Corporate lawyers know the most important question to ask about a pension scheme: is it a defined benefits (“DB”) scheme or a defined contribution (“DC”, also known as a money purchase) scheme?
Identifying a scheme as DB or DC is as fundamental as knowing apples from pears, but are you sure you can spot the difference?
The difference dictates not only risks and benefits for scheme members, but also the applicable regulatory framework, with major implications for transactions. (See What’s at stake? below).
However, spotting the difference between a DB and a DC scheme is not always easy – and the consequences of getting it wrong can be very expensive. In this article, we set out a case study of how this mistake can occur, what’s at stake if you get it wrong, and some practical pointers to help you avoid being that lawyer who trips up.
KPMG Case study: a £88 million mistake
KPMG got this wrong in a big way a few years ago in dealing with their own staff pension scheme. They had assessed the scheme as purely DC, whereas the courts found it guaranteed a certain level of payout, and was therefore a DB scheme. The court’s decision turned on the fine detail of the scheme wording.
KPMG were ordered to make up a funding shortfall to the tune of £88 million.
What’s at stake?
So making this mistake can be expensive. What’s at stake for corporate lawyers if you cannot tell these apples from pears on a transaction? The implications include:
- Acting for either party: Mistaking a DB scheme for a DB scheme, or vice versa, could mean you fail to apportion risk and liabilities appropriately between buyer and seller. For example, where acting for a seller, you may use inappropriate drafting in a disclosure letter, or (when acting for either party) include the wrong standard warranties.
- Acting for a buyer: If you mistake a DB Scheme for a DC Scheme, the buyer could end up with a heavily underfunded DB Scheme with full liability to make good the deficit and no provisions in the sale agreement offering the buyer any comfort.
- The mistake can work both ways. If a trustee mistakenly runs a DC Scheme as a DB Scheme or vice-versa, it will be in breach of its trust law duties which include reading, understanding and obeying the trust deed and rules and open itself up to claims for negligence where loss arises to any beneficiary. In addition the Pensions Regulator has power to remove trustees who it deems are unfit to act.
- Incorrectly identifying a scheme as DB when it is really DC could also lead to pension assets being wrongly distributed – see Beware old Inland Revenue limits below for a horror story.
It goes without saying that, in all these cases, your client will look to their lawyer for redress.
Don’t be that lawyer: what should you look out for?
What are the key things to look out for in telling a DB scheme from a DC scheme? Some pointers (obvious and less so):
|Read the benefits rule||In a DB scheme, this would usually state the benefits recipients will receive, e.g. by reference to a proportion of final salary. A typical DC scheme rule will say the benefit will depend on the value of the pot built up.|
|Don’t trust the scheme title or description in the documentation||It’s not definitive.|
|Beware old Inland Revenue limits (eg which refer to 2/3rds final remuneration)||Don’t mistake these as creating a defined benefit. They could equally apply to old DC scheme documents. We encountered a case of a DC scheme being administered as a DB scheme with disastrous consequences, on the mistaken assumption that the reference to these limits created a defined benefit obligation. Scheme funds were distributed to some beneficiaries on this assumption, leaving the remaining beneficiaries out of pocket – and the administrators facing significant liabilities.|
|Beware wording imputing end values – even if not obvious or precise – into an apparent DC scheme||Just ask KPMG. This wording could bring the scheme within the regulatory framework for DB schemes.
In many cases, the position will be fairly clear cut, but determining this issue can be complex and fact-sensitive.
For further information or if you are unsure how to categorise a pension scheme, please contact Gary Cullen, Pensions Partner, email@example.com or on 0203 051 5711, or email us at firstname.lastname@example.org.
Glossary: different types of pension scheme
|Defined benefits (“DB”) or final salary, scheme||Employer promises a pension based on years of service and salary.|
|Defined contribution (“DC”), or money purchase scheme||Contributions are made to the scheme and those contributions are then invested.|
|Hybrid pension scheme||Combines elements of DC and DB schemes.|