The Legal Implications of Final Salary Scheme Deficits & the Move Away From Final Salary Provision

The publication of the annual NAPF survey for 2001 triggered a series of articles in both the national and pensions press on the move away from final salary to money purchase provision by employers. The survey found that out of 800 of the UK's major employers, 46 had closed their final salary schemes to new entrants, compared to 18 in the previous year. Thirteen employers had switched from providing a final salary scheme to providing a money purchase scheme and a further seven had switched from a final salary scheme to a group personal pension plan.

The reasons for the move away from final salary to money purchase provision have been the subject of much discussion. In summary, increased costs have combined with longer life expectancy and decreased investment returns to reduce the funding levels in many schemes. The effect of the Pensions Act 1995 has also created a regulatory burden for schemes, not least in respect of compliance with the minimum funding requirement. The attraction of the fixed and certain costs of money purchase provision, as opposed to the variable and unknown costs associated with final salary schemes, is easy to understand. Furthermore, under the new accounting standard FRS17, a pension scheme's surplus or deficit has to be reflected in the sponsoring employer's balance sheet, which means greater transparency, but also greater volatility in the company accounts.

In this briefing we discuss some of the legal implications surrounding these issues, in particular:

The options for dealing with a funding deficit; and

Restructuring employees' pension arrangements.

Dealing with a funding deficit in a final salary scheme

After the pension scheme surpluses of the 1980s and 1990s, many sponsoring employers and trustees are now finding that their schemes are in deficit, and are having to consider for the first time the effect of the funding deficit provisions that were brought into force under the Pensions Act 1995. We discuss below what the legal position is on pension scheme deficits, including recent changes.

Every three years (or more frequently if the scheme rules provide) the scheme actuary has to provide a full actuarial valuation of the fund. The valuation must be signed by the scheme actuary within one year of the effective date of the valuation. The trustees and the employer then have eight weeks from the date that the valuation was signed in which to reach agreement on the future level of employer contributions. Failing agreement, the trustees must decide an appropriate contribution rate, within the following four weeks, to ensure that the statutory minimum funding requirement (MFR) is met. The level of contributions over and above those required to meet the MFR will depend on the provisions of the scheme rules, which will usually provide that either the employer, the trustees and/or the actuary determines what additional contributions are required by the employer.

The amount and rates of the contributions are then set out in the scheme's schedule of contributions. The actuary has to certify that the rates set out in the schedule are adequate. Where the scheme is fully funded, adequate means that the contributions should maintain full funding on the minimum funding requirement (MFR) basis throughout the period covered by the schedule. If the scheme is in deficit on an MFR basis, then adequate means that the contributions should be sufficient to bring the scheme up to the fully funded level by the end of the schedule period. The schedule period is 10 years where the scheme is under funded on the MFR basis either at the valuation date or the date that the actuary certifies the schedule of contributions. Prior to 19 March this year the schedule period was five years, or 5 April 2007 if later.

Different provisions apply where the scheme is less than 90% funded on the MFR basis (a serious shortfall). An employer may either secure the shortfall by making additional contributions to the scheme or follow a prescribed method which guarantees that the serious shortfall (ie the amount that the funding level falls below 90%) will be met in the event of the employer's insolvency or if the scheme were to be wound up. A combination of these methods can be used.

Under the additional contributions method, payments totalling the serious shortfall must be made within three years of the date that the scheme actuary signs the minimum funding valuation. Prior to 19 March, this was one year, or 5 April 2003 if later. The payments can be made on a regular or one off basis. Under the prescribed method, the outstanding balance of the serious shortfall would be secured either by means of the relevant sum being paid into a designated escrow account, a letter of credit in favour of the trustees being put in place for the relevant amount or by granting the trustees a charge over unencumbered assets.

Changes to the position on funding

The Government intends to replace the MFR with a long-term, scheme specific, funding standard. Implementing these changes will require primary legislation and the Government is consulting further on this.

This means that eventually the "one size fits all" nature of the MFR will be replaced with funding and investment objectives that are linked to a scheme's own liability structure rather than to some external benchmark.

In the...