Pensions briefing - Defined benefit scheme liability management exercises

Publication September 2015


Many sponsoring employers of defined benefit pension schemes are keen to limit their exposure to the volatility of their scheme’s liabilities and increasing funding deficits. It is open to these employers to carry out a number of liability management exercises to achieve these aims. However, the liability management exercises that can be implemented will often depend on the circumstances of a particular scheme, including the drafting of the pension scheme’s rules and what liability management options have been exercised in the past.

Closure to accrual

One of the most common ways liabilities can be managed is by closure to future benefit accrual. This will limit the scheme's liabilities and its risk exposure to benefits accrued before the date of closure. In addition, employers will no longer have to meet the cost of future defined benefit accrual for existing active members. Although some other form of pension provision will have to be made for these members (not least because of auto-enrolment requirements), the cost of future benefit accrual may be significantly reduced, although care must be taken to price in revaluation costs.

The way in which closure can be achieved depends on the drafting of the scheme's rules. The rules may allow an employer to effect the closure unilaterally or, alternatively, the rules may need to be amended in accordance with the scheme's power of amendment. The power of amendment may require the consent of the scheme's trustees and may be subject to other restrictions, such as a requirement to maintain the link between service accrued up to the date of closure and each member's salary whilst they remain employed by the employer. Restrictions may also be imposed (albeit less commonly) by the members’ contracts of employment and consultation with employees will be required, subject to the employer having 50 or more employees (whether or not they are affected by the closure).

This is a complex area, but several options (including those described above) are open to employers who wish to achieve this. However, care should be taken that the closure does not inadvertently trigger the termination of the scheme and the payment of the employer's section 75 liabilities.

Further complications may arise from recent case law (in particular, the IBM case). Following this, in carrying out any necessary consultation, employers must be open with their employees about the reasons for the proposed closure and must consider employee responses in good faith.

Changing the benefit structure

If the scheme is still open to future benefit accrual, an alternative way to reduce future service liabilities would be to change the basis on which members continue to accrue benefits. Whether this is to provide future service benefits on a defined contribution basis or a change to a different defined benefit basis (for example, at a reduced rate of accrual or on a career average salary basis), it is likely that the change will have to be made by exercising the scheme’s power of amendment.

In exercising the power of amendment, the same restrictions and consent issues are as relevant here as they would be if the scheme were being closed to accrual. In addition, any amendments to the benefit structure may only reduce the cost of benefits accrued after the date of the changes. The Pensions Regulator may render void any amendments that attempt to reduce the cost of previously accrued benefits unless the informed consent of the affected members has been obtained.

Similarly, many changes to the benefit structure will require employers to carry out consultation with affected members. However, this should be checked, as not all changes will give rise to this requirement.

Pension increase exchange

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.

Transfer exercise

To remove the investment risk and volatility associated with pension scheme liabilities, another option available to employers is to incentivise members to transfer their benefits to another pension arrangement. In this case, the incentive will usually be an enhancement to the transfer value (funded by the employer), to allow the member to secure a higher level of benefits in a new pension arrangement. Most transfers will be to a defined contribution pension arrangement, which now has the added incentive of the benefit flexibilities that would become available following the transfer.

Incentivised transfer exercises are subject to the same considerations and restrictions as pension increase exchanges, including the code of practice. Therefore, employers should not incentivise members to transfer out their benefits by means of a direct cash payment to the member. It is worth noting, however, that recently introduced legislation (section 34 of the Pensions Act 2014) permits the Government to introduce regulations that could potentially prohibit all incentives that encourage a member to transfer-out. However, this power has not yet been exercised and the Government has indicated that it is not minded to do so if employers continue to comply with the code of practice.

Other exercises

As well as the possibilities already covered, members may be encouraged to take their benefits as trivial commutation lump sums if this is permitted by the pension scheme’s rules and legislation. If members are incentivised by an employer to do this, the industry working group has stated that this would also be covered by the code of practice. Similarly, any incentives provided to members to take early retirement and take the maximum pension commencement lump sum would most likely be treated in the same way.

Other options include reviewing the actuarial factors used to calculate certain benefits under a pension scheme to verify that they are appropriate in the current environment and not over-generous (for example, in light of changes to mortality rates since the factors were last reviewed). There are also numerous steps that can be taken to address the risk and volatility associated with investments, including interest rate swaps and hedges, and to align more closely investment returns with scheme liabilities, such as longevity swaps and buy-ins.

Although it is not possible to eliminate the exposure of employers to pension scheme funding risks, the range of liability management options permits steps to be taken to at least exercise a degree of control. Employers may have taken action to limit this exposure in the past, but further steps may still be available.

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