When a defined benefit pension scheme is in danger of becoming too expensive to maintain, for exampler because it has recently failed the statutory minimum funding standard, the first option often focused on is winding the scheme up. An alternative to winding the scheme up may be to place limits on the benefits payable to members.

This note discusses some of the legal issues that employers should consider if they propose to limit entitlements in this way. Clearly, if these options cannot deliver the savings necessary to maintain the scheme in an amended form, winding it up may be the only alternative.

As outlined in the first note, there are good reasons to consider all the cost saving options in detail. To do so in an informed manner will require (amongst others) an understanding of:

  • The human resources/industrial relations issues impacting on any such options;
  • Actuarial advice in relation to the savings and implications of the various options;
  • Pensions consultancy advice in relation to the various options and future pension;
  • Legal advice in relation to the viability of the various options in light of the scheme's governing regime (to include legislative, regulatory, governing trust documentation and contractual); and
  • The position of the scheme's trust.  

Options

Entitlements under a defined benefit scheme can be limited in various ways, including the following:

  1. A cap can be introduced to limit the future level of some or all members' pensionable salary, and hence the ultimate level of their pensions.
  2. In a similar vein, the definition of members' pensionable salary can be narrowed to exclude elements such as bonus payments.
  3. The pensionable salary of each member can be frozen altogether at its current level.
  4. The yearly increase in pension entitlement which is credited to each employee (usually an additional 1/60th of final pensionable salary) can be reduced (say, to 1/80th of final pensionable salary).
  5. The yearly increase can be halted altogether (future accrual ceases).
  6. Guaranteed increases to pension in payment can be converted to discretionary increases.
  7. Requests from trustees for consent to discretionary pension increases can be reduced down, or simply turned down (the employer will usually have a power of veto in this regard).  

In addition, the contributions required from members can be increased – or, where no members' contributions are currently required, compulsory contributions can be introduced.

Preserved Benefits

In deciding on the savings from the various options the effect of the "preserved benefit" provisions of the Pensions Act which entitle employees who leave employment with at least two years' service to a certain minimum level of pension benefits need to be factored in. If benefits have been cut and the member is not actually leaving in order to retire, the reduction in his pension benefits may be limited. The extent of the limitation will be greater if the member is still some years away from retirement and this may limit the cost savings of reducing benefits. The effect is that it may not be possible to apply the full effects of the reduction to members who subsequently leave service before retirement. This is a matter of some complexity, however, and in any event the fact that a change might not have the full effect desired of it is not necessarily a reason not to adopt it.  

Express restrictions on amendments

Most of the options listed above require a scheme amendment. A pension scheme can be amended only within the parameters allowed by its amendment clause. It is not unusual to find clauses prohibiting amendments that would reduce benefits "accrued" by members or "secured by past contributions", or containing some other form of words that appears to protect the entitlements already enjoyed by members.

Certain UK cases have interpreted the scope of members' existing rights widely, and in such a way as to cast doubt on the possibility of making changes of the sort outlined above where the scheme's amendment clause contains relevant restrictions. This approach might be adopted in Ireland if the court was especially concerned with protecting the interests of members.

The specific wording of the amendment clause of the relevant scheme will be pivotal in deciding whether a particular amendment can or cannot be made. It may also be possible to avoid a restriction that would otherwise apply by obtaining the consent of the members to the amendment. Such consent may well be forthcoming, particularly if the scheme is not too large or the alternative is a switch to defined contribution pension provision.

Implied restrictions on amendments

Arguably, amendments cannot be made to a scheme if they would reduce members' entitlements to benefits in respect of their past service even if there is no express restriction on the power of amendment to this effect. The theory is that amendments of this sort would go against the very purpose of a pension scheme, which is to provide benefits rather than to take them away.

Employment law issues

Occupational pension schemes are not free-standing entities. They are set up by employers, and their members consist of current and former employees. Altering the terms of a pension scheme may well raise employment law issues alongside the more basic pensions law issues.

Employment law issues which may be relevant in this context include the following:

  1. Individuals' employment contracts. Have particular promises relating to pension benefits been made to individual employees in their contracts or other related documents/announcements?
  2. "Custom and practice". This is an umbrella term used to refer to obligations that the courts might deem to be included in (or implied into) the employment contract because they amount to an established custom. Under certain circumstances, particular levels of pension provision may be taken to be covered by this doctrine even in the absence of explicit wording in the employment contract. Have the employees, for example, been issued with scheme booklets that seem to suggest that particular levels of benefits are not subject to alteration? Where pension increases are being withheld, is this in contravention of consistent past practice?
  3. The duty of good faith. Employers are, broadly speaking, required to act with good faith towards their employees and former employees. This includes respecting "legitimate expectations" that it may have given them. Employers may be able to implement some of the options outlined in this note without breaching this duty where they can demonstrate their self-interest objectively requires them to do so. In other words, the selected option would need to be shown to be a proportionate and reasonable reaction to the issue faced by the employer. However, this issue can complicate matters. Is there a robust and legitimate business case for amending the scheme?
  4. "Estoppel". This rather obscure legal doctrine means, in essence, that, where the employer has led its employees to act on a particular assumption, it cannot then unjustly go back on that assumption. Again, matters such as the contents of members' booklets, contract and any other announcements will be relevant here.  

Conclusion

Defined benefit schemes which are becoming impossibly expensive can be – and, in practice, are – amended to reduce their cost burden, and there are good reasons why an employer would wish to pursue this course in preference to switching entirely to defined contribution pension provision. However, the business of making scheme amendments (and in particular the amendments outlined in this note) is not altogether straightforward, and careful consideration will have to be given to each particular case. Where there is no viable alternative but to wind-up the scheme, many of the issues outlined above will arise in determining what an employer can legitimately achieve. In addition, the possibility of the trustees demanding a final contribution from the employer and what that might be will be an important factor in considering whether to wind-up a scheme.