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Occupational pension schemes
Types of scheme What are the most common types of pension scheme provided by employers for their employees in your jurisdiction?
There are two main types of pension scheme in the United Kingdom: defined benefit schemes and defined contribution (or ‘money purchase’) schemes.
Defined benefit schemes typically offer one of three types of defined benefit:
- final salary – where members are promised a percentage of their final salary for each year of pensionable service;
- career-average re-valued earnings – where members are promised a percentage of their average salary over the period of their pensionable service for each year of pensionable service; or
- cash balance – where members are promised a retirement pot of a pre-defined amount for each year of pensionable service.
In a defined contribution scheme, employers and employees contribute a set amount each year to a member’s retirement account, which is then invested. These schemes do not promise members a particular level of benefit or guarantee the size of the account when the member retires.
As well as promising retirement benefits, both defined benefit and defined contribution schemes typically provide survivors’ benefits when a member dies, whether before or after retirement.
Statutory framework Is there a statutory framework governing the establishment and operation of occupational pension plans?
Pension schemes in the United Kingdom are subject to a number of pension-specific statutes, as well as numerous regulations made under those statutes.
The Pensions Act 2008 sets out the requirements that a scheme must satisfy in order to be a qualifying pension scheme for purposes of the automatic enrolment regime. The Finance Act 2004 sets out the requirements that registered pension schemes must meet. The Finance Act 2004 and the Income Tax (Earnings and Pensions) Act 2003 govern the tax treatment of contributions to, and payments from, pension schemes.
The other principal statutes include the Pension Schemes Act 1993, the Pensions Act 1995 and the Pensions Act 2004, which between them impose a wide range of requirements on pension schemes, including:
- investment restrictions;
- minimum scheme funding requirements (for defined benefit schemes);
- protection for early leavers;
- disclosure and reporting obligations;
- dispute resolution requirements; and
- scheme termination rules.
The Pensions Act 2004 also established the Pensions Regulator, which is responsible for the regulation of pension schemes used by employers, and the Pension Protection Fund, which acts as a lifeline for underfunded defined benefit schemes whose employers become insolvent.
Further, the Equality Act 2010 imposes non-discrimination requirements regarding entry to, and the terms of membership of, pension schemes.
What are the general rules and requirements regarding the vesting of benefits?
Under statute, benefits under a trust-based pension scheme vest after the member has completed:
- two or more years’ qualifying service in a defined benefit scheme or in a defined contribution scheme if the member joined the scheme before October 1 2015; or
- 30 or more days’ qualifying service in a defined contribution scheme if the member joined the scheme on or after October 1 2015.
‘Qualifying service’ is membership of the scheme plus membership of any scheme from which a transfer payment has been accepted in respect of the member. Schemes can provide for members’ benefits to vest after a shorter period of qualifying service than that required under statute.
Members with vested benefits are entitled to a deferred benefit, which is payable from the scheme’s normal retirement age and calculated using the same formula as the benefit payable on retirement from active service at that age.
Members with less than two years’/30 days’ qualifying service (as applicable) are entitled to a refund of their contributions. Members with statutorily vested benefits are not entitled to be offered a refund of their contributions.
Benefits under a contract-based pension scheme vest immediately, subject to a 30-day ‘cooling-off’ period during which the member can cancel the pension contract and receive a refund of any contributions made.
What are the general rules and requirements regarding the funding of plan liabilities?
If a defined contribution pension scheme is a qualifying pension scheme for automatic enrolment purposes, statutory minimum employer contribution rates apply; the scheme must satisfy one of four prescribed contribution structures. If an employer maintains a defined contribution scheme that is not a qualifying pension scheme, the employer need not contribute to the scheme (ie, contributions are discretionary). However, employers that maintain such schemes typically make monthly contributions, which are usually expressed as a percentage of the employee’s salary.
Statutory scheme funding requirements apply to defined benefit pension schemes. Schemes must have sufficient and appropriate assets to cover the value of their liabilities as calculated by the scheme actuary on a prudent (not merely a best estimate) basis. They must carry out a valuation of the scheme’s assets and liabilities every three years, and if that valuation shows that the scheme is in deficit, a recovery plan must be put in place, including a schedule of contributions which sets out:
- the level of employer deficit reduction contributions to be made to remove the deficit; and
- the level of employer and member contributions to fund any future service benefits – these are usually expressed as a percentage of the members’ salaries.
A one-off employer contribution, which may be substantial, is typically also required if:
- an employer withdraws from a defined benefit scheme;
- the scheme terminates; or
- an employer becomes insolvent.
Employers are responsible for deducting member contributions from their salaries and must pay those contributions (and any employer contributions) over to the scheme within a statutory timeframe.
What are the tax consequences for employers and participants of occupational pension schemes?
Pension schemes that are registered with Her Majesty’s Revenue and Customs receive favourable tax treatment under the Finance Act 2004, including tax relief on employee and employer contributions and on investment income and capital growth. Employer contributions are also exempt from national insurance contributions. However, registered pension schemes are subject to a number of restrictions, including the following:
- There are annual and lifetime limits on the level of tax-relieved pension savings that can be made by a member of a registered pension scheme.
- A registered pension scheme cannot generally pay benefits to a member before he or she is 55 years old (unless the member is suffering from ill health), and payments from a registered pension scheme may be made only in certain prescribed ways.
