There has been a growing trend amongst employers of exploring ways to persuade members to agree to a reduction in benefits or to transfer from a defined benefit to a defined contribution scheme, and the Pensions Regulator is now well and truly on the case. We look at the issues for employers to consider before making an inducement offer and also the factors trustees must consider when faced with an inducement-related proposal.
For over 20 years or more employers and trustees with defined benefit (DB) occupational pension schemes have faced a deluge of increasing scheme costs, burgeoning funding deficits, investment volatility, the abolition of advance corporation tax, the legacy of deferred pensioners and the tightening up of funding legislation. Traditional methods of coping with these rising costs have included scaling down benefit accrual for future service and increasing member contributions.
More recently there has been a growing trend amongst employers of exploring ways of offering inducements to persuade members to agree to a reduction in benefits, or to transfer out of the employer’s DB scheme to a defined contribution (DC) scheme. At the same time, a growing buy-out market has emerged which offers employers who can afford it another way out of escalating pensions costs.
So what are inducements? One can search in vain through pensions legislation for a definition of the term. In a nutshell, an inducement is where an employer offers DB members incentives such as enhanced transfer values or cash payments in return for transferring to a DC scheme or consenting to rule amendments resulting in a reduction in future (and sometimes past) benefits.
Presumably relying on its statutory objective to protect member benefits, and no doubt wary of being blamed for another misselling saga, the Pensions Regulator reacted to recent inducement activity and issued guidance1 which expresses concern that members should be provided with “information they might reasonably need to be able to make an informed choice”.
The background to this statement of the obvious by the Regulator is the risk of claims which might arise where members subsequently find they have suffered financial loss compared with the situation they would have been in had they declined the relevant inducement. The member would have to show both that he relied upon the representations made by the employer and that those were false or misleading and negligently made, and were of such significance to have caused the member to agree to the inducement, which had he not been misled, he would not have accepted. Any negligent misrepresentations might also equate to maladministration and so a complaint might be brought to the Pensions Ombudsman.
On the same day in January this year, HMRC published guidance2 saying that, contrary to previous practice, cash payments in return for a member giving up possible future rights, or an enhancement to encourage a member to transfer, will be liable to national insurance and income tax, except where the payment or enhancement forms part of a transfer value transferred from the scheme to another scheme. To complete the regulatory picture, the Financial Services Authority had already produced a guide about the risk to members of transfers-out3.
Issues for trustees
Trustees have fiduciary duties to the membership and so should monitor the inducement process. However, trustees have no duty to provide members with any financial advice relating to a member’s choice or whether a member should transfer from a scheme (and indeed might well fall foul of financial services legislation if they recommended or endorsed a transfer to, say, a personal pension). The Regulator guidance suggests trustees should question the appropriateness of an inducement offer, check that the employer’s communication includes key information and ensure members understand the importance of taking independent advice.
To assess the appropriateness of the offer, trustees will as ever need to consider the assumptions underlying the normal transfer basis, any reductions applying due to underfunding, the strength of the employer covenant and the extent to which this affects scheme security, and the level of the proposed enhancement. Trustees would need to feel comfortable, following actuarial advice, with any additional funding provided by the employer in order to fund enhanced transfer values.
However, the guidance arguably goes beyond what the law requires of trustees in suggesting that where “the trustees take the view that the inducement offer may not be in the best interests of members, the trustees should think seriously about issuing their own announcement to those members to whom the offer was made to highlight the risks for those members.”
In our view, trustees should, of course, ensure that statutory formalities for transfer procedures are adhered to, in order to ensure that the transfer cannot subsequently be called into question. Precautions could include asking the member to complete and sign a form asking the company (which would in turn ask the trustees) to provide the transfer information. If an employer makes an inducement proposal, trustees might also want to reconsider the extent of their indemnity/exoneration clauses under the scheme plus any insurance protection.
In certain circumstances, the inducement may have to be notified to the Regulator. This would be the case where the inducement involved making a transfer out of the scheme which exceeds 5% of the value of the scheme assets or £1.5m, whichever is lower. It would also be a notifiable event if benefits were to be granted on more favourable terms than those provided for by the scheme rules, without either seeking advice from the actuary or securing additional funding where the extra funds were advised by the actuary.
Issues for employers
There is no duty at law on an employer to provide employees with advice on financial matters or on the implications of choosing certain benefit or retirement options4. However, employers do have a duty of good faith to employees which includes the provision of information about any companyprovided pension schemes.
However, an employer should ensure any inducement offer is clear and provides all necessary information to members - rather like the British Code of Advertising Sales Promotion and Direct Marketing’s principle that communications should be “legal, decent, honest and truthful”.
The Regulator’s guidance highlights numerous issues which it would expect an inducement offer to explain to members. Amongst other things, it suggests there should be a clear explanation of: the nature and amount of the inducement; the implications of the benefits being given up; the risks inherent in transferring from a DB scheme, including the protections afforded by the winding-up legislation and the Pension Protection Fund (PPF); the possible tax implications; and a suggestion that the member considers taking independent financial advice (which the employer could consider providing access to and paying for). Apart from the above considerations emerging from the Regulator’s guidance, what other issues and potential pitfalls should employers and trustees be mindful of?
Naturally, employers need to take care that the basis of calculation for any enhanced transfer is correct and verified by the actuary, even though in theory the actuary would be liable for any errors. Once a member accepts an inducement offer, the “bargain” is struck from which the employer cannot easily resile, even if he later discovers calculation errors.5
Even if an employer has a unilateral power to amend the scheme to reduce future benefits, the employer will nevertheless need to consult with the members under the Occupational and Personal Pension Schemes (Consultation by Employers and Miscellaneous Amendment) Regulations 2006. If the power to amend lies with the trustees, the employer will need to persuade them that the change will be beneficial to members. This might only be achieved by the employer paying substantial additional contributions to improve scheme funding, although clearly the circumstances for each employer and scheme will differ. Where the employer wants to remove or reduce subsisting rights, section 67 of the Pensions Act 1995 requires that members give their informed consent to such a change, which may prove difficult to obtain.
It hardly needs to be said that any member offered an inducement should consider taking independent financial advice for his particular circumstances. An inducement offer may just be one of many financial planning choices facing an individual member.
The whole issue of inducements is far from clear-cut, and the associated risks for all those involved will depend on the offer, the specific circumstances and the information given. Professional advice should be sought by employers and trustees before any offer is made and communicated to members. In short, the moral of the tale is ‘offer in haste, repent at leisure’!