Annex A - The context
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Introduction
1. This annex describes in broad terms the system of pension provision in the UK and some key aspects of the statutory framework that governed final salary occupational pensions in the relevant period.
2. Before doing so, I should explain that many of the provisions I go on to describe have been replaced since the commencement of the new regime governing private pension provision in April 2005. Other aspects remain in force. In this annex, I generally use the past tense throughout. This is in recognition that the events relevant to this investigation took place from 24 January 1995 to 6 April 2005.
Pension provision in the UK
3. One way of describing the system of pension provision within the UK is to categorise pension provision according to the different sources of the various elements of possible retirement income and how these sources interact with each other.
4. Using this approach, we might say that there were five principal categories of pension provision in the UK:
(i) state retirement pensions;
(ii) retirement annuity contracts – which have ceased to be entered into since July 1988;
(iii) personal pension plans (from July 1988 onwards) and stakeholder pensions (from April 2001 onwards);
(iv) public sector occupational pension schemes, including those for current members (and veterans) of the armed forces; and
(v) private sector occupational pensions.
5. Before setting out both the main features of the occupational schemes relevant to this investigation and how the contracting-out provisions affected pensions provided by such schemes, I will summarise the main features of state pension provision insofar as these were relevant to the matters I have investigated.
State retirement pensions
6. A state pension is payable to all individuals who have reached state pensionable age, who have made or been credited with (or whose spouse has made or been credited with) sufficient national insurance contributions, and who have made a claim for a state pension.
7. There are four principal categories of state retirement pension:
(i) a Category A retirement pension - which is payable to someone who reaches the relevant state retirement age and who has in their own right made or been credited with sufficient national insurance contributions to qualify for the basic state pension;
(ii) a Category B retirement pension - which is payable to someone who reaches the relevant state retirement age and whose spouse has made or been credited with sufficient national insurance contributions to enable their spouse to qualify for the basic state pension;
(iii) a Category C retirement pension – which is payable to those people who were already over pensionable age on 5 July 1948, regardless of their contribution record; and
(iv) a Category D retirement pension – which is payable to people aged 80 or over, who either get no basic state pension or whose pension is below a given amount and who have lived in the country for at least ten years after reaching age 60.
8. A state retirement pension payment may include one or more of the following elements, namely:
- the basic state pension - a flat rate payment at generic rates set for single people and, for each couple, a payment to reflect the total rate of Category A and B pensions;
- the additional state pension - an earnings related element with respect to an individual’s specific earnings between April 1961 and April 1975 (graduated retirement benefit) and/or after April 1978 (the State Earnings Related Pension Scheme – SERPS - and, since 6 April 2002, the State Second Pension);
- increases for qualifying dependants or for invalidity;
- an age addition for those aged over 80;
- increments in respect of periods of deferred retirement, where the individual has elected not to take their state pension as soon as they were entitled to do so; or
- a Christmas bonus and/or winter fuel allowance.
9. Where an individual’s national insurance contribution record falls short of the minimum qualification requirements, which are set out in legislation – or where an individual moves abroad to certain countries on retirement - a reduced or frozen state pension may be payable.
10. There are three classes of national insurance contributions which may qualify an individual for a state pension in his or her own right:
(i) class 1 contributions, of which there are two types:
- primary contributions, which are made by all employees whose earnings are in excess of a primary threshold and are paid on all of their earnings up to an upper earnings limit (both limits are set out in statute); and
- secondary contributions, which are payable by employers in respect of their employees whose earnings are in excess of a secondary threshold (there is no upper limit for secondary contributions);
(ii) class 2 contributions, which are flat rate contributions payable by the self-employed; and
(iii) class 3 contributions, which are voluntary contributions which may be made by an individual to boost their contribution record so as to ensure that he or she has made or been credited with sufficient contributions to qualify for a state retirement pension.
