closing pension schemes – some hazards
by Roderick Ramage, solicitor, www.law-office.co.uk
first distributed to professional associates by letter 27 December 2002, revised 3 July 2003 and 3 February 2006
published (with minor alterations) in New Law Journal 1 August 2003
This article is not advice to any person and may not be taken as a definitive statement of the law in general or in any particular case. The author does not accept any responsibility for anything that any person does or does not do as a result of reading it.
Closing a final salary pension scheme may result in employers facing greater expense than they had expected. Although this has been so since the minimum funding requirement (MFR) was introduced, the issue became acute only more recently with increasing funding problems affecting final salary schemes. The draft regulations laid before Parliament on 11 June 2003, while intended to improve the lot of members (particularly those not yet in receipt of pension), has made the position even worse for employers with final salary schemes. This note deals first with the general issues of closing scheme and closes with a post script about the impact of the new regulations.
There are commonly two forms of closure, closing a scheme to new members and closing a scheme for the accrual of future benefits. This note discusses the latter, is no more than a simplified outline and must not be taken as advice in any individual case.
What the employer might hope for is that at a fixed date both it and the employees cease to pay contributions to the scheme and no period after that date is taken into account in calculating benefits. At the same time both start to pay contributions to a stakeholder or some other money purchase pension scheme and sometime soon something will be done to deal with the members’ accrued rights, such as transferring them to the new scheme, so that the old scheme can be brought to an end with no further expense. It might happen like this, but a combination of poor funding and typical trust deeds and rules generally results in something rather more complex with a financial sting in the tail.
It is rare that an employer has the power to close its pension scheme without triggering a winding-up. Typically it can close a scheme only by giving notice to the trustees to discontinue its contributions, and, again typically, the consequence of that notice is to pass effective control of the scheme to the trustees, who, to the exclusion of the employer, will then have the power to decide whether to wind-up the scheme immediately or to defer its winding-up. It is in the winding-up that there can be traps for the unwary, and so the planning of a scheme’s closure needs to start with a review of the likely outcome of the winding-up process, the main elements of which are:
1 the members in active service become deferred members, in the same class as those who had left previously without becoming pensioners;
2 the trustees realise (and maximise) the scheme’s assets; and
3 to the extent that the assets are sufficient and members do not transfer to other schemes, the trustees secure members’ benefits by the purchase of annuities, immediate for pensioners and deferred for the other members.
In addition, apart from any financial considerations, there are two other key consequences of the start of the winding-up of a pension scheme:
4 in the absence of an express provision, the scheme’s deed and rules cannot be altered; and
5 if there is an MFR shortfall, which while a scheme is ongoing can be discharged over a number of years in accordance with a schedule of contributions, that shortfall becomes a debt on the employer payable as a lump sum on demand.
The risk of creating a debt on the employer may of itself affect the employer’s decision to close the scheme, but the timing of the establishment of the debt may exacerbate the problem by either increasing the amount of the debt or creating a debt where none existed previously. Under s75 of the Pensions Act 1995, the debt on the employer for an MFR shortfall is ascertained at the first to occur of three possible times (the 1st preceding the winding-up of the scheme and the 2nd and 3rd being the “applicable time” after the start of the winding-up of the scheme):
1 immediately before the employer goes into liquidation or, if an individual, bankruptcy (an “insolvency event”);
2 immediately before an insolvency event in relation to the employer; or
3 if there is no such insolvency event, any time, which may be determined by the trustees.
It is in the third case that the determination of the applicable time can be crucial. If at an early stage in the winding-up the trustees fix the applicable time and ascertain either the amount of the debt on the employer or that there is no MFR shortfall and no such debt, they would then recover the debt, if any, realise the scheme’s assets and secure the members’ benefits as far as the funds permit. If the scheme’s assets are insufficient to secure members’ benefits in full, the order of priority in which they are secured is set out under the Pension Act 1995, overriding any priorities in the trust deed and rules. The priority clause or rules normally states expressly that, benefits may be reduced or abated, but this does not necessarily limit members’ benefits to the available assets or release the employer from further liability to contribute to the scheme if the following alternative is applicable.
There is an alternative timetable, which the trustees may be required to follow in order to maximise the funds they can obtain to secure members’ benefits. They should consider first securing members’ benefits as far as possible by applying all the available funds in the purchase of annuities and deferred annuities and only then fixing the applicable time and instructing the actuary to prepare an MRF valuation. The scheme would then have no assets but would have members whose benefits have been only partly secured, and it is almost certain that there will be an MFR shortfall and a debt on the employer, even if at the start of the winding up there had been no such shortfall. If there had been an MFR shortfall at the start, the amount of it is likely to be increased at this stage.
The trustees, some or all of whom may have conflicts of interest as directors or senior employees of the employer, risk personal liability, if they fail to consider and if appropriate take the alternative course of action and if, as a result, an aggrieved member, whose benefits are less than they might have been, makes a successful complaint to the Pensions Ombudsman against the trustees alleging maladministration on their part.
This set of problems has been altered by Occupational Pension Schemes (Winding Up and Deficiency on Winding Up etc) (Amendment) Regulations 2004, SI 2004/403 (which were in draft when this article was written). The draft with proposals for other measures were published by the Government on 11 June 2003 (and may be regarded as the UK pensions 6/11). These regulations came into force and apply to all schemes which begin to wind-up on or after 11 June 2003. The main effect is that, where the employer is not insolvent and for the purpose of calculating the debt on the employer, the liability for members not in receipt of pension is to be calculated on the basis of the cost of buying deferred annuity contracts instead of the old and relatively weak MFR basis.
The cost of purchasing annuities is very much higher than the cost of satisfying the MFR on the pre-6/11 basis. The cost of satisfying the MFR has caused the insolvency of some employers and it may be expected that more businesses will be at risk of insolvency as a result of this measure. Three likely consequences flow from the new regulations. The first is that it may become crucial to establish when the wind up starts: ie whether of not the winding-up started before 11 June 2003. The second is that employers considering winding-up their final salary schemes may, if they are able to do so, choose instead to continue the scheme on a closed basis. The third is that, if the cost of annuity basis applies, the date for fixing the debt on the employer may be less important than under the pre-6/11 rules.
Whether an employer will be able to continue the scheme on a closed basis. will depend in on both the terms of the trust deed and rules and regulation 2 of the Occupational Pension Schemes (Winding Up) Regulations (SI 1996/3126). Where (a) the Regulations do not fix the date of the start of the winding up and (b), as is common, closing the scheme for future pension accrual passes effective control of the scheme to the trustees, any proposal to run the scheme on a closed basis may necessitate a negotiation with the trustees and possible some enhancement of members’ rights and a consideration for trustees agreeing to a change in the deed and rules or a postponement of the winding up.
Solutions or partial solutions may be available in individual cases, but in all cases careful planning and anticipation of the risks are necessary to avoid unbudgeted costs and unwanted conflicts between employers and trustees.
The perceived loophole, through which companies participating in multi-employer scheme could “escape” with no more liability than the MFR debt, has been closed: see my article on this site about multi-employer schemes.
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