Final Salary Pension Schemes Under Attack

Pension provision has never been so controversial. In the late 1980s and early 1990s there were scandals about funding, surpluses and mis-appropriation of pension scheme assets. In the mid 1990s there was the mis-selling scandal. Now final salary pension schemes are under attack and millions of occupational scheme members are worried about their future. This leaflet explains the background to the crisis and what rights members have.

What has gone wrong?

Contrary to popular belief the new accounting standard, FRS 17, imposed by the Accountancy Standards Board is not to blame. FRS 17 has no direct bearing on the funding of pension schemes. All it does is deal with the way in which pension scheme assets appear in the employer’s accounts. So the extent of the deficit is revealed by, not caused by, FRS17.

The blame has also been put on the Minimum Funding Requirement imposed by the Pensions Act 1995. Although the MFR is very artificial because it values investment returns in a prescriptive manner which doesn’t reflect the pension scheme’s security of funding, the problem, from an employer’s point of view, is that the legislation imposes a statutory obligation to make the deficit good within a specified timetable.

The economic background to pension scheme funding is the real reason for the crisis investment returns are falling and annuities are increasingly expensive. At the same time, assumptions made by actuaries about life expectancy have been changing to reflect trends in longevity.

The removal of Advance Corporation Tax Credits took a reputed £5bn annually off the collective value of occupational pension schemes in the country.

Instead of providing a cushion for the future, schemes have been underfunded to the extent that surpluses in the late 80’s and early 90’s were used to take contribution holidays.

It is only now, when employers have to contribute again, that they have realised the open-ended nature of the commitment to pay the balance of costs in a typical final salary pension scheme.

Their solution has been to close the scheme and offer a defined contribution scheme as an alternative. This transfers the problems associated with investment returns to the membership.

A contractual right?

The deeds and rules governing the typical final salary pension scheme will not usually help a member to insist on remaining an active member of the scheme in question. Unless something went seriously wrong when the scheme was drafted, the employer will have reserved the right to cease contributing.

At that point the trustees may have a right to keep the scheme going as a closed scheme, but if there is no more money coming in then sooner or later the scheme will go into wind-up. The employer’s decision to stop contributions is constrained by the duty of good faith but that is all.

An employee defending their right to continue active membership will have to turn to the terms of the contract which they have with the employer. The typical contract of employment or letter of engagement will say something to the effect of:

“There is a company pension scheme which you are/may be entitled to join. Details are set out in the member’s guide to the pension scheme and further details can be obtained from the pension scheme administrator.”

The reason why there is this provision is because Section 1 of the Employment Rights Act 1996 requires every employer to provide a statement of the main terms and conditions of employment including pensions.

The Occupational Pension Schemes (Disclosure of Information) Regulations 1996 requires the provision of an outline of the principal terms of any occupational pension scheme to members (actual and potential) – usually done by providing a handbook of some description.

It is important to note however that the statutory statement of terms and conditions is just that: a statement which outlines the terms of employment. It may reflect the actual provisions of the contract of employment. But not necessarily.

Those terms may actually be contained:
in a job description
in a collective agreement incorporated into the contract
in a company manual
in an advertisement for the job.

If the contract contains contradictory provisions the affected employees can go to an Employment Tribunal to get the Section 1 Statement corrected.

The typical contract of employment refers to a handbook containing words such as:

“The company regards the pension arrangements which it offers as an important part of the remuneration package and has no current intention of changing the scheme. Nevertheless the scheme may be amended in accordance with its rules and the company reserves the right to terminate it without necessarily providing a replacement.”

An employer which doesn’t make that sort of reservation is in trouble. But if there is such a power, it can be used, and using it does not amount to a breach of contract. It must be exercised in good faith, but as the House of Lords said in the leading case on the subject:

“…it must be open to the company to look after its interests, financial or otherwise, in the future operation of the scheme…”

Acting in its own selfish interests doesn’t mean that the company is not acting in good faith, provided it has no ulterior motive, and has properly considered what it is doing and considered (but not necessarily given any great weight to) the interests of scheme members.

Terms incorporated from a collective agreement (or implied by custom and practice) may give rise to a right to join a pension scheme and the right to join to remain a member.
As a matter of law, however an express term of the contract will overule an implied term. Reserving the power to amend or terminate contained in the handbook is an express term.

Employers sometimes make commitments unintentionally. The High Court has held that promises made to encourage members to transfer pension benefits to a new scheme can amount to negligent misrepresentations, entitling members to damages.

The same principle can attach to promises of future benefits under an existing scheme when it is reorganised. Existing members are usually told that they will retain the same benefits in the future. That can easily end up being a commitment to provide the same or no less favourable benefits into the indefinite future.

Various types of scheme ‘closure’

Closure to new entrants

This is the most typical case. Existing members carry on as before, but new employees will be offered membership of an inferior money purchase scheme.

It isn’t possible to breach a contract which doesn’t yet exist, and new employees are offered a job on a take it or leave it basis.

The rules of the scheme and the company handbook may say that all employees are automatically members of the company pension scheme unless they opt out of membership, but this is very rare. The rules can always be changed anyway.

It is more common that the scheme provides for membership at the company’s invitation, or that members have to opt in rather than opt out. It is much easier for the employer to assert that it has achieved its aim, even though mistakes were made in the contractual documents, simply by saying “you can’t join anyway because I won’t invite you to”.

Excluding the right to future accruals

Closing the scheme to new members will not solve an immediate funding problem for the employer. The savings take time to come through. A more radical step is to close the scheme to current members, in the sense that they will not be allowed to accrue any future benefits.

This will usually require an amendment to the rules of the scheme. But while Section 67 of the Pensions Act 1995 will prevent amendments which adversely affect accrued rights or entitlements, it means past service benefits and not future accruals.
However the amendment power in the scheme documentation sometimes states that it protects future accruals too.

Winding up

This is the heavy-handed approach, and will cause the employer more problems than it solves. During the course of the wind-up the employer will have to pay off the deficit on the demand of the trustees. And since they must act in the best interests of scheme members they will use this power to extract the maximum payment. They can probably exercise the power more than once in the course of the wind-up.

The issue for the scheme’s members however is that the deficit on winding up is much more substantial than the deficit on an ongoing basis, and benefits are not likely to be secured in full.

The point is whether the employer is obliged to meet the whole deficit as a contractual right, or under the scheme documentation.

Some cases proceed on the basis that the employer’s obligation is to contribute whilst the scheme is ongoing, but the obligation ceases once the wind-up starts.
The employer can simply walk away from the mess under this approach, leaving the trustees to pay accrued benefits as best they can.

Other cases proceed on the basis that the employer’s obligation is to pay benefits. So pensions are deferred pay and the scheme is nothing more than a means of providing the funds.

If there is a solution to the worries of the members, it probably lies in the hands of the trustees. Even if the employer’s obligation to fund benefits ceases once it has given notice that it will do so the obligation to pay the balance of costs continues until the employer’s notice expires. If the trustees can do so under the scheme documentation, they can and should demand a one-off deficit payment to meet the full balance of costs before the notice expires.

Protecting employees

In almost every case, an employer which wants to terminate its final salary scheme is going to be able to do so. While sloppy drafting of the scheme may cause the employer problems, the best protection for scheme members is more likely to come from negotiations rather than threats of legal action.

The most important aim in negotiations is going to be to keep some form of final salary scheme going, even if the accrual rate is worse, or the retirement age goes up, or favourable ill health benefits have to be sacrificed.