11. For class 1 contributions, individual employees pay additional national insurance contributions of 1% of their earnings above the upper earnings limit – towards the National Health Service.
12. In addition to the basic element of the state pension, which is dependent on national insurance contributions, there is, as noted above, a further, earnings-related component to the state pension, known as the additional pension.
13. The additional state pension over time has had three manifestations: graduated retirement benefit, SERPS, and the State Second Pension.
14. Graduated retirement benefit is payable as an increase in the weekly rate of state retirement pension and was introduced by the National Insurance Act 1959. It is now governed by the provisions of the National Insurance Act 1965, which remain in force in order to ensure payment of the benefit for those who had actual or prospective rights prior to 6 April 1975, from when this form of additional pension no longer accrued.
15. Through SERPS, an individual may qualify for an additional pension through contributions made in relation to earnings received in the period from April 1978 to April 2002, in respect of earnings for each year between the lower and upper earnings levels, as determined in law.
16. At retirement, once an individual’s earnings up to the upper limit for each year have been determined, they are increased in line with the rise in national average earnings (as set out in the relevant Revaluation of Earnings Factors Order, a statutory instrument made by the Secretary of State) to take account of inflation. Finally, an amount equal to the lower earnings limit in the last complete tax year before the one in which the individual attains state pension age is deducted to produce that individual’s surplus earnings for each tax year.
17. Prior to 6 April 1999, an individual reaching state pension age would qualify for an annual rate of additional pension which was calculated by multiplying the aggregate of his or her surplus earnings for all the years which counted for additional pension by 1.25%.
18. After 6 April 1999, the annual rate of SERPS that a person reaching state pension age would receive would consist of:
(i) the aggregate of their surplus earnings in the tax years from April 1978 to April 1988, multiplied by 25% and then divided by the total number of years between 6 April 1978 (or 6 April immediately preceding their 16th birthday, if later) and the 5 April immediately preceding their 65th birthday (or their 60th birthday, in relation to a woman); plus
(ii) the aggregate of their surplus earnings in the tax years from 6 April 1988 to the 5 April immediately preceding them attaining state pension age, which is multiplied by the relevant percentage (which varies between 20% and 25% depending on the year in which they reach state pension age) and then divided by the total number of years between 6 April 1978 (or 6 April immediately preceding their 16th birthday, if later) and the 5 April immediately preceding their 65th birthday (or their 60th birthday, in relation to a woman).
19. From 6 April 2002, SERPS was reformed to provide a more generous additional state pension for low and moderate earners, and to extend access to include certain carers and people with a long-term illness or disability. The reformed additional state pension is known as the State Second Pension. The State Second Pension is based upon earnings between a lower earnings level and an upper earnings level.
20. Where a person is contracted-out of the additional state pension (see below), their entitlement to additional pension for the period during which they are contracted-out is reduced or removed to recognise the pension derived from contributions made to an occupational or personal pension scheme instead of towards the state scheme.
21. For earnings in the tax years from 1978/79 to 1996/97, a member of a contracted-out occupational pension scheme accrued additional state pension in the same way as someone who was not contracted-out, but the rate payable was reduced by a contracted-out deduction.
22. For earnings in the tax years from 1997/98 to 2001/02, a member of a contracted-out occupational pension scheme did not accrue additional state pension in respect of earnings in contracted-out employment.
23. For earnings in any tax year starting from 2002/03, a member of a contracted-out occupational pension scheme earning between £4,264 and £27,800 (in 2005/06 terms) in a tax year will get a State Second Pension top-up in respect of that year. The top-up reflects the more generous additional state pension provided by State Second Pension and is paid as part of the state pension.
Occupational pensions
24. During the relevant period, there were three types of occupational pension scheme:
(i) defined benefit schemes (also known as final salary schemes), which are the principal focus of this report;
(ii) money purchase or defined contribution schemes; and
(iii) mixed benefit schemes, which combine features of the above.
