This article gives a broad introduction to the pensions systems in the UK, and highlights some important issues which are currently affecting employers of UK employees.
Defined Benefit (DB) Pension Schemes
In a DB pension scheme, the benefits that the member will receive are calculated according to a fixed formula. Typically this may be 1/60th of final pensionable salary at retirement (or leaving employment) for each year of pensionable service; but alternatives include using a smaller fraction or calculating the pension on the employee’s average salary throughout his employment.
Scheme members are generally offered the opportunity to draw 25% of the value of their benefits on retirement in the form of a tax-free lump sum.
Other benefits typically offered by DB schemes include a pension and/or lump sum for the member’s spouse or other dependant(s) in the event of the member’s death.
Who is the Pensions Regulator?
The Pensions Regulator is a statutory body which is charged with the following objectives:
- To protect the benefits of members of work-based pension schemes
- To promote good administration and improve understanding of work-based pension schemes
- To reduce the risk of situations arising which may lead to compensation being payable from the PPF (see below)
- To maximise employer compliance with employer duties and with certain employment safeguards
The Pensions Regulator is tasked with enforcing many aspects of pensions legislation. It has powers to levy financial penalties where the legislation is breached.
The Pensions Regulator also issues codes of practice and other guidance notes. These can be taken into account by the courts and the Pensions Ombudsman in the event of a dispute.
DB schemes in the private sector are structured as trustbased occupational pension schemes. This means that their assets are entirely separate from the assets of the employer, and that they are governed by a board of trustees. The trustees have strict duties to protect the interests of the scheme members. This can lead to conflicts of interest in cases where managers of the company also act as trustees. The trustees will typically delegate the day-to-day running of the scheme to an administration company.
DB schemes must be valued every three years: this includes an actuarial assessment of the value of pension benefits in the scheme. A shorter actuarial report is drawn up for each of the intervening years. The actuarial assumptions used in each valuation will differ from scheme to scheme, depending on the circumstances. The trustees must decide on the assumptions, which must be approved by the scheme’s actuary, and they must usually be agreed by the employer.
If a valuation reveals a deficit, a “recovery plan” must be put in place providing for contributions to be made by the employer to repair the deficit. This recovery plan must usually be agreed with the employer, and be reported to the Regulator.
The future contributions payable by the employer and members to the scheme will be set out in a “schedule of contributions”.
In general terms, trustees are advised to keep the strength of the “employer covenant” of their scheme under review. The strength of the employer covenant amounts to a combination of the strength of the legal duty of the employer to fund the scheme and the current and prospective financial strength of the employer. The covenant strength will determine the approach the trustees take to setting the assumptions.
Defined Contribution (DC) pension schemes
In a DC scheme, the members’ retirement benefits are not known until the point of retirement. A member will be assigned a personal “account”. The member and/or the employer pay fixed contributions – for example, 5% of the member’s salary – into this account. On retirement, the member receives the accumulated value of the account, consisting of the contributions as modified by any investment returns.
The member will typically apply the value of his or her account to buy an annuity from an insurance company. This means that the insurance company will commit to paying the member a set level of pension until death (often with cost of living increases and/or a survivor’s pension for the member’s spouse or a dependant). It is not, however, required that a member buys an annuity in every case. Under “capped drawdown” and “flexible drawdown” arrangements, the member can effectively treat their pension account as a savings account from which they can draw down sums of money as an when they need them. Tax laws restrict when and how individuals can do this.
DC schemes can take the form either of trust-based occupational pension schemes or of contract-based personal pension schemes. In the first case, the scheme is (like a DB scheme) run in the form of a trust by a board of trustees. In the second case, the scheme is run by an insurance company and does not involve any trust structure.
The characteristic feature of DC schemes is that the investment risk lies entirely on the member. This can be contrasted with a DB scheme, where the investment risk lies with the employer, which will meet any shortfall in the investment returns of the scheme.
A number of structures are available which combine features of DB and DC schemes. These are known as “hybrid” or “Defined Ambition” schemes. Structures of this type are currently being promoted by the Government. They have the effect of sharing the risk of providing a pension between the employer and the member more evenly than a DB or DC Scheme.
The State pension system
State pensions in the UK are currently made up of two components: the Basic State Pension and the State Second Pension. These are funded through National Insurance (NI) contributions. Proposals are currently in the pipeline to consolidate them into a single, flat-rate pension.
The State pension age is currently subject to change. The State pension age for men is currently 65. For women, however, it is 60 but is being phased upwards over a period of time, rising eventually to 65 to equalise it with the male State pension age. The State pension age for both sexes is then set to rise to 66 by 2020, to 67 by 2028 and to 68 by 2046. These changes are being kept under review and may be brought forward.
What is the Pension Protection Fund?
The PPF acts as a lifeboat for underfunded defined benefit pension schemes whose employers have become insolvent. It commenced operation on 6 April 2005. It is funded by a compulsory annual levy payable by all eligible DB pension schemes.
Pensioners over normal retirement date will receive compensation from the PPF amounting to 100% of their pension plus future cost of living increases. Other scheme members will receive compensation on a more limited basis.
The Basic State Pension
The Basic State Pension is currently £107.45 per week and is available to anyone who has paid at least 30 years’ worth of NI contributions. A lower pension is available to those with fewer years of NI contributions.
Individuals whose Basic State Pension, combined with their other means of support, does not give them enough to live on are entitled to an additional benefit called Pension Credit. At present, 40% of pensioners receive Pension Credit.
The State Second Pension (S2P)
The second component of the State pension system consists of the State Second Pension, formerly called the State Earnings-Related Pension Scheme (SERPS). The State Second Pension is calculated in accordance with a complex formula based on the NI contributions that the individual has made over their working life.
