How to equalise GMPs – High Court decision in the Lloyds case

After over 25 years of uncertainty, we now know that UK pension schemes must remove the last traces of sex inequality from benefits built up since May 17, 1990. Guaranteed minimum pensions are required to be different for men and women, and they create differentials in otherwise equal pensions which fluctuate over time. As a result of the Lloyds Banking Group judgment, trustees must correct those differentials for the future, and pay arrears for the past, but employers can control the costs of doing so. This is a significant step change for the pensions industry.

The Lloyds decision affects every defined benefit scheme which was formerly contracted-out and which has historic liabilities for GMPs as a result. Although most such schemes took action to equalise male and female members’ retirement ages following Barber, inequalities arising from the provision of GMPs were generally not addressed.  There was no consensus on the need to equalise or the methodology to use if it were required.

In this briefing we explain the problem with GMPs, look at what the High Court has now told us we should all do, and offer some ideas on how to approach your GMP equalisation process.

Between April 6, 1978, and April 5, 1997, employers could contract their employees out of the then State Earnings Related Pension Scheme and pay reduced National Insurance contributions. In return the employer provided a guaranteed minimum pension benefit under its pension scheme in lieu of the SERPS benefit employees would forgo. In 1988 an alternative, money purchase contracting-out option was introduced, and in 1997 the original salary-related contracting-out system of GMPs changed to a reference scheme test. Despite the end of contracting-out on April 6, 2016, affected schemes still retain obligations relating to any GMPs they hold.

Ever since the ECJ’s Barber judgment on May 17, 1990, the principle of equal pay for men and women has applied to occupational pension scheme benefits in the UK. It was previously common to have different normal retirement ages for men and women, and other differences of treatment. Trustees had to “level up” benefits for the period from May 17, 1990, to the date benefit accrual was actually equalised in the individual scheme.

GMPs though, have always presented a particular equalisation problem. The GMP sits within the scheme pension and pushes up its overall value. The structure of the GMP is laid down by law and is inherently unequal as between men and women. GMPs come into payment at 65 for men, and 60 for women.  In addition, the female GMP will be a larger proportion of her overall pension as a woman’s GMP accrued at a faster rate than a man’s to reflect her shorter working life.

This inherent inequality shows up as soon as the pension comes into payment. Revaluation of the GMP is at a different rate to the excess over the GMP and, for GMPs, finishes at the unequal GMP age. Late retirement factors are different for GMPs and the excess, and start for GMPs at the unequal GMP age. And finally pension indexation is different for the GMP and the excess. So a woman may initially see greater increases than an equivalent man, and then the situation may reverse over time. Who would end up better off in the end is difficult to predict, being a combination of many different factors.

With GMPs being statutory, and the degree, and indeed the victim, of inequality fluctuating over time, there was no consensus in the industry as to the extent to which further equalisation was needed, nor the method to deliver it. The risk of getting it wrong was high and potentially expensive. 

Prompted by some union-sponsored individual equality claims to the Employment Tribunal, in 2016, the trustee of three pension schemes in the Lloyds Banking Group (LBG) sought directions from the High Court on the need to equalise benefits for the effect of unequal GMPs. The judge considered four main issues.

• Is there an obligation to equalise benefits for the effect of unequal GMPs? 
• If so, what method should be adopted? 
• For what period in the past can a member claim in respect of previously underpaid benefits?
• What should be done in relation to benefits which have been transferred into, or out of, the relevant schemes?

In the Lloyds Banking Group judgment handed down on October 26, 2018, the judge, Morgan J, confirmed that

• State benefits do not need to be equalised, but GMPs cannot be treated as state benefits.
• Trustees and employers cannot justify the differential caused by GMPs so they must correct it via the main scheme benefits.
• The equalisation requirement applies to benefits accrued between May 17, 1990 and April 5, 1997 (when GMPs ceased to accrue), inclusive.
• Trustees can (and must) change the scheme rules to comply, but can only do so without employer consent if they do the minimum necessary to comply.
• If there is a choice of ways to deliver equalised benefits (as there was for LBG), the trustees can only select the option that interferes least with the employer’s funding obligations, unless the employer agrees.
• Three methods were identified that correctly delivered equalisation for the past, with a further option of conversion of benefits available for the future (if the employer consents).
• Arrears of underpaid pension must be paid (subject to any limits on back-payments in the scheme rules – see below) and will carry simple interest at one per cent. above base rate while they remain unpaid. 