Scheme governance and membership
25. Pension schemes in the private sector were established by trust law. Schemes were governed by trustees, whose role it was to apply the scheme assets for the benefit of scheme members and other beneficiaries in accordance with the law and the scheme’s trust documents.
26. Trustees were largely appointed by the employer or employers who sponsor the scheme, although since 1997 there has been a requirement (although certain schemes may in specified circumstances opt out of this) that each scheme has a number of member nominated trustees.
27. Sometimes an insolvency practitioner may be appointed in relation to the sponsoring employer of a scheme or the official receiver may become the liquidator of the relevant company or the manager of the estate of a bankrupt employer. In those circumstances, it was the duty of the insolvency practitioner or official receiver to satisfy themselves at all times that at least one of the trustees of the scheme was an independent person.
28. If that was not the case, an independent trustee had to be appointed, who could not have an interest in the assets of the employer or the scheme, who could not have been associated with the scheme in a professional capacity during the preceding three years, and who could not be connected with or be an associate of the employer, the insolvency practitioner or official receiver, or other persons with a direct interest in the scheme.
29. All trustees had a duty not to profit from their position as trustee and were obliged to act as a prudent person would, not only in their own conduct but also in relation to third parties. Trustees had to act in accordance with the trust deed and other rules and had to act impartially as between different classes of beneficiaries. Finally, trustees had to familiarise themselves with their investment powers and seek appropriate professional advice to enable them to apply the assets of the scheme in the best interests of its beneficiaries and to comply with the relevant legislation.
30. Trustees were obliged to disclose certain documents and information to scheme members, prospective members, other beneficiaries and to appropriate trades unions. Each scheme was also obliged to establish an internal dispute resolution mechanism.
31. Since 1988, membership of an occupational scheme could no longer be compulsory and any term of a contract of service purporting to make membership of a particular scheme compulsory was void unless it related to death-in-service benefits within a scheme which was non-contributory.
32. There were broadly four types of members of final salary pension schemes:
(i) active members – those who were working for the sponsoring employer and having contributions made on their behalf (and who may themselves be contributing) to the scheme;
(ii) pensioners – those who were receiving benefits from the scheme;
(iii) deferred members – those who had left the service of the sponsoring employer but who retained benefits in the scheme; and
(iv) other qualifying individuals – those in receipt of a survivor pension (for example, a widow) paid in respect of the benefits accrued by a deceased member.
Scheme funding and benefits
33. In defined benefit pension schemes, the trust deed and rules set out the basis on which benefits were paid. Typically these defined the amount of benefit and the circumstances under which it was paid.
34. The amount would normally be defined as a proportion of an individual’s salary (‘salary’ for this purpose was defined in the rules) and typically depended upon the length of service the employee had completed as a member of the scheme. Benefits were paid from an age laid down in the scheme rules. The rules also stated whether benefits were payable in other circumstances, for instance where a member left work on ill-health grounds.
35. If an individual left to take up employment elsewhere, the benefits would usually be calculated based on service and salary as at the date of leaving. The individual had the opportunity to leave the benefits in the scheme (i.e. to become a deferred member of the scheme) or to take a transfer value to another scheme.
36. In order to provide these benefits, the employer (and the employee, if required under the rules) made contributions. These contributions are said to ‘fund’ the benefits. Upon receipt of contributions, the trustees arranged for them to be invested. The invested contributions then became the ‘assets’ of the scheme.
37. The obligation to pay the benefits of a given amount and in the specified circumstances, became the scheme’s ‘liabilities’.
Setting contribution rates
38. The current value of a scheme’s liabilities was not generally known in advance with any certainty and in most schemes the employer picked up the balance of cost in terms of a variable rate of contributions to fund the liabilities. Members’ contributions were usually a fixed percentage of salary although in some schemes their contributions could vary too.
