Welcome to Issue 4 of our Pension series for Corporate Lawyers. In Issue 1 we explored underfunded pension schemes in a corporate transaction and the use of an apportionment agreement to reduce exposure to such a debt (see here for article). In this issue we look at other solutions that seek to reduce the employer’s pension liability in a way that simplifies a pending corporate transaction from a pension perspective. In particular, we examine what impact the recent legislation regarding accessing pensions may have on this area.
Issue 4 – Reducing underfunded pension liability prior to a corporate transaction
In 2015 Alan Rubenstein, whilst head of the Pensions Protection Fund (PPF), claimed that five in six final salary schemes were underfunded; and a report from the Pensions Institute (part of Cass Business School) showed that up to 1 000 Defined Benefit schemes (DB scheme) were at risk of falling in to the PPF. The cost of funding pension deficits, along with the high administration and management costs, is the reason many companies are making the decision to close their DB schemes.
How does this affect a corporate transaction
No buyer on a corporate transaction wishes to inherit a significantly underfunded pension liability from the seller, and a seller does not want to pay for the liability on a costly annuity buy-out basis. An annuity buy-out occurs where a DB scheme is terminated or a participating employer leaves the scheme. The deficit is calculated on the basis that annuities will be purchased for the beneficiaries. Importantly, the employer is liable for the deficit (i.e. the difference between the annuity buy-out cost and the value of the assets). So it has been usual for employers to embark on exercises to encourage employees to transfer out of DB schemes in order to reduce the funding deficit, and in turn the employer’s pension liability on the balance sheet.
Incentivising the move from a DB to a DC scheme
The incentives to employees used as part of these exercises can include enhanced transfers where the employer pays a top up to the payment the employee receives from the pension trustees if the employee transfers out of the scheme, or a “pension increase exchange” whereby pensioners agree to give up all future non-statutory increases in return for an early one-off larger increase. Mostly, being able to access pension funds can help in encouraging employees to transfer out of DB schemes. The move to a Defined Contribution scheme (DC scheme) has become a popular one following the changes to how the pension scheme savings in this type of scheme can be accessed.
From 6 April 2015 (subject to the scheme rules permitting), any amount up to the entire accumulated pot can be taken out of a DC scheme as a lump sum from the age of 55 (at age 57 from 2028), with the first 25% being tax free and the remainder being taxable. There will also no longer be a requirement to have to buy an annual pension on retirement, or at any other point. (See here for more information)
[Note: A DC scheme is based on the assets within each employee’s individual retirement plan and is built up through contributions from the employee and employer (usually a percentage of salary as a set amount), and tax relief from the government. This is also sometimes referred to as a money purchase scheme.
This contrasts with a DB scheme in which the income an employee receives at retirement is predetermined and is usually based on a guaranteed formula involving years of service and earnings. This is also known as a final salary scheme and involves little to no active involvement from the employee as the employer is taking the investment risk.]
Transferring to a DC scheme: Who benefits
- The sponsoring employer: if the employee transfers from a DB scheme to a DC scheme this reduces the employer’s funding liability in the DB scheme given that the funding provision for the member is likely to be greater than a transfer value. The transfer value paid is also normally significantly less than the cost of purchasing annuities as we mentioned in Issue 2 (see here).
- The employee: who has access to the pension pot in the form of one lump sum, smaller portions, or as a guaranteed regular income with the option of making other investments with this money and may see this as a comparative benefit. A DC scheme also allows greater flexibility in the structure of the scheme, for instance employees who do not have spouses, but have a spouse’s pension under their DB scheme, should receive some benefit by way of the transfer value in respect of the spouse’s pension as this has a value.
- HM Revenue & Customs: who will immediately receive tax on the pension pot (excluding the 25% tax free portion), when an employee accesses their funds.
Transferring to a DC scheme: What to consider
Transferring out of a DB scheme can be a time consuming and costly exercise as certain restrictions may apply:
- If the value of the employee’s pension exceeds £30 000 they will need to seek independent financial advice and obtain an IFA report before transferring from a DB scheme to seek access to their pension. (Although where the employer is eager for the transfer to take place they may help them cover the cost of obtaining this.)
- Under certain scheme rules the transfer may need the approval of the employer – although we can assume that the employer will agree to this in situations such as those outlined above. In some circumstances however (such as with Insurance companies and insured schemes) the scheme rules may need to be amended to allow the transfer.
- There is a statutory right to take a transfer value out of a scheme, but not within 12 months of normal retirement date or after retirement. If a transfer is to take place during this time the scheme rules will need to be amended (which is possible even if the employee is in the lock-in period).
It is also crucial to ensure that the transfer is carried out in a fair and compliant manner as there are many companies promising early access to pension cash in a fraudulent way, or by means not meeting the approval of HMRC, which could result in substantial loss for the employee.
How can we help
Whether you are acting for the company, bank or trustees there are many ways that we can help you navigate this complex area. For example:
- Assessing and advising on mitigation of liability of a DB scheme.
- Amending schemes and scheme rules to allow transfers.
- Introducing third parties such as Independent Financial Advisers.
- Producing effective and compliant communications for employees to ensure successful change management, taking into account existing legal entitlements.
Helping You Help Your Clients
Abbiss Cadres has a unique service model incorporating all the expertise needed to help you manage the complexities of your clients’ pensions, employment and people issues. As well as pensions expertise our pension law solicitors can help with employment, immigration, tax, compensation and benefits and global mobility. We have extensive experience of working alongside a variety of corporate law teams, including some of the world’s largest law firms to deliver an integrated service to their clients.
If you would like advice on how we can help you with this or another employment related issue get in touch with us on 0203 051 5711 or send us an enquiry.
In the next part of our series we will look at the pension tax and other reform changes in 2016 Spring Budget.
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