Why we are where we are: history and context
The growth of final salary schemes
UK employers have a long history of providing pensions for their employees and dependants. This may partly have been a response to modest levels of state pension and partly paternalistic impulse. Whatever the reason, occupational or workplace pension schemes are part of British industrial and commercial history. Pensions for civil service and other public sector workers, established in the 19th and first half of the 20th century, were based on members’ salary at or near the time they retired or left service, and many private sector industrial companies broadly followed this benefit pattern.
Schemes were set up throughout the 20th century, but greatly expanded after the Second World War. During the 1980s, corporate transactions invariably required purchasers to set up comparable final salary pension arrangements for transferring staff. This led to a proliferation of schemes, with acquisitive companies often ending up with a number of group schemes, each with different benefit scales and provisions. It was also common practice to set up separate schemes for different classes of workers – typically works, staff and executive members. As costs and regulation increased, many employers brought their different schemes together.
Final salary schemes were originally set up on the basis that they could be terminated at any time, applying available scheme assets towards providing benefits, and reducing benefits to the extent that there were insufficient assets to pay for them in full. The establishment of pension schemes was also encouraged by the tax system. As long as they were set up under trust – ensuring that pension assets were kept separate from the employer’s business – schemes could be approved by the Inland Revenue. Contributions by employers and members were deductible for tax purposes, members escaped any ‘benefit in kind’ tax in respect of employer contributions and investment income rolled up tax-free within the fund. Benefits could not exceed limits set down by the Inland Revenue.
The decline of final salary schemes
A number of events came together that made schemes riskier and more expensive for employers and, as a result, precipitated the long decline in final salary pension provision.
The first was the Maxwell scandal. Following Robert Maxwell’s death in November 1991, serious irregularities were discovered in pension schemes of the Mirror newspaper group: some £450m of assets were found to be missing from the schemes. An enquiry into the law of occupational schemes by Professor Roy Goode led to the Pensions Act 1995. For the first time, a pensions regulator, OPRA, was created to oversee statutory obligations imposed on employers and trustees. These included mandatory member representation on trustee boards and a minimum funding requirement. The Act sought to impose light-touch regulation that reflected best practice and the existing trust law structure. The objective was to avoid penalising the many schemes that were prudently funded and properly run. However, compliance costs proved to be considerable, and arguably the legislation did nothing to improve the governance of those schemes that most needed it.
In 1997, an abrupt change in tax policy abolished tax credits on dividend income. In final salary schemes, where employers bear the balance of cost (members usually pay a fixed percentage of pay), reduced investment income meant higher employer costs. The change of policy undoubtedly undermined the confidence of sponsors.
The third was a change to the law on scheme wind-up. A requirement for employers to make up a funding shortfall on winding up had been included in the Pensions Act 1995 – but only on the then statutory minimum funding basis that most schemes could easily meet. Now, employers who wished to terminate a final salary scheme had to ensure that all promised benefits were secured in full with an insurance policy. Any shortfall between the cost of arranging such insurance and the scheme assets became a legally enforceable debt to the scheme – the so-called ‘buy out’ or ‘section 75’ debt. In September 2002, this obligation was extended to withdrawals from multi-employer schemes, creating a material impact on corporate sales and purchases, and group internal reorganisations.
The final chapter
The Pensions Act 2004 introduced a further raft of regulation. A new Pensions Regulator was introduced, with the ability to determine funding disputes between employer and trustees, and in certain circumstances to extend liability to companies connected or associated with the sponsor. Prior clearance of corporate transactions conferring protection from regulatory intervention can be obtained in certain circumstances, although this will often come at a price. Final salary pensions have therefore begun to take centre stage in many corporate transactions.
Administering final salary schemes has also become more complex and more costly. There have been numerous changes to pensions tax policy, most notably in 2006 and 2015. Regulatory guidance on everything from funding to disclosure and conflicts has grown. Trustees are encouraged to monitor the ‘company covenant’ – the ability of the employer to meet its funding obligations. Under certain circumstances, activity within the wider employer group may become relevant. The full impact of European discrimination legislation is still being felt, litigation is increasing and more European legislation is on the way. In the near future, this is likely to centre on disclosure and governance, but there have been attempts to introduce stricter funding and solvency requirements as well.
The growth of contract-based schemes
The risks associated with final salary schemes have led many employers to terminate future service accrual or reduce benefits and to turn to contract-based schemes for future provision.