for each money purchase scheme to publish a governance statement in the 2014/15 scheme year, see here.
We have also seen an increasing number of employers setting up governance committees for their group personal pension schemes.
To add to this ever-increasing focus on money purchase schemes, the Government has (finally) confirmed that certain types of scheme that are currently treated as money purchase (or defined contribution) will become defined benefit schemes from July 2014.
What type of scheme is affected?
You’d be surprised how many schemes could be affected by this. The new definition in effect means that:
- before coming into payment, a benefit cannot be treated as money purchase if it could be underfunded – it must be calculated solely by reference to the assets which fund it; and
- once in payment, the benefit must be secured by an external annuity or insurance policy.
So, examples of the kind of benefit that could give rise to issues include schemes:
- where the value of members' accounts is calculated by something other than a simple application of investment returns (so, where there is some kind of discretion about investment returns or a guaranteed return);
- where the members' benefits are subject to a minimum amount;
- in which scheme pensions are paid in respect of a member account (including AVCs); and
- that offer defined benefit type dependants’ pensions provided from other than money purchase schemes.
This list is not exhaustive. We believe that there are many schemes whose benefits will be reclassified under the new law.
Does this matter?
Yes – this is important. Whether your scheme is money purchase or defined benefit affects:
- the legal requirements that apply to those benefits going forward (including the need to include these benefits in the calculation of “section 75 debts” and the protection afforded to these benefits on a scheme wind-up);
- how those benefits should be administered in the future; and
- the extent to which the new law will apply retrospectively to a pension scheme and require past actions and decisions to be revisited.
Why is this happening?
The Supreme Court in the Bridge case in July 2011 decided that the definition of a “money purchase scheme” at that time was wide enough to include schemes that could have a funding deficit.
The Government was concerned about this for various reasons. First, it was alarmed that this could put the UK in breach of the Insolvency and IORP European Directives. Secondly, there was concern that the protection regime in place for defined benefit schemes (in terms of funding and on corporate insolvency) would not apply to money purchase schemes with a funding deficit.
In order to address this, the Government changed the legal definition of “money purchase benefits” from July 2014 to introduce the new definition with effect from 1 January 1997 (but subject to a large number of exceptions).
What are the implications?
The new law is very complex (it comes into force from 1 January 1997, but with 57 pages of regulations providing exceptions to this start date).
Under the new law, benefits will effectively be divided into the following categories:
- money purchase benefits (see above);
- money purchase underpin benefits (broadly, money purchase benefits with a defined benefit underpin);
- top-up benefits (broadly, money purchase benefits that benefit from a top-up where the money purchase benefits are less than a promised amount);
- cash balance benefits (broadly, benefits where there is a promise about the amount of money that will be available to a member but no promise as to the rate or amount of any pension to be provided from that sum);
- pure defined benefits; and
- pensions deriving from money purchase or cash balance benefits.
The category that applies to a benefit is very important, as the application of the new law differs depending on which category applies.
So, does the new law come into force from 1 January 1997?
Whilst the new definition will be introduced retrospectively with effect from 1 January 1997, the final version of the legislation provides that schemes will not need to revisit past actions and decisions except in limited circumstances.
So, for example, generally speaking:
- section 75 debts will not need to be recalculated;
- pension schemes in wind-up will not need to revisit past decisions; and
- pension schemes will not need to recalculate the revaluation and indexation of benefits.
So, how could this affect things in the future?
The reclassification of benefits under the new law could have significant implications for pension schemes and members going forward. For example, in future, benefits that were treated as money purchase benefits and which “flip” to be defined benefits will:
- no longer be protected where an underfunded scheme is wound-up, meaning members’ benefits may be reduced in these circumstances;
- need to commission an actuarial valuation in 2015 and will be subject to the statutory revaluation and indexation rules relevant to such benefits; and
- need to be included in a scheme’s PPF valuations for the period 2015/16.
Are there any particular areas of concern?
A key area of concern is where money purchase schemes have a defined benefit underpin or top-up. Whether these benefits are treated as money purchase or defined benefit will depend on the position whenever the underpin or top-up is tested. This would certainly apply on the date of retirement for example, but could also apply at other times where you need to calculate a scheme’s liabilities (such as on triennial valuations).
The treatment of the benefit will then depend on whether the underpin or top-up “bites” at that moment. So:
- if the money purchase benefit on the relevant date is more than the defined benefit promise, the benefit will be money purchase; whereas
- if the money purchase benefit is less than the defined benefit promise, then the benefit will be treated as a defined benefit.
This will be difficult for trustees and employers, as they have no certainty about what legislative framework to apply to members’ benefits from time to time
The legislation which will introduce the new definition of money purchase benefits is complex and determining which category some benefits fall into under the new legislation is far from straightforward.
Given the significant implications of this change in the law, we consider that trustees and employers should carry out a due diligence exercise on their schemes to understand if they have benefits which will change from July 2014 to be treated as defined benefits. This due diligence exercise could be picked up as part of a wider review of the money purchase arrangements to ensure compliance with the Regulator’s 31 Quality Features.
Where benefits are reclassified, trustees and providers will need to consider the impact of this on the way in which the scheme is administered going forward. They may also need to notify members where any reclassification has implications for them, for example, by taking away the protection afforded to their benefits on a scheme wind-up