The judgment affects all pension schemes which contain salary-related contracted-out benefits built up between 1990 and 1997 (i.e. GMPs). This includes defined contribution schemes with an underpin of contracted-out benefits, but doesn’t directly affect pure defined contribution schemes.

The court tested various methods to deliver equalisation of benefits, looking at the potential impact of each on members and employers. The methods tested are in the table below.    A second judgment in December 2018 confirmed the calculation of method D.  Part of the test was the estimated financial impact. LBG estimated the increased value of liabilities under each method based on the three schemes’ own member data, demographics, scheme rules, administrative practices and history of revaluation and pension increases. For these specific schemes the methods produced very different increases in liabilities, with method A being the most expensive for LBG and C and D the least.

The figures below do not include the administrative costs of delivering the benefits, which may significantly alter the overall financial impact. 

The judge decided that the trustee must equalise benefits for the impact of GMPs earned after the Barber case, and that this could be achieved in a number of ways. However, of the methods outlined above, C2 was the only one which the trustee in this particular case could adopt without the consent of the employer.

To get to that conclusion the judge took account of the “principle of minimum interference” with the rights of any party. For the employer this means that where one method of equalisation is significantly more expensive to the employer than another method, this infringed the rights of the employer and could not be adopted by the trustee without employer consent. For the LBG schemes that meant method A3 was immediately disqualified unless LBG consented.

Minimum interference also protects members. Method D1 was ruled out because of its impact on members. Although it was less costly from an administrative point of view (and was therefore favoured by LBG) it was based on assumptions so was highly unlikely to deliver the right result for any individual member. Method D2 (which involves GMP conversion) was equally flawed, but is lawful because it is enshrined in statute. The judge also helpfully confirmed that the statutory conversion basis is workable as currently written, despite the doubts expressed by the pensions industry in the past.  However it requires employer consent, which LBG had not given. 

For LBG, that left the trustee with method C2 unless LBG agrees to something else. However that doesn’t mean it will be the default for every scheme, or that employers won’t prefer other options because of the implementation and administration costs. The only option not on the table for on-going schemes is D1 because of its potentially detrimental effect on members.

Trustees must now pay arrears of underpaid pension as well as fixing future payments. As well as ordering the trustee to pay interest on the arrears, the judge also looked at how far back trustees must go to top-up past payments. He concluded that the default is that there is no natural stopping point – trustees are liable to correct all past underpayments. However, if the scheme itself has a forfeiture rule which provides that trustees only pay up to six years of arrears, the trustees must limit back-payments to that period.

Not every scheme has a six year rule, and even when it does, the rule as drafted may still not cover this particular liability.  We have already looked at a wide variety of such rules, some less helpful than others.  That means that, as with the Government’s change from RPI to CPI a few years ago for pension indexation, we have another drafting lottery on our hands. As a result we could easily see other cases brought about this issue. 

The effect of the Lloyds judgment is that the obligation to pay benefits equally actually started on May 17, 1990, so trustees are already in breach and in arrears. There will now have to be a big push to correct everything as speedily as possible. You cannot wait for individuals to come forward to claim their benefits.

 Stage 1: immediate next steps

• Everyone: talk to your advisers. This is going to be an unavoidably complex process, and you will need help from legal, administrative, actuarial and accounting professionals. Start that process now – there will be a lot of employers and trustees needing help in a hurry and it will take a long time to calculate and deliver the correct benefits.
• Trustees and employers: talk to members and staff. They will have seen the reports in the press and may be worried, excited, confused or angry. Get onto the front foot and put up a short note on your scheme website, or write to members, to say what’s going on, confirm that you will be correcting benefits and contacting affected beneficiaries individually, and explain that this will take some time to get right as it is a complex issue. Confirming you will be adding interest on past underpayments at the court-approved rate until the arrears are all paid out should help members cope better with the delay and avoid complaints. Give your administrators and switchboard /pensions team a statement to give to members who contact them.
• Trustees and administrators: change benefit processes for transfer quotes, transfer requests, pensions sharing on divorce, trivial commutation and other small lump sum payments.
   
