Scheme terminations: the legal maze
In its green paper published last year, the government did not give much prominence to the issue of winding up. Yet by the time it published its action plan in the summer, the subject had moved centre stage, prompted by a number of high-profile cases in which members suffered losses when their schemes were terminated. Here we put the government's proposals in context by summarising the current provisions.
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Partly as a result of the high profile gained by a number of cases of members losing benefits on winding up, the government has moved the issue to the front of its legislative agenda. The current main legislative requirements regarding winding up are contained in the Pensions Act 1995. The 1995 Act introduced many changes, including a new priority order for securing benefits on wind up and giving OPRA, which was established by the Act, extensive powers in relation to scheme wind-ups. Among the issues trustees need to consider when winding up a scheme are how to secure benefits, whether to defer winding up, how to invest funds while the process is taking place, and how to deal with any surplus that arises. |
In the year ending 31 March 2003, nearly 1,500 pension schemes commenced winding up. In the same year, over 3,500 schemes completed the process. Despite the large number of pension plans being terminated at any one time, winding up continues to be problematical for trustees, employers, members and legislators.
Over the years, various governments have passed legislation to ease matters and to provide greater protection for members' benefits on winding up, and yet high-profile cases of employees losing benefits still emerge. The Pensions Advisory Service (OPAS) has been particularly critical of solvent companies that have reneged on their pension promises (OP, December 2002).
In its Green Paper the government proposed a whole raft of changes to pension regulation, including changing the priority order for securing benefits where a scheme is underfunded and introducing a more proactive regulator to replace the Occupational Pensions Regulatory Authority (OPRA). It floated the idea of some form of insurance to help the members of underfunded schemes where the employer is insolvent. However, the Green Paper's main focus was on simplification and extending working lives. By the time the government published its action plan in the summer, the protection of members' benefits on winding up had leapt to the top of its agenda, with its plans including a Pension Protection Fund. It published draft Regulations intended to prevent solvent employers walking away from underfunded schemes and more recently, started consulting on Regulations changing the priority order on winding up .
However, there are already extensive legislative requirements covering all aspects of the winding-up process. In this feature we summarise some of the main provisions that currently apply to defined-benefit (DB) schemes (in theory, winding up defined-contribution schemes should not be such a problem), and highlight some particular issues that those involved in winding up need to consider. Box 1 lists a number of useful publications that explain the current law in more detail.
Pensions Act 1995
Normally a pension scheme's winding-up rule will list a number of events that may trigger winding up. These could include the employer ceasing to pay contributions to the scheme, the employer going into liquidation, or the organisation or its pension arrangements being restructured. In the last of those situations, it is likely that a bulk transfer will be paid to another plan rather than the assets of the scheme being distributed to members and we do not intend to cover that scenario in this feature.
Depending on the wording of the rules, the decision to wind up may be the responsibility of the trustees or the employer. The same rule may also give the trustees power to run the scheme as a closed fund, which means that the normal pension scheme provisions continue to apply. The advantages and disadvantages of this approach are touched on below.
Until the Pensions Act 1995 was passed, there was little legislation specifically concerned with the winding-up of pension schemes. The original Disclosure Regulations (SI 1986/1046) required, among other matters, members to be notified within one month of a wind-up commencing. The Social Security Act 1990 provided for any scheme deficit arising on winding up to be treated as a debt on the employer in the event of its insolvency. Otherwise, apart from certain requirements relating to guaranteed minimum pensions, trustees could only look to the rules of their pension scheme to see what action they had to take in the event of a wind-up.
Following the 1990 Act changes came the Maxwell scandal and Professor Goode's Pension Law Review Committee's report, which was produced as a result. The Pensions Act 1995 arose out of the recommendations contained in the Goode report. Its provisions were devised with the aim of ensuring that members are treated more equitably than previously. However, after less than 10 years, its provisions have been found wanting. In particular, rules relating to cash equivalent transfer values and the minimum funding requirement (MFR) do not seem to have provided the protection anticipated.
Winding up after 1997
The main provisions of the 1995 Act took effect from 6 April 1997 (OP, September 1995). The key changes to winding up that were introduced are as follows:
If a scheme's winding-up commenced before 6 April 1997, its assets are usually applied in accordance with its trust deed and rules. The 1995 Act introduced a new priority order for schemes that are subject to the MFR requirements, and which start to wind up on or after that date. Interim measures apply up to 6 April 2007 when the full changes were planned to take effect. Both sets of priorities are given in box 2. The government's latest proposals on winding-up priorities are planned to apply from early 2004. It is intended that these Regulations will be replaced, when the Pension Protection Fund begins, by a new priority order. This is expected to happen before 2007 and the priority order listed in box 2 as applying from 2007 will therefore never become law.
