UK: Employers Beware – Pitfalls for the Employer In Reducing Final Salary Pension Costs

Typically employers are changing their pension schemes by:

• increasing employee contributions or retirement ages;
• reducing the benefit accrual rate;
• closing the scheme to new members;
• stopping all benefit accrual in the scheme; or
• changing the nature of benefits provided.

Regardless of any HR or publicity issues, changes of the type described above can raise a number of legal issues. Some of these issues are described below. In any event, it is important that the employer and the trustees of the pension scheme take separate legal advice.

Unless employees consent to the changes, an employer should be careful to ensure that the proposed changes will not breach the employees’ contracts of employment. The terms of an employee’s contract may comprise not only the written contract but also, for example, elements of the offer of employment, staff handbook, pension scheme rules and oral statements made to the employee. Statements made in pension scheme announcements and the member’s booklet may also be incorporated into the contract of employment.

A duty of mutual trust and confidence (often known as the duty of good faith) exists between the employer and the employee. The precise scope of the duty remains uncertain but in recent years the law has developed in favour of employees. Whilst in our view the duty should not generally, at present, prevent the amendment, closure or winding up of a pension scheme, the contrary position is arguable. It is likely, however, that the duty will soon be tested in the courts in the context of the amendment, closure or termination of a pension scheme. Regardless of whether the duty will prevent proposed changes, it does limit how an employer can act towards its employees. An employer should ensure that any steps it does take in relation to its pension scheme comply with the requirements of the duty.

The employer should always check that it has power under the pension scheme to achieve its aims. Restrictions on scheme amendment powers are common. The employer’s proposals may require the consent or cooperation of the trustees (who are required to act in the best interests of the members). Proposals that require the involvement of the trustees could, therefore, lead to difficult negotiations with the trustees. On a practical note, the employer should be aware of and manage conflicts of interest arising for senior managers who are also trustees of the scheme.

It is common for an employer to be able to terminate its liability to contribute to a pension scheme thereby closing the scheme to new members and ending benefit accrual. Terminating the employer’s liability to contribute to the scheme will often allow the trustees to wind up the scheme either immediately or at a later date with some surprising consequences.

If the winding up is postponed the employer’s liability to fund the scheme to the statutory minimum funding requirement (MFR) will continue until the scheme goes into winding up despite the fact that the employer has attempted to terminate its liability to contribute.

Employers should also be aware that some members will see their benefits reduced or extinguished on winding up unless the scheme is funded significantly in excess of the MFR. In such circumstances the trustees will be obliged to try and secure as much funding from the employer as possible and may attempt to recover more than the statutory minimum described below.

If a scheme is under funded by reference to the MFR during its winding up a debt on the employer equal to the deficit will arise. At present many schemes are underfunded on the MFR basis. The trustees choose the date on which the deficit is calculated and will almost certainly choose the date that will result in the largest deficit. By altering the investment policy of the scheme and/or securing some benefits with annuities the trustees can also substantially increase the size of the debt; such action would cause a significant deficit in a scheme funded at 100% of MFR immediately before winding up.

An employer should, therefore, be careful not to take any action that could lead to the scheme winding up without taking appropriate legal and actuarial advice as to the potential consequences.

An employer should be aware of any contractual commitments it may have to third parties. For example, on the acquisition of a business from a vendor the employer may have committed to provide a certain level of benefits to the affected employees.

The government is consulting on many potential changes to UK pension law that may alter an employer’s ability to change or close its pension arrangements or increase the expense of doing so. As mentioned above, the courts may also develop relevant areas of the law.

The govenment has now issued a response to its consultation; it contains a number of points relevant to the issues discussed in this article. Please contact us for more information.