What is the Financial Conduct Authority?
The FCA regulates personal pension schemes, together with many other kinds of consumer investment products. For example, it regulates the way in which personal pension schemes are marketed, and it prescribes the documentation and information which personal pension providers must give to their customers.
The FCA does not have a role in regulating occupational pension schemes.
In the past, employers have been able to “contract out” of the State Second Pension. This was accomplished by the employer providing a pension scheme for its employees of above a certain quality level. In return for this, the employer received a rebate on its NI contributions. However, contracting out was abolished in respect of defined contribution pension schemes in April 2012, and it is currently scheduled to be abolished in respect of defined benefit schemes in 2016.
Proposals for reform
The Government proposes to introduce a new flat-rate State pension from 2016-17. This will replace the Basic State Pension, the State Second Pension and Pension Credit. It is estimated that the new pension will be worth at least £144 per week at today’s prices, which corresponds with the current basic level of means tested support. It will be available to all workers with 35 years’ worth of NI contributions. Workers with fewer years of NI contributions will be entitled to a reduced pension. The reforms are designed to be cost neutral overall.
Current issues in pensions
What’s the problem? These new rules place extra obligations on employers to make pension provision for employees
Commencing from October 2012, all employers are being required by law to make arrangements for workers in the UK to be automatically enrolled into a pension scheme. This includes a requirement to make contributions towards workers’ pension savings. Automatic enrolment is being phased in according to size of workforce, and all employers with more than 50 workers will have to comply by April 2015. All businesses, other than start-ups established during the phasing-in period, will have come within the ambit of the legislation by 1 April 2017.
Employers will have to automatically enrol “eligible jobholders” into a pension scheme. A defined contribution scheme can be used for this purpose. Eligible jobholders are workers who work or ordinarily work in the UK, are aged between 22 and State pension age, and have “qualifying earnings” (currently £9,440 per year). The employer will need to pay contributions of at least 3% of their earnings in a band from £5,668 to £41,450 (although the employer can opt, if it wishes, to comply with other contribution criteria which are substantially similar). The “work or ordinarily work” test for qualification as an eligible jobholder can raise tricky questions about the treatment of secondees both into and from the UK.
Workers who are not eligible jobholders need not be automatically enrolled into a pension scheme, but they have other pension rights under the legislation.
This is a bare summary of the automatic enrolment requirements. For more details, please see our briefing note.
Defined benefit scheme funding
What’s the problem? This means employers may be obliged to pay out large sums to clear their company pension scheme’s deficit. These obligations can be triggered unwittingly by group restructurings.
A defined benefit scheme within your corporate group can be an onerous financial commitment. Not only are there ongoing funding requirements, an employer can become subject to an immediate obligation to pay a “Section 75 debt” equal to the employer’s proportionate share of the total deficit. For the purposes of calculating a Section 75 debt, the scheme’s deficit is valued on the assumption that the liabilities are to be secured by means of annuities from an insurance company. A Section 75 debt is triggered where:
- A scheme is wound up;
- An employer becomes insolvent; or
- One or more employers withdraws from a multi-employer scheme
This last method can cause problems in M&A activities, and we have also seen Section 75 debts unwittingly triggered by group restructurings.
Section 75 debts can be sizeable, and considerably in excess of any ongoing funding requirement. However, the legislation provides for several mechanisms by which a Section 75 debt of one employer can be apportioned to or guaranteed by another company. Such a debt does not, therefore, necessarily have to be paid immediately or by the employer which incurs it; but it is important to address this early in any proposed corporate activity.
An employer cannot, by law, walk away from its DB pension liabilities. Where an employer seeks to use contrived arrangements to avoid such liabilities, the Pensions Regulator can intervene with its “moral hazard” powers under the Pensions Act 2004. These consist of Contribution Notices and Financial Support Directions. In summary, a Contribution Notice can be issued where an employer has attempted to circumvent or escape from a potential Section 75 debt, while a Financial Support Direction can be used to pierce the corporate veil and require other group companies to fund pensions liabilities. There are detailed criteria and processes for issuing Contribution Notices and Financial Support Directions, including a requirement that it must be “reasonable” for the Pensions Regulator to issue to do so.
There has been a general trend away from DB schemes over the last 15-20 years, but the move has been accelerating more recently, with employers closing schemes to existing employees. Such a move requires joined-up employment and pensions law advice, and can involve protracted discussions with trustees. Typically, such an exercise can take around nine months to complete.
What’s the problem? This means benefits may not have been equalised correctly meaning the scheme may be underfunded
Employers and trustees must not operate their pension schemes on a discriminatory basis. In particular, both EU and UK law require equal treatment between men and women. This has proven problematic in the past because UK pension schemes typically had a normal retirement date (NRD) for women of 60 and an NRD for men of 65 (which mirrored the State pension age).
This differential treatment was declared unlawful by the European Court of Justice in the case of Barber v Guardian Royal Exchange with effect from 17 May 1990. The Barber case had the effect of automatically lowering men’s NRDs to the equivalent female NRDs (this being the move favourable age) in respect of future accruals of pension. In many cases, the NRDs for both sexes were subsequently increased back up to age 65, in respect of accruals of pension from the date of the increase, in order to reduce the cost to the employer. However, a common problem is that the rules were not correctly amended, so that, although the scheme has been run on the assumption the NRD is 65, it actually remains at 60. This means pensioners may have been underpaid pensions and the value of liabilities has been understated. Even though the Barber case is more than 20 years old, it is still causing problems. It is important that careful due diligence is carried out when taking on responsibility for a pension scheme in order to ensure that benefits have been equalised correctly.