  • There is very limited scope to delay new statutory transfer quotes. We suggest adding a warning on your new transfer quotes that the calculation does not include the outcome of the equalisation process you are about to start. If the member insists on proceeding with the transfer in the meantime, they should be aware their benefits may be undervalued. Whether you promise follow-up top-ups at this stage requires careful thought – we do not yet know which members will need it - but consider asking recipient schemes to agree in advance to accepting equalisation top-up transfers if they become necessary.
  • Contact members who request transfers, or who have already requested transfers that have not yet been processed. Think about giving them the same warning and ask them to reconfirm whether they still want to transfer. If you don’t catch a transfer currently going through, make sure a record is kept to review later once you know what you have to do on transfers (see below).
  • Can you suspend trivial commutation and similar small lump sum payments? You are now on notice that your calculation may not include the whole benefit so there may not be a full discharge.
• Employers: talk to your auditors. This additional liability will need to be assessed and disclosed, and it will ultimately hit both profit/loss account and balance sheet. However we understand that different auditing firms have differing views over the level of disclosure required, the treatment of the liability in the profit/loss account and the level of approximation they will accept.

Stage 2: getting it sorted

• Trustees and employers: talk to each other. There is no one-size-fits-all solution for this particular issue. You need a plan for paying future equal benefits, and a plan for fixing the past. Employers can insist on trustees choosing the solution that costs the least, but working out which one that is will take time and data. The answer will depend on your own scheme’s history, administration and demographics. That means employers and trustees have to run the numbers and talk to each other about the options to agree what works best for each scheme.
• Trustees: check your scheme rules on payment of arrears. There is no overriding limitation on how far back you need to make up past underpayments, except the original equalisation date of May 17, 1990. However your scheme rules may require, or permit, you, to limit back payments to the last six years-worth.  If they do, there is a second question around when that time starts. It’s all in the drafting so let us know if you would like us to review your forfeiture clauses.
• Trustees: assess your data. To deliver accurate equalisation you will need to understand the breakdown of members’ benefits between the various elements of GMP and the excess over the GMP over time. Now would be a good time to commission data-cleansing if you haven’t done so already. The second stage will be working out the appropriate assumptions and methodology to fill in the gaps where data is missing and still deliver legal equalisation.
• Trustees and insurers: check your buy-outs and buy-ins. For future transactions, make sure the benefit specifications cover fully equalised benefits – this may mean that any current transactions have to be delayed until the scheme’s own equalisation method is selected. For existing buy-outs and buy-ins, it’s a question of looking at the contracts to see who has liability and whether there is any alternative cover for the liability. Again, let us know if you would like us to help with this.
• Employers and trustees: factor this liability into funding discussions and valuations. Should you hold an out-of-cycle valuation if there is already significant funding strain? Talk to your actuary. The impact on individual schemes will depend on each scheme’s circumstances, and given the length of time it may take to recalculate and reset benefits, you may find your existing valuation timetable is actually still fit for purpose.

The Department for Work and Pensions has been quoted as promising further guidance on its GMP conversion option “in the near future”. We could also expect the DWP to want to go ahead to remove the need for comparators for GMP equalisation issues, as it originally proposed in 2012. However Brexit may well slow down the delivery of actual legislation. 

HMRC now need to focus on their treatment of top-ups, payments of arrears, and changes to benefit structures.  There are risks of unauthorised payment charges, and loss of existing protections.  The Association of Consulting Actuaries has written to HMRC spelling out the issues and inviting them to change their approach to ensure all benefit corrections are authorised.  However, in the meantime, if you plan to start correcting past payments quickly, we would suggest contacting HMRC to confirm their tax treatment. 

The United Kingdom’s exit from the European Union is unlikely to change things. The Government has already suggested that European Union law will continue to apply to acts prior to Brexit. In the Lloyds case the judge suggested that freestanding UK law required equalisation just as much, if not more, than the overarching EU law, although the point was not definitively settled.  What is clear is that the Government has no appetite to re-write the past to remove the benefit uplifts now ordered by the court.

Whilst it is still possible that the Lloyds case might be appealed, we currently think this is unlikely. 

We may see a second hearing in the Lloyds case, possibly early next year, to address some outstanding issues

• What to do where the actual change in benefits after equalisation might be insignificant – the judge confirmed that administrative costs are not a consideration in choosing an equalisation method, but there may still be a case for some rounding off.
• Treatment of transfers in and out. The judge suggested schemes should be responsible for transfers in, which begs a number of questions around how, but parked what residual liability there might be for transfers out. Who picks up the tab for past transfers to personal pensions and other defined contribution structures?

The issues arising for affected schemes are complicated and could carry significant costs.  Please contact your usual Norton Rose Fulbright adviser to discuss the implications and options for your scheme.