The rules of many pension schemes require members’ pensions in payment to be increased each year by rates that are greater than those required by legislation. In particular, the legislation does not require any increases to be applied to pensions accrued before April 1997 (except guaranteed minimum pensions) and many pension increase rules have not been amended to reflect the subsequent changes to the minimum required level of increase. These include the reduction in the cap from 5% to 2.5% and the change from the retail prices index to the consumer prices index as the measure of the cost of living for the purpose of calculating this minimum level.
For the purpose of eliminating the cost of providing pension increases greater than those required by legislation and thus achieving greater certainty in relation to future liabilities, members may be given the option of giving up their entitlement to pension increases above the legislative minimum. In exchange for this, members are provided with an increase to the initial level of their pension when it comes into payment. Consequently, this may require significant initial financial outlay by an employer.
Any such exercise must be made in accordance with the pension scheme’s rules, which may require amendment before the exercise can proceed. In addition, members’ informed consent will be required to the extent the exercise reduces their entitlement to increases in respect of previously accrued benefits. Care should also be taken to reduce the risk of any targeted exercises being challenged as being discriminatory (for example, on grounds of sex or age).
Incentive exercises, including pension increase exchanges, are covered by a voluntary code of practice. This code was prepared by a pensions industry working group and published in June 2012 to address many of the concerns that such exercises may be used to disadvantage members. The code, which is expected to be updated by the end of 2015, is based around a number of objectives, currently including clear communication, member engagement and the provision of independent financial advice paid for by the employer. Of particular note is the code’s prohibition of the payment of cash incentives to members in exchange for their agreement to the proposed exercise. The full code can be found here.
Although the Pensions Regulator supports the code, there are no specific sanctions for an employer’s failure to comply. However, there is a risk that failure to comply may lead to the introduction of a more rigid framework and sanctions.