UK Pensions Reform: The White Paper

August 14, 2003

Following on from the consultation process on the Green Paper (which was the focus of our On the Subject… in February 2003), the UK Government published its White Paper entitled "Simplicity, Security and Choice: Working and Saving for Retirement Action on Occupational Pensions" on 11 June 2003 which sets out the first stage of a programme of reforms for the UK pensions system. In this article, we discuss the most important of these reform proposals.

There is in fact some doubt as to whether the publication is a "White Paper"; it is referred to in its own text as a "document" and by other commentators as a "Command Paper." However, for the purposes of this paper, we will refer to it as a "White Paper" in the fashion most often adopted by previous governments.

Introduction
One of the most striking aspects of the White Paper is the admission by the UK Government that "occupational pensions, traditionally a source of strength in the UK pensions partnership, face particular pressures that require early action." This marks a significant change in the government’s approach which, up until the publication of the White Paper, had been to play down claims of a UK pensions crisis. Although in some areas detail is still lacking (with further consultation expected in due course), the White Paper does contain some far-reaching reform proposals which reflect the government’s acknowledgement of at least some of the problems of the existing occupational pensions system.

The bulk of the changes seem likely to be introduced in April 2005, at the same time as the Inland Revenue changes to the tax regime. However, other reforms have immediate effect (e.g., the new debt on the employer) while others will be introduced later this year (e.g., changes to the statutory priority order on winding-up). The reforms centre around the two key aims of greater protection for members; and reduction of costs for employers.

In summary, greater protection for members is to be achieved through the following:

It is envisaged that employers’ costs will be reduced by:

Greater Protection for Members
Voluntary Winding-Up Where Employer is Solvent
A solvent employer who wishes to wind-up its defined benefit pension scheme on or after 11 June 2003 will have to meet the scheme’s pension promises in full, i.e., the employer and/or the scheme will have to meet the full buy-out cost of all members’ accrued rights. However, the White Paper does contemplate a "compromise position" so trustees are to be permitted to accept a lower payment from the employer where requiring it to meet the full buy-out costs would put that employer "at risk".

Although this proposal was put forward as a possible approach in the Green Paper, its inclusion in the White Paper with immediate effect has taken the pensions industry by surprise. However, once the proposal was announced the government had little choice but to make it effective immediately in order to avoid sponsoring employers trying to avoid this additional liability and rendering the reform proposals worthless.

The statutory debt due from a solvent employer to an underfunded scheme in wind-up was originally calculated according to the MFR basis. In March of last year the legislation was amended to extend the debt to include wind-up expenses and the cost of buying out pensions and pension increases. The current proposal extends employers’ obligations further by requiring that the full buy-out costs of all benefits be met. Employers with defined benefit schemes now face greater financial responsibilities, particularly given the ever-increasing cost of purchasing annuities (particularly for deferred benefits). This is even more onerous when one considers that although employers often have the power to trigger termination of a scheme, for example by ceasing contributions, it is often the trustees who make the ultimate decision to wind-up a scheme. Accordingly, there are situations where an employer may not have control over the decision to wind-up the scheme but could be faced with an increased financial burden in having to meet the full buy-out costs of all accrued rights on the trustees deciding to place the scheme in wind-up. This in turn will be made worse by the trustees adopting a gilt-matching investment strategy in the period between the termination notice and the commencement of the wind-up, as the trustees must consider doing to satisfy their fiduciary duties in maximising the debt.

Draft regulations to implement these proposals have been published. However, they do not accurately reflect the White Paper. For example, the "compromise position" (described above) is not referred to in the draft regulations at all. It also remains to be seen what will constitute a company being "at risk" and also whether the powers of the trustees to agree a lesser amount will be set out in detail in the final regulations or whether trustees will continue to be guided by general trust law principles (as set out in case law).

Priority Order on Winding-Up
Where a scheme has insufficient assets to meet all liabilities, the level of benefits secured on wind-up are to be based on the period of time that the individual member has been contributing to the scheme so that longer contributing members will stand a greater chance of receiving a greater part of their benefits. The changes (supposedly coming into force in the autumn) mean that although pensioners will still get their full pensions, non-pensioners (i.e., active and deferred members) will be given priority over increases to pensions in payment.

The unfairness of the current statutory order of priorities has long been criticised. Under the current regime, where a scheme’s assets are insufficient to meet all its liabilities, pensions in payment as well as increases to those pensions must first be met in full before any non-pensioner benefits are met. This has meant that active members very close to retirement have walked away with much reduced or even no benefits.

Although this proposal is to be welcomed as a step towards remedying the current imbalance, it should not be overlooked that active members nearer retirement may still not enjoy greater protection if they have not been in the scheme for a long period of time. Indeed, an alternative approach considered in the Green Paper was to upgrade those members approaching retirement age on the order of priorities but this has not found its way through to the White Paper.

