Defined benefit pension schemes face fresh uncertainty following recent high court judgment
The judgment will affect schemes that were formerly contracted-out on a salary related basis between 1997 and 2016 and where changes were made to benefit terms in that period without obtaining the required actuarial confirmation. This note examines what the judgment is likely to mean in practice for trustees, sponsors and bulk annuity insurers.
Legislative background
The regime that allowed pension schemes to contract out from the state earnings related pension scheme (SERPS) was significantly amended on and from 6 April 1997. Prior to that date a contracted-out salary-related scheme was required to provide each member with a guaranteed minimum pension, broadly equivalent to the SERPS pension that it replaced. With effect from 6 April 1997, further accrual of GMP ended and instead contracted-out schemes had to satisfy a more general test of overall quality, which became known as the “reference scheme test”. Whether that test was met had to be confirmed by the scheme actuary.
The Pension Schemes Act 1993 (the Act) was amended to reflect the changes to the contracting-out regime. In particular, section 37 of the Act and Regulation 42 of the Occupational Pension Schemes (Contracting-out) Regulations 1996 (the Regulations) together provided that the rules of a salary related contracted-out scheme could not be altered in relation to any section 9(2B) rights unless:
- the trustees had informed the scheme actuary in writing of the proposed alteration;
- the actuary had considered the proposed alteration and confirmed to the trustees in writing that they were satisfied the scheme would continue to satisfy the statutory standard in accordance with section 12A of the Act if the alteration was made (note, a formal certificate was not required); and
- the alteration did not otherwise prevent the scheme from satisfying the conditions of section 9(2B) of the Act.
Section 9(2B) rights were defined as rights to the payment of pensions and accrued rights to pensions (other than rights attributable to voluntary contributions) under a contracted-out scheme so far as attributable to an earner’s service in contracted-out employment on or after 6 April 1997.
Facts of the case
The case concerned the National Transcommunication Limited Pension Plan (the Plan), which was a salary related contracted-out scheme. In 1999 a new trust deed and rules was executed. One of the amendments was to reduce the rate of revaluation of deferred benefits under the Plan. The reduced rate only applied to benefits accrued after the date of the amendment. If the amendment to the revaluation rate was held to be void then members would be entitled to the higher rate of revaluation that previously applied. It was estimated that this would increase the Plan’s liabilities by around £10m.
The case proceeded on the assumption that the actuarial confirmation was not available, with Virgin Media and the Trustee of the Plan reserving the right to trawl through their records for evidence that the confirmations were in fact provided.
The judge, Mrs Justice Baron, found that:
- the absence of the required actuarial confirmation when making amendments in relation to post-6 April 1997 benefits meant those amendments were void (meaning they did not take effect);
- the amendments were void in respect of changes to both accrued benefits and future benefits; and
- the voidness applied equally to amendments that were prejudicial to members and amendments that would (had they not been invalidated by the absence of the actuarial confirmation) have enhanced member benefits.
In practice, most amendments around this time were likely to have been to “reduce” member benefits (for example, by capping pensions increases, reducing accrual or shifting the basis of accrual from final salary to career average) which means the judgment could result in a windfall for some members by invalidating amendments and providing benefits that were not intended by either the sponsor or the trustees.
It is not yet known whether Virgin Media plan to appeal the decision. Schemes may want to wait until they know whether there will be an appeal and, if so the outcome, before they take any of the actions referred to below. There will, however, be circumstances where some schemes need to act sooner, for example, if they are about to buy-out benefits with an insurer.
What this means in practice
We are still digesting the judgment and what it will mean in practice. However, we have set out below some initial thoughts on the practical implications of the court judgment for trustees, sponsors and bulk annuity insurers (assuming the judgment is not overturned if it is appealed).
Due diligence of historic deeds
Trustees of defined benefit occupational pension schemes that were formerly contracted-out on a salary related basis between 1997 and 2016 may want to review deeds of amendment from within this period to determine whether:
- the deed makes amendments that are potentially affected by this judgment. Some amendments will clearly not be such as amendments to administrative powers or relating to voluntary contributions. Other amendments may be less clear cut, for example amendments to trivial commutation rules or to allow flexible retirement; and
- on the face of each deed there is sufficient evidence that the actuarial confirmation was provided.
If there is doubt, trustees, sponsors, scheme actuaries and legal advisers may be tasked to trawl through their records for past emails, faxes and correspondence for evidence to support that the actuarial confirmation was provided. Given that some amendments may have been made over 25 years ago, it is quite possible that schemes will not be able to find the actuarial confirmation or any evidence as to whether or not it was provided. In these circumstances, trustees will need to take legal advice on whether this means the amendments should be treated as void.
Benefit corrections
If it is concluded that the actuarial confirmation was not provided for certain amendments to benefits, trustees will need to correct members’ benefits to reflect the fact those amendments were invalid:
- if the amendment was to reduce benefits then members’ benefits will need to be increased. This will give rise to the usual issues when a scheme has underpaid benefits such as paying arrears of pension and interest on those payments, and forfeiture; or
- if the amendment was to improve benefits, trustees will need to discuss with the sponsor whether they are willing to augment members’ benefits (assuming sponsor agreement is required). While one might expect the sponsor to agree given they had previously decided to make the amendment, if there have been amendments reducing benefits that are now invalid the sponsor may want to offset some of the increase in liabilities.
Journey planning
Trustees may need to pause their journey planning or plans to enter a buy-in transaction until they have ascertained whether there will be any increase in the scheme’s liabilities.
Legal action against advisers
If amendments are found to be void because of a failure to obtain actuarial confirmation, trustees may want to consider whether they have a claim for negligence against their advisers. There are likely to be limitation issues in respect of amendments made more than 15 years ago.
- If amendments reducing benefits are found to be invalid, sponsors could face additional funding requirements as a result of the increase to the scheme’s liabilities. There will also be additional expenses resulting from the benefit correction exercise.
- On corporate transactions, potential buyers may raise questions about whether the scheme’s liabilities could be greater because of the judgment. The ability for potential buyers and/or sponsors to diligence this may be limited due to deal timing and confidentiality (there would need to be engagement with the trustees and their advisers on the issue). Buyers may therefore seek some form of protection in the event that the scheme’s liabilities turn out to be greater than expected.
- For sponsors with formerly contracted-out schemes that have been bought in, if the scheme’s liabilities turn out to be significantly higher than those covered by the buy-in contract the trustees will be more reliant on employer contributions to fund those liabilities because they won’t have any assets to generate investment returns. If the sponsor has entered into a formal agreement with the trustees to pay any final premium required to buy-out benefits, it may want to check whether that obligation extends to paying a premium to cover the additional liabilities.
- Insurers who have entered into residual risks policies may want to check the terms of those policies to ensure it carves out any claims arising from the invalidity of any deed or amendment (in our experience, such a carve-out is relatively common). We expect insurers will want to maintain such a carve-out in the near term. However, once industry thinking has developed on this issue it may become a risk that can be appropriately diligenced and so may not need to be carved-out in every case.
- Insurers could see some business disruption if schemes do find they have significant additional liabilities, for example requests for quotes being pulled or delays in schemes moving to buy-out.
