Scheme inducement payments under attack

In recent months there has been a spate of cases of employers trying to reduce their pension fund liabilities by offering inducements to scheme members to give up some of their benefits. These inducements take various forms, such as the payment of a cash sum in return for accepting reduced benefits, often in exchange for giving up future pension increases.

Alternatively, members of defined-benefit (DB) plans are offered enhanced transfer values if they agree to move their accrued benefits, usually into a defined-contribution arrangement. In some instances, members may be offered a choice of inducements.

Now, in a rare example of two government bodies responsible for pensions acting in tandem, HM Revenue & Customs (HMRC) has published a statement¹ setting out the tax treatment of such inducements, and the Pensions Regulator issued guidance² on the topic on the same day.

HMRC changes its stance

Until now, the taxation treatment of cash inducements offered to members to give up benefits has not been clear. Employers who proposed such arrangements have had to negotiate with individual tax inspectors on a case-by-case basis. In some circumstances, tax offices have allowed payments to be made without attracting a national insurance (NI) or taxliability.

The Revenue now says it has received "further legal advice" that, where an inducement payment is made, the payments are taxable as earned income under the PAYE system and count as earnings for the purposes of Class 1 NI contributions.

However, if the employer is offering members enhanced transfer values and the whole amount is included in the funds transferred, these will be treated in the same way as employer contributions to registered pension schemes so members will not be liable to tax on the increased transfer amount.

In some instances, employers may have already commenced the process; therefore HMRC has announced transitional arrangements. These apply if the following circumstances arose before 24 January 2007, the date of HMRC's statement:

where the inducement payment has already been paid;

where the employer has been told by HMRC that its particular payment is not taxable and an offer has been made to employees, although no payments have been made; and

where an employer has made an announcement to employees that it is going to offer inducement payments and it can demonstrate that it has relied on HMRC's former view of the law.

Regulator's guidance

The Pensions Regulator is particularly concerned about inducement payments as they impact on its statutory duty to promote the security of pension benefits. Its guidance is aimed at trustees, members and employers, and it is intended to help them identify and fully understand the implications of inducements. It points out that although the practice is not illegal, it creates problems for trustees and risks for members.

The areas that the regulator highlights as being those where trustees should be especially mindful of their responsibilities are:

trust law: trustees have a fiduciary duty to act in the best interests of members, which may mean that they have to challenge the appropriateness of any inducements;

modification of scheme rules: trustees should consider the impact of s.67 of the Pensions Act 1995 (as amended) on any proposed modification and refer to the regulator's guidance on the topic to see if they need to take any action, as well as taking legal advice;

data protection responsibilities:trustees need to take advice on their duties under the Data Protection Act 1998 before releasing details of deferred members to the employer; and

independent financial advice: trustees should check that employers have informed members of the need to take independent advice before accepting any inducement offers.

The guidance stresses the importance of members making informed choices. It places the responsibility for good communication of offers on employers. The box below sets out the main items that must be covered in any member communications. If trustees do not believe that the employer has included all the necessary information, the regulator suggests that they should issue their own communications.

While the regulator appreciates that ultimately trustees cannot prevent the employer offering inducements, it points out that they can refuse to cooperate. In addition, they should notify members if they were either not consulted about the offer or do not wish to be associated with it.

End of the road for inducements?

The actions of the Pensions Regulator and HMRC may, when taken together, act to reduce the attractiveness of cash-inducement arrangements both to employers and scheme members. Employers and trustees run the regulatory risk of members arguing at some point in the future that they would not have accepted the inducement had they been properly informed of the risks involved.

In addition, some commentators believe that if employers continue to try and reduce their pension commitments in this manner, the government will decide to legislate against inducement payments.

¹ "Employers: The Tax and National Insurance Treatment of Employer Cash Inducement Payments to Pension Scheme Members", available from HMRC's website (www.hmrc.gov.uk/pensionschemes) via "News", and then look under 24 January.

² "Inducement Offers", available from the Pensions Regulator's website (www.thepensionsregulator.gov.uk) via "Regulatory guidance", then "Subject listing" and "Inducement offers".

KEY ITEMS TO BE COVERED IN EMPLOYER COMMUNICATIONS TO MEMBERS ABOUT INDUCEMENTS The reason for making the inducement offer; the amount of the offer; the form of the offer (for example, cash or enhanced transfer value); if members have a choice of inducements, and, if so, whether the amount is affected by the option they choose; and for how long the offer is open. The nature of the benefits being given up in exchange for the inducement and, in particular if reductions in pension increases are involved, the potential loss of inflation protection should be explained. If a transfer out of a defined-benefit scheme is involved, an explanation of the risks inherent in transferring to a different type of scheme and a warning that the new scheme may not offer the same benefits, and that certain guarantees and protections, including Pension Protection Fund coverage, may be lost. If a rule change leading to a reduction in benefits is being proposed, the likely cost of making good the benefit. The tax and NI implications of the inducement offer. A recommendation that the member takes independent financial advice before accepting any offer. Explain that members do not have to accept the offer and that there is a lack of consumer protection in respect of this type of financial transaction.