Pension funding options

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We shall now go on to discuss the key elements to defined benefit schemes starting with the likely benefits that members can expect to receive.

The Employment Equality (Age) Regulations 2006 give all employees a statutory normal pension age of 65. This means that, despite what their contract of employment or pension scheme rules say, all employees have a basic legal right to continue working until they are 65 but not beyond.

Any difference in normal retirement age between men and women in a scheme is not now permitted, due to various rulings from the European Court of Justice and the Pensions Act 1995.

Most schemes equalised their normal retirement ages at 65. Some allowed employees of either sex to retire between 60 and 65 without reduction in the pension accrued by that date.

Eligibility

Entry ages are lower than they had been in the past. In many cases this age is as low as 18 or 21. Probationary periods have been decreased to six months or a year or in some cases abolished completely.

Employers can include any group of employees they wish. However exclusion or stricter eligibility condition...

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The maximum PCLS allowed is calculated as:

PCLS = 25% x (PCLS + [20 x residual pension])

With a bit of algebra, this can be simplified to:

PCLS = 6.666 x residual pension

When we start to factor in the impact of a scheme’s commutation terms, it gets even more complicated. After more algebra, we can come up with the following formula to calculate the maximum PCLS that can be paid from a defined benefit scheme with a commutation factor of £C per pound of pension given up:

PCLS = (pre-commutation pension x C)/[1 + (0.15 x C)]

Example

Tom is retiring from a defined benefit scheme offering a pension of £40,000 a year. He can commute part of this pension for £12 of PCLS for every £1 of pension given up. The maximum PCLS Tom can take is as follows.

(£40,000 x 12)/[1 + (0.15 x 12] = £171,428.55

Lump sum

The maximum effective lump sum death in service benefit (LSDB) following A-Day is the amount of the lifetime allowance. Any excess is taxed at 55% if taken as a lump sum.

Prior to 6th April 2006, the pre-simplification maximum lump sum death in service benefit was 4 times pensionable earnings plus a return of personal contributions plus interest. As a result many schemes established a LSDB using a multiple of salary basis of normally between 1 and 4 times salary and many have continued with this basis post A-Day.

As schemes are written in trust the trustees have discretion on who can receive the LSDB, this ensures prompt payment to beneficiaries and also avoids inheritance tax. Members are encouraged to complete an ex...

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There is no limit on the amount of survivor's pension that can be drawn if the member dies before their 75th birthday. If the member dies after age 75, then the survivor’s pension is restricted to 100% of the member’s pension, plus 5% of any pension commencement lump sum drawn by the member.

Many schemes allow an allocation option giving retiring members the chance to surrender part of their pensions so as to increase the potential survivor's pension.

Public service schemes are usually established by statute and are designed for employees working in public services such as central and local government, the police, the fire service, the armed forces, the NHS and teachers.

Traditionally these schemes have offered a pension benefit of 1/80th of final earnings for each year of service plus a cash sum of 3/80th of final earnings.. However, many schemes in recent tim...

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Public sector schemes

Public sector schemes are more similar to private sector arrangements.

They are funded and have their solvency position monitored

They are governed by trust documentation and are administered by trustees

In the main they still provide full RPI protection and are also members of the Public Sector Transfer Club.

Insured schemes

With this approach, an insurance company will generally invest the employer/employee contributions that are set at a level believed to be sufficient to cover the scheme’s liabilities. The scheme’s actuary calculates this amount.

Contributions are paid to a central pool from which funds are drawn to pay member benefits such as an...

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Scheme assets are measured at market value

Scheme liabilities are measured using an AA corporate bond discount rate

Past service costs are immediately recognised (to the extent they are vested)

Actuarial gains and losses are immediately recognised.

Full implementation of these standards took place in 2005 by which time a similar international standards (IAS19) took effect for listed companies.

The use of these standards and the transparency by which they demonstrate the costs of running a scheme has been given as a reason why many employers have decided to abandon the defined benefit route altogether and opt for defined contribution schemes.

Scheme accounts

A defined benefit pension scheme produces annual accounts giving a description of income and expenditure over the scheme year. It also produces a balance sheet denoting the value of its assets and liabilities at the last valuation. If assets are greater than the liabilities, the scheme is in surplus. If liabilities are greater than assets, it is in deficit. If assets and liabilities match each other, the scheme is 100% funded on the valuation basis.

Scheme valuations can swing wildly depending upon the make up of assets held within the fund as investments.

Setting the employer’s contributions

Initially the scheme actuary will provide a recommended contribution for the scheme and will also provide proposals to change it where necessary at the scheme’s triennial valuation or sooner if needed. The actuary’s aim is to maintain the scheme on a stable footing by attempting to achieve a 100% funding match. ...

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Since 11 June 2003, if a pension scheme gets wound up and the sponsoring employer is solvent, the employer is required to “stand behind” the benefit promises of the scheme. The net result of this is that the employer will be subject to a debt equal to the difference between the full buy out cost of the scheme and the value of the scheme’s assets.