39. The trustees of a scheme were bound to follow the trust deed and rules and relevant legislation with regards to the funding of members’ benefits. The terms of schemes’ legal documentation varied widely but might have stated either that the sponsoring employer determined the rate of contributions to the scheme or that the trustees decided on this, after having taken advice from the scheme actuary, after consultation with the employer, and subject to the provisions of the MFR legislation.
40. The common reference to the MFR legislation was a reminder to the trustees that this was the legal minimum at which they must plan to fund the scheme. This would have been the default position in the absence of agreement to higher amounts.
41. In this situation, the employer had a duty, after consultation, to pay the contributions decided on by the trustees. Consultation between trustees and employers took place at various different levels. There were also schemes where the employer held more of the contribution setting powers.
42. In rare cases the scheme actuary may have had the power to set contributions. There may have been other constraints on the employer(s) contributions contained in the scheme documentation.
43. However, in all cases, shortly after an actuarial valuation had been carried out, the trustees and employer needed to jointly agree on a schedule of contributions which specified the contributions that the employer(s) and employees would pay in future.
44. The scheme actuary was a statutory role with responsibilities to carry out MFR valuations, generally every three years, on the prescribed basis and to certify that the contributions agreed between the trustees and employer would be sufficient to satisfy the MFR – that is, to remain above or restore the scheme to a 100% MFR funding level within prescribed time limits - for the period of the schedule of contributions.
45. Legislation also required ongoing valuations, generally every three years, and individual schemes’ documentation may have placed additional requirements on the actuary in terms of carrying out valuations and recommending rates of contributions.
46. The MFR only provided a minimum level at which schemes needed to aim to be funded. The range of contribution setting powers of different schemes, the interpretations given to these powers and the employer’s willingness and ability to fund at higher levels meant that the dispersion within which schemes were funded was very wide.
47. The pace of funding, or the level to which a scheme was funded, was a major factor in determining the level of security for members’ benefits in that scheme.
Actuarial valuations
48. Formal actuarial valuations involved the carrying out of calculations on a number of possible different funding measures by the scheme actuary.
49. However, in essence any actuarial valuation had two main purposes:
- to compare the liabilities for benefits that members have accrued in respect of their service to date against the assets in the scheme at the same date (known as a past service valuation); and
- to value the liabilities for benefits that active members will accrue in respect of future service.
50. This enabled the scheme actuary to make recommendations on the funding - that is, the contributions - required to be paid for the future service benefits with possible adjustments upwards or downwards to take into account the deficit or surplus of assets held to meet the past service liabilities.
51. In order to make these assessments, the scheme actuary made assumptions about how the scheme would develop in the future.
52. For an MFR valuation, these assumptions were prescribed. However, for an ongoing valuation the scheme actuary would make assumptions - about such things as future wage growth, life expectancy, future increases to pensions once in payment, the probability that people would leave by early retirement, retirement at the normal scheme age or by other means - in order to project forward the cash flows out of the scheme.
53. Having projected forward the cash flows from expected benefit payments, the scheme actuary then ‘discounted’ these future payments back at an assumed rate of interest in order to give a ‘capital value’. The capital value of the liabilities earned in respect of service up to the valuation date was commonly called the value of the past service liabilities.
54. In considering the asset value, the scheme actuary would typically either take the market value of the assets (as provided by the auditor in the scheme accounts) or the ‘assessed’ or ‘actuarial’ value of the assets.
55. The ‘assessed’ or ‘actuarial’ value took the income from the assets and projected it forward using assumptions about growth (equity dividends, property rental income and so on) and inflation and then discounted this income stream back at the valuation rate of interest to give a figure which could be compared with the past service liabilities to assess whether a surplus or deficit existed.
Different funding measures
56. A formal valuation exercise generally included the production of valuation results on several different measures for different purposes. These could be broken down into two main categories as follows:
- ongoing valuations: with liabilities valued assuming that active members remain in service - in order to check that the pace of funding is on track; and
- discontinuance valuations: with liabilities valued assuming that active members leave active service immediately - principally as a check on the security of benefits.