In all circumstances trustees have a duty to pay expenses, such as the fees of independent trustees, before meeting any other scheme liabilities. This provision is starting to attract criticism. In its latest annual review, OPAS draws attention to the fact that the activities of independent trustees are unregulated at present, and in some cases hinder, rather than assist, the winding-up process. The draft Regulations do not cover this point.
OPRA's powers
OPRA was established by the 1995 Act, which gave it considerable powers to supervise the winding-up of schemes. These include the ability to order the winding-up of a scheme in certain circumstances and to take measures to try and speed up the winding-up process. Among the actions that OPRA may take are: to appoint trustees; to modify a scheme's provisions to ensure a scheme is wound up correctly; and to direct that action is taken to ensure good progress is made in winding up a scheme. Full details of OPRA's requirements are contained in OPRA Note 10 (see box 1 for details of how to obtain a copy).
OPRA was granted further powers in 2002 to accelerate the winding-up process. It was given a much greater role in overseeing the winding-up of schemes. In future trustees will report regularly to OPRA on the progress of the termination of their schemes. Plans that began to wind up before December 1992 have already had to send a report to OPRA. After three years from the start of wind up, trustees have three months to contact OPRA. Thereafter, annual progress reports must be made.
The Green Paper proposes that OPRA will be replaced by a more proactive regulator. However, as it will use OPRA's current staff and premises, it is likely that the new regulator will evolve from the existing organisation and play a more active part in wind ups.
Securing benefits
Among the other changes introduced by the 1995 Act was a requirement for trustees to secure members' benefits in a specific manner. Before 1997, the rules of a scheme would in most cases provide who had power to secure benefits and how those benefits would be secured. The requirements of the 1995 Act override scheme rules in most instances. From 1997 the main ways in which trustees (and under the Act only trustees now have this power) can secure benefits are as follows:
When securing benefits, trustees must take all necessary steps to identify all of the scheme's assets and liabilities. They may wish to insure themselves against the possibility of further beneficiaries turning up after the wind-up is complete. Another consideration is that of costs and expenses (referred to earlier). Trustees will need to hold back sufficient assets to cover all costs. If trustees are relying on the statutory discharge, they must issue a formal notice to members. The notice requirements are complicated and depend on the manner in which benefits are being secured.
Deferring wind-up
As well as ensuring that they meet all of the regulatory requirements, trustees have to consider a number of other important issues. One key decision is whether to exercise their statutory power to defer the winding-up after a triggering event has occurred. The reasons why trustees may wish to follow this course of action include:
With the recent decline in world stockmarkets, it is unlikely that trustees will wish to defer for the first reason. However, if the scheme is large, they may have to defer the wind-up because of the difficulty of buying out all the benefits at once.
Even if the trustees do decide to defer the wind-up, they need to keep their decision under review. A change in circumstances may necessitate the winding-up proceeding. A particular problem arising out of deferring a winding-up involves "priority drift". This is where members move into a higher priority, for example, a deferred pensioner reaching normal retirement age and becoming a pensioner. If too many people start moving up the priority order during deferment, it could have a detrimental effect on the scheme's finances.
Other issues
There are many other issues that have to be considered when winding up a pension scheme. One important fact to determine from the outset is the date on which winding up was triggered. Since April 2002, failure to record the decision to terminate a scheme has been a breach of the 1995 Act.
Another issue that may not seem immediately obvious is the need to review investment policy. Winding up is a slow process, and while it is taking place, trustees probably should consider moving funds into safer investments than equities. If the employer is insolvent, an independent trustee should be appointed as soon as possible and should be able to assist with investment strategy.
In the past trustees have had to grapple with the problem of how to deal with surpluses in the fund, although in the current investment climate this is less of a problem. However, if the scheme does contain a power to return surplus to the employer, it will be overridden by the 1995 Act unless the scheme's liabilities have been fully discharged and limited price indexation (annual increases in line with the retail prices index up to 5% a year) applied to all benefits. In addition, extensive notification requirements have to be met and scheme members have the right to object to OPRA if unhappy about the proposals.
More recently, trustees have had to deal with the equalisation of guaranteed minimum pensions and with transfer requests when schemes are underfunded. In OPRA Update no.3 (OP, October 2003), the regulator has issued guidance on these issues for trustees of schemes that are in the course of winding up, which should make their task a little easier in future.
An onerous function
When the decision to wind up a pension scheme is taken, the trustees have a demanding job to try and ensure that termination is a smooth process. It is very important to take advice. Members and OPRA must be kept regularly informed of progress. Box 3 contains a summary of the action OPRA now expects trustees to take on winding up. It is important for trustees to remember that they could be fined if they do not follow the correct procedures.