Pensions Protection Fund
A fund is to be established to protect members of defined benefit schemes by guaranteeing them a minimum level of pension benefit when the sponsoring employer of their scheme becomes insolvent. Compensation will not be available retrospectively in that it will not be available to those members whose schemes have already been wound-up, although whether it will apply to schemes already in wind-up when the applicable legislation comes into effect or only to those where wind-up commences after the legislation comes into force remains to be seen. Pensioners will have the full amount of their benefits guaranteed while non-pensioners will have up to 90 per cent of their benefits guaranteed, subject to a salary cap of between £40,000 and £60,000 (the exact figure is still to be determined). The rationale behind guaranteeing different proportions of benefits for different groups of members is unclear.

This proposal is to be welcomed in principle. There have been calls for this type of compensation fund for some considerable time. However, there are concerns regarding its implementation and particularly how it is to be funded. It is intended that the scheme will be funded through a flat rate levy (the amount of which is still to be determined) payable by all employers with defined benefit schemes as well as risk-based premiums payable by underfunded pension schemes. Crucially, the government has stated its intention not to stand behind the scheme in the last resort and whether this will result in a higher levy being payable to try to avoid the scheme falling into deficit (a problem now facing the equivalent US body, the Pension Benefits Guaranty Corporation) remains to be seen. The risk-based premium raises issues of whether trustees may try to increase employer contributions to ensure a scheme’s funding level is sufficient to avoid paying the additional levy or at least to minimise the amount to be paid. Employers could find themselves in a "no-win" situation of either having to increase their contributions to maintain a scheme’s funding level in order to avoid the additional levy or having to increase their contributions to cover the cost of the risk-based premium.

Concerns have also been expressed that the establishment of the fund may encourage employers and trustees to be less cautious in their funding and investment decisions, and that trustees could be less likely to compromise the amount of the statutory debt owed to a scheme in wind-up by the employer knowing that if the employer goes insolvent the members will be able to fall back on the protection of the compensation fund.

Pensions Regulator
The Occupational Pensions Regulatory Authority (OPRA) is to be replaced with a new regulator which is to be more proactive, focusing on schemes where there is a higher risk of fraud, bad governance or poor administration. The regulator is to have powers to issue Codes of Practice which would supplement legislation, thereby reducing the need for detailed regulation. These codes would not have the force of law but would provide guidance on how to comply with legislative requirements.

The current system imposes onerous and costly administrative and regulatory burdens on schemes and has been criticised for focusing too much on reporting non-material breaches of the legislation rather than concentrating on those acts and omissions which materially affect members’ benefits. OPRA has powers which allow it only to respond to events once they have happened rather than to anticipate and prevent those events in the first place. It is to be hoped that the new regulator will be able to take a more practical and balanced approach to safeguarding members’ benefits.

The Transfer of Undertakings Protection of Employment (TUPE) Regulations
Employees transferred under TUPE (i.e., on the transfer of a business undertaking) will have to be provided with membership of at least a stakeholder pension plan with their new employer matching employee contributions up to 6 per cent.

Occupational pension rights relating to "old age, invalidity or survivors" benefits do not currently transfer under TUPE, so there is no obligation on the purchaser of a business undertaking to set up an occupational pension scheme offering the same or similar benefits for future service. Accordingly, the proposals do offer some protection to members of occupational pension schemes for future service. However, membership of a money purchase arrangement with matching employer contributions of up to 6 per cent does not compare favourably with a scheme offering benefits linked to final salary where employer contributions are usually considerably higher than 6 per cent. This protection is also considerably less than that afforded to public sector employees who transfer to the private sector, which protection looks set to continue.

Amendments
Employers will be required to consult scheme members before making changes to pension schemes. The types of changes to which this rule will apply are still to be considered and further consultation on this is planned.

Vesting
In an attempt to encourage employees to build up pension rights, those who have been members of a scheme for at least three months but who leave during the statutory two-year vesting period must be given the choice of either receiving a refund of their contributions or the transfer of the cash equivalent of their benefits to another pension scheme. Although scheme rules may provide for a shorter vesting period, generally early leavers are only entitled to a (deferred) benefit under a scheme once they have completed at least two years of qualifying service.

The White Paper proposal represents a compromise position from the Green Paper position which advocated compulsory immediate vesting (i.e., that all members would be entitled to (deferred) benefits under a scheme irrespective of their length of service) but with the possibility of trustees being able to transfer to "safe harbour" products those deferred pensions of small value. This initial proposal was criticised for placing additional administrative obligations on schemes. However, the amended proposal does not overcome these burdens which will still arise as a result of schemes having to administer a larger number of (deferred) benefits of relatively small value.

Trustee Training and Expertise
Legislation will require trustees to be familiar with and have relevant knowledge across the full range of their duties. Codes of Practice issued by the new regulator will set out guidance for trustees on how to fulfil the statutory requirements.