57. An ongoing valuation typically made allowance for future wage inflation in projecting forward active members’ benefits from the valuation date to their eventual retirement date. Discontinuance valuations, on the other hand, treated active members as having left employment; that is, as deferred pensioners. The projection of such benefits therefore only allowed for statutory deferred pension increases.
58. The valuation rate of interest for placing a capital value on the discontinuance liabilities depended on the nature of the valuation. There were three common bases on which discontinuance valuations were made. These related to either a position where the liabilities were run off on a ‘closed scheme’ basis, or where they were secured by the payment of transfer values, or where they were secured by the purchase of annuities.
59. Prior to the abolition of tax credits on UK equity dividends in 1997, ongoing valuations typically used a discounted income value of assets (see above). This reflected the longer term nature of these valuations and a desire to smooth out market volatility in the asset valuation.
60. Subsequently, the use of market values (or market-related values) became increasingly common in ongoing valuations.
61. However, discontinuance valuations were designed to show a current or at least a much shorter term view of the scheme’s financial position. As such, they more commonly used market values of assets.
62. Tax approved occupational pension schemes were also required to carry out an assessment of their funding position against a prescribed surplus valuation basis. The legislation for this statutory surplus test was designed to prevent over-funding and schemes risked the loss of tax relief if they found themselves over the prescribed limit.
Disclosure of valuation results and related guidance
63. Scheme actuaries are bound by the professional guidance issued by the Faculty and the Institute of Actuaries on what they need to include in their valuation reports to trustees. The relevant professional Guidance Note is GN9, of which version 5.1 was current for valuations signed from 1 June 1994 until 31 July 1997 and version 6.0 was current for valuations signed from 1 August 1997 until 19 March 2004.
64. There are a number of sections of version 6.0 of GN9 which have particular relevance to this investigation:
2.1 The purpose of the Guidance Note is to ensure that reports contain sufficient information to enable the current funding level of a scheme to be understood and also, in the case of a defined benefit scheme, to enable the expected future course of a scheme’s contribution rates to be understood. It is not intended to restrict the actuary’s freedom of judgement in choosing the method of valuation and the underlying assumptions…
3.1.3 A report on a scheme subject to the Minimum Funding Requirement may incorporate the actuary’s statement (prepared in accordance with Guidance Note GN27) on that Requirement if it is appropriate to do so, i.e. the prescribed calculations have been made by the appointed Scheme Actuary and the report is addressed to the trustees. Care should, however, be taken that the results of calculations with different objectives are clearly identified…
3.4.1 In the case of a defined benefit scheme, the report should explain the funding objectives and the method being employed to achieve those objectives. A statement should be made as to the extent to which there have been changes in the objectives or the method since the last report of a similar nature. Implications in terms of stability of contribution rates and of future funding levels should be explained. If the scheme is subject to the Minimum Funding Requirement, comment should be made on the difference from the objectives of that requirement…
3.7.1 In the case of a scheme subject to the Minimum Funding Requirement, the Minimum Funding Requirement funding level as given in the most recent statement should be stated with appropriate explanation.
65. Under the heading ‘current funding level — discontinuance assumption’, GN9 stated:
3.8.1 The purpose of the statement on this subject is to give an indication of the accrued solvency position of a scheme in discontinuance or were the scheme to become a scheme in discontinuance at the valuation date and, in particular, if there were no further contributions due from the scheme sponsor. The actuary should adopt an approach with that principle in mind.
66. The actuary is further required to give an opinion on whether the assets would have been sufficient to cover the discontinuance liabilities of pensioners, deferred pensioners and active members. If the assets were not sufficient, an indication of the level of coverage was to be included.
67. The statement of which liabilities are covered in this way needed to reflect the priority order for securing benefits that applies in a winding up. At a basic level, pensioners’ benefits would be secured fully with remaining assets being used to secure deferred and active members’ benefits.