Trustees of defined benefit schemes must provide a schedule of contributions defining employer and employee contributions and their due dates. This must cover a period of five years, or if longer the period of any recovery plan to bring funding up to the required level.

Trustees must also ensure that scheduled contributions are certified by the scheme actuary as being sufficient to meet the scheme’s funding requirement. The schedule must be reviewed annually in order to assess both internal and external influences that may affect funding.

Scheme members often start to draw retirement benefits prior to normal retirement age. There are numerous reasons for this but the three primary ones are:

Voluntary

Ill health

Compulsory

Voluntary

Frequently if a scheme allows voluntary early retirement, it will calculate the accumulated pension benefit to the date of early retirement and then decrease that amount using a discount rate such as 4% for each year that early retirement precedes nor...

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Postponing a pension in a defined benefit scheme could give rise to year on year increases. A common increase factor is 9% although the scheme details will need to be checked.

A hybrid scheme is a defined benefit scheme which utilises defined contribution concepts.

The two main types of hybrid are:

Money purchase underpin – this is a defined benefit scheme that provides pension benefits at retirement or earlier death using the normal defined benefit basis or that can be drawn from a notional defined contribution arrangement, whichever pro...

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Integrated schemes – these are schemes where benefits at retirement attempt to integrate with State benefits either partially or wholly.

Prior to A-Day, all occupational pension schemes had to offer an in house AVC scheme. Whilst that requirement no longer exists, many schemes still retain such schemes.

Benefits from an in house AVC scheme can either accumulate on a defined contribution basis, added years or a flat additional amount.

The choice of provider for an in house AVC scheme is usually made by the employer or formall...

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Employer financed retirement benefit schemes

Employer financed retirement benefit schemes do not receive the same tax privileges as registered pension schemes and therefore would be unlikely to be a popular form of topping up.

In the 1980s companies would take over other organisations with large pension scheme fund surpluses with the intention of bringing that surplus back into the company even after allowing for tax at 40% (now 35%).

Such a practice began to decline in popularity when the Occupational Pensions Board, HMRC and the courts started to decide that refunds could only be paid where there was a surplus to the scheme after improvements had been made to pensioners’ and active members’ benefits in suitable ways. The Pensions Act 1995 reinforced these ideals by requiring that surpluses could not be recaptured by employers unless the trustees believe it to be in the best interests of the members.

The Pensions Regulator

Following the Pensions Act 20...

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Active members of a scheme to which the former employer contributed; or

Eligible to become active members of such as scheme; or

Would have become eligible for membership of the scheme after a longer period of employment.

The new employer does not have to replicate the old scheme. However, employees must be provided with a minimum:

A defined benefit scheme that meets the contracting out reference test; or

A defined contribution occupational scheme or stakeholder scheme with a minimum overall contribution of 6% of pay from the employer. The matching compulsory employee contribution is 6% of pay.

Several defined benefit schemes have been closing in recent years either to new members or simply outright.

The financial risks of defined benefit schemes are largely put on the employer who has to fund any shortfall between required and actual funding levels in order to pay the defined benefits of the scheme. This risk has been heightened in recent years by poor performance in the investment markets (causing scheme asset values to be lower than anticipated) and further regulation such as the funding requirements arising originally from the Pensions Act 1995 and Pensions Act 2004 and new powers provided to the Pensions Regulator to ensure schemes are adequately funded to meet their liabilities depending upon their situation.

Winding up process

There are a number of stages involved in the winding up process:

Checking the scheme rules

A termination clause will be found within the scheme’s trust deed and rules giving notice of the situations where a wind up can happen.

Where a scheme is wound up, it could be found to be in surplus or in deficit. Typically the scheme rules and trust deed will also advise on how such situations should be dealt with. If they are not specific, then the trustees will usually have discretion as to what action to take.

Since April 2005, the priority order in accordance with statute (pensions Act 2004) is as follows for defined benefit schemes:

Pensions in payment secured by annuities bou...

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A closed scheme does not crystallise any debt due from the employer assessed under the deficiency valuation nor does it excuse the employer from finding sufficient assets to match scheme liabilities.

Scheme specific funding requirements arising from the Pensions Act 2004, still apply to closed schemes, as do FRS17, IAS19 and contributions to the Pension Protection Fund.

Bulk transfer

Bulk transfers of scheme assets and liabilities can be made from pension schemes in circumstances other than scheme wind up.

Employers could making the decision that from now on, pension provision for certain categories of member should become defined contribution for future service with the option to convert accrued defined benefits to a defined contribution basis if desired.

In other cases, a segment of a business could be sold by an employer.

Bulk transfer without consent

Preservation of Benefits Regulations 1991 and the Winding up Regulations 1996 (as amended) allow trustees of defined benefit pension schemes to buy out the accrued benefits for members on winding up without consent, using non profit deferred annuities or if permitted under scheme rules, insured contracts.

Bulk buy outs by scheme trustees by way of insured or non profit deferred annuity contracts without consent are also allowed under the Preservation of Benefits regulations 1991 in restrictive circumstances when a scheme is not winding up. A number of conditions have to be met.