This follows from the Myners’ Report (and resultant voluntary Code of Conduct) which concluded (amongst other things) that there should be a higher duty of care placed on trustees making investment decisions. Although it is important to ensure trustees are held to a high standard of care, one cannot help but wonder whether imposing ever stricter standards will simply further deter lay persons from accepting trustee appointments and at a time when, somewhat paradoxically, the government has indicated its support for changes to the Member-Nominated Trustees (MNTs) regulatory provisions to achieve greater member participation.

Compulsory Scheme Membership
Employers are not to be permitted to make compulsory membership of their occupational pension scheme a condition of employment. However, the new regulator may issue guidance to the effect that employers should include, in the ordinary course, all employees in their scheme unless the employee chooses to opt-out. This guidance will then be used to put forward the approach originally suggested in the Green Paper. However, this does raise legal and practical issues, such as how an employer can deduct contributions from an employee’s salary without his or her permission.

It remains to be seen whether the government will revise its position on compulsory membership which is, to say the least, a politically sensitive issue.

Reducing Employers Costs
Scheme-Specific Funding Requirement
The MFR is to be replaced by a long-term, scheme-specific funding standard (as described in the Green Paper) under which funding and investment decisions will be made in light of the scheme’s own experience and circumstances. The key features are as follows:

• The trustees must draw up a statement of funding principles;
• A full actuarial valuation will be required at least every three years;
• The trustees must put in place a schedule of contributions;
• The trustees will have to send to members every year information regarding the funding position of their scheme;
• Where the trustees and an employer are unable to agree over various prescribed issues relating to the funding of the scheme, the trustees will have, as a last resort, the unilateral power to freeze or wind-up the scheme.

The MFR has been much discredited and its replacement is to be welcomed, particularly if it does allow schemes greater flexibility. However, whether this will actually be achieved will depend on the details of the proposal which have not yet been determined, and there is always the possibility that its implementation could increase scheme funding costs rather than reduce them.

The additional powers given to trustees are the most controversial aspect of this new funding requirement. The retention in the White Paper of these proposals initially set out in the Green Paper is an example of how, within the occupational pensions system, the balance of power is shifting more towards trustees.

Indexation Requirements
Pensions in payment must be increased each year by Limited Price Indexation (LPI) which is the rate of inflation currently capped at 5 per cent. This cap is to be reduced to 2.5 per cent. The change will only relate to future service and will not affect pensions already in payment.

While this will result in cost reductions for employers, it may increase the administrative burden on schemes with different rates of increases applying in respect of different periods of service.

Increasing Flexibility
Section 67 of the Pensions Act 1995 (which restricts the power to alter schemes) is to be amended so that changes to accrued rights may be made without member consent. This is subject to a proviso that the overall actuarial value of the member’s accrued rights is maintained.

The aim of this proposal is well intentioned. Section 67 has been greatly criticised for being overly complex. However, draft legislation will need to be published before an assessment can be made of how this revised provision will actually work in practice.

Simplifying Legislation
Various areas of legislation, including tax and contracting-out, are to be simplified in a bid to ease the administrative burden on schemes. Other areas targeted for simplification include internal dispute resolution procedures, member communications, the treatment of pensions on divorce and the Pensions Ombudsman’s jurisdiction.

A new simplified tax regime for pensions is expected to be implemented from April 2005. Further consultation on this and details of the new tax regime are expected this autumn.

Pensions legislation is often criticised for being overly complex and meaningful simplification is to be welcomed. However, in the case of contracting-out it would be preferable if the entire system was simply abolished.

AVC Facilities
Occupational pension schemes will no longer be obliged to offer AVC facilities to members. Instead, following changes to the tax regime, members will be able to make their own arrangements for AVCs through stakeholder or personal pension arrangements.

Miscellaneous Provisions
The White Paper sets out various proposals aimed at helping people to plan for their retirement. These include the following:

• Changing the Inland Revenue rules to allow people to draw a pension while still in employment and, thereby, allowing people greater flexibility to extend their working lives;
• Introducing legislation requiring members of defined benefit schemes to be provided with annual statements showing the amount of the benefit already built up and the benefit they can expect to receive on retirement;
• Outlawing age discrimination (legislation is to come into force in late 2006);
• Increasing the earliest retirement age from 50 to 55;
• Raising the normal retirement age in public sector schemes to 65 (from 60) for all new members from the end of 2006.

The White Paper is about balancing the competing interests of employers and members. Whether these reforms will restore confidence in the occupational pensions system and achieve the government’s stated aims remains to be seen. What is striking about some of these reforms is that they will impose further obligations on sponsoring employers and give trustees additional powers, thus shifting the balance of power between trustees and employers in favour of trustees. Reactions to the proposals have been varied to say the least. It is hoped that some proposals will provide workable solutions for both members and employers.

Practice Areas & Industries:

• Employment - London
• London
• Pensions & Incentives - London

Subscribe

• Subscribe to Newsletters and News Alerts