68. Under the heading ‘current funding level — on-going assumption’, GN9 stated:
3.9.1 If the scheme is not already in discontinuance, the report should include a statement as to the funding position on the assumption that both scheme and the scheme sponsor(s) are on-going. The statement should include, where relevant, a comparison between assets and accrued liabilities, the latter with pensionable salaries projected where appropriate to assumed end of pensionable service, if this is not otherwise conveyed by the comments on the funding objectives and the contribution rate.
69. Valuation reports were therefore required to provide trustees with information on the different funding measures and the differences between them - and members had the right to request copies of actuarial valuation reports.
70. Regulations also required an ‘actuarial statement’, as appended to the valuation report, to be included in the scheme’s annual report and accounts. These accounts were also disclosable to members.
71. Version 6.0 of GN9 contains guidance to actuaries preparing these actuarial statements including the following:
4.3 …the Statement requires an opinion from the actuary on the adequacy of the resources of a scheme “in the normal course of events”. In interpreting this expression at the date of each Statement, the actuary should take a prudent view of the future without taking into account every conceivable unfavourable development…
4.5 Care should be taken to avoid confusion between MFR liabilities, liabilities on an ongoing valuation basis and discontinuance liabilities.
72. Again the actuary was required to make sure that the reader was aware of differences between the different funding measures.
MFR: actuarial methodology and assumptions
73. The MFR became operational from 6 April 1997. However, much of its development took place before then to allow for consultation and time for actuaries to become familiar with the MFR and to update their systems.
74. The methodology and actuarial assumptions for the MFR test, and for determining the statutory minimum level of employer contributions, were during the relevant period prescribed by The Occupational Pension Schemes (Minimum Funding Requirement and Actuarial Valuations) Regulations 1996, which referred to a mandatory actuarial guidance note (GN27) for the technical actuarial details underlying the calculations.
75. The specifics of the methodology and assumptions underlying the MFR calculations were contained in the actuarial guidance note and were set by the actuarial profession - the Faculty and Institute of Actuaries - with the approval of the Secretary of State.
76. The actuarial profession’s remit was to devise a methodology and assumptions which met the Government’s objectives for the MFR and which:
- did not impact unduly on compliance costs for employers;
- was consistent with the actuarial valuation methods that were in practice at that time (hence a methodology based on a true market based model was not considered, as such methods were not commonly in use for ongoing valuations at that time);
- did not rely on complex mathematical models for compliance (hence the MFR methodology did not explicitly tackle market value volatility);
- took account of instructions from Government on the extent to which the MFR basis should include an equity risk premium, that is the expected out-performance of equities relative to gilts (advice to DSS from the Pensions Board of the actuarial profession had been that, if it were desired to give the member increased security, then a greater weighting would be required in bonds with a consequent increase in compliance costs); and
- was objective in its nature to the extent that different actuaries should not produce answers which were more than 2% different given the same data.
77. When the MFR was introduced, its basis was also used to provide a ‘floor’ to the calculation of cash equivalent transfer values (CETV) when an individual left a scheme and transferred his or her benefits to another suitable pension arrangement.
78. From 6 April 1997, a CETV had to be underpinned by the value of the MFR liability in respect of the member to whom the CETV related - except if the scheme was not fully funded on the MFR basis, in which case the transfer value could be reduced to reflect this under-funding.
79. Legislation introduced a change to the calculation of the debt (if any) due from the employer to the pension scheme when a scheme starts to wind up. From 6 April 1997, the amount of such a debt was calculated as the difference between the amount of the scheme’s assets and the value of its liabilities calculated on the MFR basis.