Benefits taken from a registered pension scheme are generally subject to income tax, but up to 25% of an individual’s benefits can be taken as a tax-free lump sum.
Unregistered pension schemes do not receive the tax advantages available to registered pension schemes, but are not subject to the restrictions imposed on registered pension schemes. As a result of the unattractive tax treatment of unregistered schemes, employers rarely use such schemes.
Is there any requirement to hold plan assets in trust or similar vehicles?
Pension schemes in the United Kingdom can be set up under either trust or contract.
Trust-based pension schemes (also known as ‘occupational pension schemes’) are established by an employer for the benefit of its employees, and are governed by a trust deed and rules. Trustees are appointed to administer the trust and are the legal owners of the trust’s (ie, the pension scheme’s) assets. The trustees hold the assets for the purposes of the scheme (ie, chiefly in order to fund the benefits promised to the scheme members) rather than for their own personal benefit. Trust-based schemes can provide defined benefit or defined contribution benefits.
Trustees are subject to a wide range of legal duties, including fiduciary duties. These include a requirement to exercise their powers for the purpose for which they were conferred (sometimes described as a duty to act in the best interests of the scheme’s members). Employers are also subject to fiduciary duties (albeit less stringent duties than apply to trustees). The key fiduciary duty for employers requires them, when exercising their rights and powers under the employment contract and under the pension scheme, not to undermine the relationship of mutual trust and confidence that should exist between employers and employees.
Contract-based pension schemes (also known as ‘personal pension schemes’) are an individual contract between the member and the pension provider (normally an insurer). The pension provider is responsible for administering the scheme. Contract-based schemes generally provide only defined contribution benefits. Employers can set up a group contract-based pension scheme by selecting a pension provider – each employee will then have an individual contract with that provider. Providers of contracted-based schemes must be authorised by the Financial Conduct Authority (FCA) and are therefore subject to the rules and regulations made by the FCA.
Are there any special fiduciary rules (including any prohibited transactions) in relation to the investment of pension plan assets?
In a trust-based pension scheme, the trustees are responsible for the investment of the scheme’s assets. Legislation gives trustees wide investment powers, but also requires them to take into account a broad range of factors when making investment decisions and imposes a number of restrictions, including on a limit on the level of employer-related investment and a prohibition on employer-related loans. Trustees are also subject to fiduciary duties under trust law, including a duty to invest assets in members’ best financial interests. Further, trustees must comply with any investment restrictions set out in the scheme’s trust deed and rules.
A trust-based pension scheme may not provide for the employer’s consent to be required to the exercise by the trustees of their investment powers, but the trustees must consult with the employer on the scheme’s investment strategy. In a defined benefit trust-based scheme, members have no involvement in scheme investment. In a defined contribution trust-based scheme, the trustees are responsible for selecting the range of investment funds available under the scheme and for keeping the range under review, while members are responsible for selecting from that range.
In a contract-based pension scheme, the pension provider determines the range of investment funds on offer and the member is responsible for selecting from that range. The employer may work with the provider to select a bespoke range of funds for the scheme from the wider range offered by the provider. There is no duty on the employer to monitor the scheme’s performance, but some employers choose to do so. The provider must comply with FCA rules in the investment options that it makes available to members.
Is there any government oversight of plan administration and/or insurance coverage for plan benefits in the event of an employer’s insolvency?
Assets held in a trust-based pension scheme are legally owned by the trustees – they are therefore legally segregated from the employer’s assets and cannot be called on in the event of the employer’s insolvency. In the event of its insolvency, an employer that participates in a defined benefit scheme becomes liable to fund its share of any deficit in the scheme. For these purposes, the scheme’s liabilities are calculated by reference to the cost of securing those liabilities by annuity purchase. The scheme becomes a creditor of the employer in this respect and is entitled to share in the distribution of the employer’s assets by the insolvency practitioner in accordance with the statutory corporate insolvency order of priority.
The employer’s insolvency will also trigger a Pension Protection Fund (PPF) assessment period, during which the PPF will assess whether the level of funding in the scheme qualifies the scheme for entry into the PPF (taking into account any distribution received by the scheme under the statutory corporate insolvency order of priority). Should the scheme be accepted, the PPF will take over responsibility for the scheme and will pay compensation to the scheme’s members based on the benefits payable under the scheme, subject to a statutory cap.
If the scheme is in deficit but too highly funded to be eligible for PPF entry (essentially where it has sufficient assets to buy annuities that exceed PPF compensation), the scheme will generally be terminated and wound up and reduced benefits will be secured for members in accordance with the statutory order of priority.
Assets held in a contract-based pension scheme are legally owned by the scheme provider and likewise therefore are not available to the employer’s creditors. The funds held in a contract-based scheme are not legally segregated in the event of the provider’s insolvency, but compensation may be payable from the Financial Services Compensation Scheme.
Are employees’ pension rights protected in the event of a business transfer?
On a business transfer, legislation provides for the employment contracts of the transferring employees to transfer to the buyer automatically. Although this does not extend to terms and conditions relating to trust-based pension schemes (subject to some exceptions relating to enhanced early retirement rights), where the transferring employees are members of a trust-based scheme, the buyer must provide replacement pension provision that meets standards prescribed in legislation.
Where the transferring employees are members of a contract-based pension scheme, the terms and conditions of their employment contracts relating to pensions are transferred to, and must therefore be replicated by, the buyer.
Pension benefits accrued before a business transfer are unaffected by the transfer.
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