In its Green Paper , the government recognised that the winding-up process had become too complicated and that the provisions of the 1995 Act were not protecting members' interests as originally envisaged, although its proposals were not fully articulated. In its subsequent action plan it placed protecting members' rights at the centre of its proposals.
As well as expressing the intention to provide increased protection for members by changing the priority order, it placed particular emphasis on the establishment of a Pension Protection Fund based on the US model. It is still to reveal details of how this is to operate.
In the meantime, trustees, advisers and other parties involved in the winding-up of a scheme must continue to act in accordance with the increasingly complicated provisions of the 1995 Act.
Our research
For this feature we have drawn on a large number of sources, including numerous reference works. Particularly helpful were the books listed in box 1 and Tolley's pensions law handbook, fourth edition.
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Box 1: Useful guidance on winding up How to wind up a scheme, available from OPRA, Invicta House, Trafalgar Place, Brighton BN1 4DW, tel: 01273 627688, email: helpdesk@opra.gov.uk, free, or from its website (www.opra.gov.uk) via "publications" and "at a glance leaflets". Winding-up a pension scheme - a guide for scheme members, available from the Pensions Advisory Service, 11 Belgrave Road, London SW1V 1RB, tel: 0845 6012923, email: enquiries@opas.org.uk, free, or from its website (www.opas.org.uk) via "Publications".
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Box 2: Priority orders on winding up
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Transitional priority order to 5.4.07 |
Priority order due to apply from 6.4.07* |
New priority order as set out in draft Regulations |
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First: expenses and debts owed to third parties. Second: pensions or benefits derived from additional voluntary contributions. Third: benefits to which entitlement has already arisen and which are secured by insurance policies bought before 6.4.97. Fourth: other benefits that have already become payable, including survivors' benefits but excluding pension increases. Fifth: (a) equivalent pension benefits, guaranteed minimum
pensions (excluding pension increases); and Sixth: pension increases on benefits falling in the third and fourth priorities. Seventh: pension increases on benefits falling in the fifth priority. Eighth: liability for any other benefits that have accrued, including increases. |
First: expenses and debts owed to third parties. Second: pensions or benefits derived from additional voluntary contributions. Third: benefits to which entitlement has already arisen and which are secured by insurance policies bought before 6.4.97. Fourth: other benefits that have already become payable, including survivors' benefits but excluding pension increases. Fifth: (a) accrued pensions and other benefits that have not
become payable (excluding Sixth: pension increases on benefits falling in the third, fourth and fifth priorities. |
First: expenses and debts owed to third parties. Second: pensions or benefits derived from additional voluntary contribution. Third: pensioners: pensions or other benefits in payment (without annual increases). Fourth: non-pensioners: first category: a proportion of accrued pension, other benefits or future benefits relating to pension credits (excluding increases) calculated using a formula based on the length of time a member has been contributing to a scheme. Fifth: non-pensioners - second category: the proportion of accrued pension, other benefits or future benefits relating to pension credits not covered within fourth priority and refunds of contributions to members with less than two years' service (excluding increases). Sixth: pensioners' indexation: increases in relation to third priority. Seventh: non-pensioners' indexation: increases in relation to fourth priority. Eighth: non-pensioners' indexation: increases in relation to fifth priority. |
* Introduced by Pensions Act 1995.
Note: Defined-contribution assets and liabilities, other than additional voluntary contributions, are excluded.
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Box 3: A summary of OPRA's requirements Reporting to OPRA by trustees Trustees had to report to OPRA before 1 June 2002 if their scheme started to wind up on or before 31 December 1989. Trustees of schemes that started to wind up after 31 December 1989 must also report to OPRA. These reports are being phased in. After their first report, trustees must report to OPRA every 12 months about the progress they are making on winding up their scheme. Trustees must report to OPRA if the scheme needs an independent trustee but does not have one. Other duties of trustees Trustees must keep written records of their decision to wind up the pension scheme, which must show clearly the date the wind-up starts.
Trustees may apply to OPRA for a modification order, if they need one, to ensure the proper winding up of the scheme.
Trustees must provide scheme members with copies ofany reports sent to OPRA about winding up within two months of the request being made.
Trustees may be able to apply to OPRA to direct action to be taken if it is the only way they can complete the wind-up in a reasonable time.
OPRA's powers OPRA can direct action to be taken if it feels winding up is not progressing quickly enough.
It can impose fines on trustees and others involved in the administration of the scheme if they do not follow the law.
It can ban or disqualify a trustee from continuing to act and can appoint replacement or additional trustees.
Source: based on "Reporting to OPRA: is your scheme winding up?", available from OPRA's website (at www.opra.gov.uk ) via "wind up reports". |