MFR valuations
80. The past service valuation under the MFR specified that:
a) the pension scheme assets were taken at market value;
b) pensions in payment were generally valued as if they were backed by long dated UK Government stock (‘gilts’) and without allowance for the possible higher returns that other asset classes such as equities might produce;
c) accrued benefits for non-pensioners – that is, active members who were still in service and deferred members who had left employment - were valued as if they were backed by UK equities before retirement and by gilts once in payment (unless the scheme’s trustees had formally adopted a ‘gilts-matching’ investment strategy); and
d) a prescribed expense allowance equal to a percentage of the calculated liabilities was added on to the liabilities.
81. The past service MFR valuation result was therefore derived from a) - b) - c) - d). If the answer were positive, there was an MFR surplus and the MFR funding level, calculated as a)/[ b) + c) + d)], would be greater than 100%. If the answer were negative, there was an MFR deficit and the MFR funding level would be less than 100%.
82. One of the purposes of an actuarial valuation was to recommend the contributions to be paid to a scheme in the future taking into account the cost of benefits that would accrue to members in respect of future service and an adjustment up or down for any past service deficit or surplus.
83. The MFR also did this by prescribing calculations for the minimum contributions (to be certified by the scheme actuary) in a scheme’s schedule of contributions. The broad purpose of determining MFR minimum contributions was to determine the contributions required to get a scheme back to an MFR funding level of 100% (or to keep it above this level) within prescribed periods.
84. However, this aspect of the MFR only set a minimum level of contributions. The actual level of funding was generally a matter for discussion between the scheme’s trustees and its sponsoring employer(s), in accordance with the terms of their own trust deed and rules. In some cases schemes were, some time after the MFR came into force, only funded at the MFR minimum level, whereas others were funded at levels well in excess of this.
MFR methodology
85. The prescribed basis for carrying out MFR valuation calculations was set out in the actuarial profession’s GN27.
86. The calculations were different for pensioners and non-pensioners. The following represents a summary of the main principles that applied to the majority of pension schemes. However, other complications existed, such as ‘gilts matching’ and an easement for valuing pensioner liabilities for larger schemes.
87. A gilts-based valuation was prescribed for pensioners’ liabilities using market yields, taken from the FTSE Actuaries range of gilt indices, at the MFR valuation date. These yields were used as the rate of return, also known as a ‘discount rate’, for placing a capital value on the liabilities.
88. Compared with ongoing funding bases, in use at the time of the introduction of the MFR, this approach to valuing pensioner liabilities represented quite a strengthening, i.e. an increase in liability values. At the introduction of the MFR in April 1997, this also provided a reasonable approximation to the cost of securing pension benefits by purchasing annuities.
89. The valuation for non-pensioners used the principle of first calculating a capital value using long term assumptions which were specified in GN27. These long term values were then adjusted through the use of market value adjustments (MVAs) into liability values that were then intended to reflect market conditions at the calculation date.
90. The principal long term return, or discount rate, assumptions for valuing non-pensioner MFR liabilities, as prescribed in GN27, were as follows:
- the effective rate of return on equities before MFR pension age was to equal 9% per annum; and
- the effective rate of return on gilts after MFR pension age was to equal 8% per annum.
91. The calculated liability value was then adjusted to smooth the jump between the two rates of return in the ten years before MFR pension age. MFR pension age was defined as the earliest age from which a member may retire, as of right, taking all of his or her benefit without actuarial reduction for early payment.
92. As noted above, instructions were given by Government to the actuarial profession on the extent to which the MFR basis should include an equity risk premium to reflect the expected out-performance of equities relative to gilts.
93. This equity risk premium was set at 2% per annum but deducting an annual allowance of 1% for the expenses of investing in a personal pension vehicle resulted in the 1% annual net equity risk premium shown in the long term assumptions above.
Market value adjustments
94. The rates of return above were selected as the long term assumptions for valuing non-pensioner liabilities and then they were adjusted using MVAs to reflect current market conditions.
95. In this way, the MFR set out to produce a market-consistent valuation where both the asset and liability sides of the valuation balance sheet reflected market conditions at the calculation date.
96. For non-pensioners more than ten years under MFR pension age, only one MVA came into play - the equity MVA. For members within ten years of MFR pension age, a combination of two MVAs (the equity MVA and the gilt MVA) was used.
97. The gilt MVA depended on the financial nature of the benefits. Effectively the gilt MVA was different for benefits that had fixed increases in payment and those where increases were index-linked:
- the fixed interest gilt MVA was the value at the annualised yield on the FTSE Actuaries Government Securities 15-year Yield Index of a 15-year stock with coupon equal to the long term rate of return on gilts; and
- the index linked gilt MVA was the value at the annualised yield on the FTSE Actuaries Government Securities Index-Linked Real Yield over 5 years (5% inflation) Index of a 15-year stock with coupon equal to the corresponding long term MFR real rate of return on index-linked gilts.
98. A further variation existed for lump sum retirement benefits (although this did not refer to tax free lump sums which could be taken by the member as an option).
Contracting-out
99. The employment of an earner who is a member of an occupational pension scheme may, if their employer so elects and certain statutory requirements are satisfied, become contracted-out employment, with the result that a lower rate of national insurance contributions will be made to - and a lower rate of retirement pension will be received from - the state scheme.
100. Prior to November 1986, employment which qualified an individual for membership of a final salary scheme could only become contracted-out if the relevant scheme satisfied two tests:
- the ‘requisite benefit test’, which involved the provision of at least one-eightieth of pensionable salary for each year of pensionable service; and
- the ‘guaranteed minimum pension’ or ‘GMP’ test, which involved the scheme providing a pension broadly equivalent to the additional state pension entitlement being given up.
101. After November 1986, the requisite benefit test was abolished and, from then until 6 April 1997 upon the commencement of the Pensions Act 1995, a scheme had only to meet the GMP test.
102. From 6 April 1997, final salary schemes wishing to contract-out were once again required to meet a test of scheme quality, called the ‘reference scheme test’, which aimed at ensuring that a certain overall level of benefits would be provided for members of the scheme generally.
103. From the same date, the GMP requirement was abolished, although GMP entitlements accrued up to and including 5 April 1997 were retained within the scheme after that date.
104. In order to deduct and pay national insurance contributions at the reduced rate, an employer must have a valid contracting-out certificate, which have been issued since 6 April 1997 by the Secretary of State.
105. Each certificate stated both an employer reference number (known as an ECON) and a scheme reference number (known as an SCON). An employer will only have one ECON but may sponsor more than one scheme and so may have more than one SCON. These reference numbers are the principal ways in which NICO monitor national insurance contributions and liabilities to secure contracted-out rights.
106. A scheme qualified to contract-out of the state additional pension:
- in relation to service completed before 6 April 1997, where it complied with the requirements of the Pension Schemes Act 1993 related to the provision of GMPs and where its rules related to GMPs were framed so as to comply with any requirements laid down by NICO in relation to contracted-out matters; and
- in relation to service completed after 6 April 1997, where NICO was satisfied that:
i. the scheme met the ‘reference scheme test’;
ii. the scheme was subject to, and complied with, the provisions of the Pensions Act 1995 regarding employer-related investments;
iii. the scheme was funded to the MFR level or would, in the opinion of its actuary, be so within a period specified in the scheme’s schedule of contributions, usually within five years (although there was a transitional period during which schemes were initially allowed a longer period to get their funding position back on track);
iv. the scheme did not permit the payment of a lump sum instead of a pension, unless the amount were trivial or otherwise allowed by Inland Revenue rules;
v. the scheme provided benefits payable by reference to an age that was equal for both men and women and otherwise permitted by Inland Revenue rules; and
vi. the rules of the scheme were framed in such a way as to comply with any requirement prescribed by NICO as to contracted-out matters.
107. For the period of service from April 1978 to April 1997, a contracted-out defined benefit scheme had to ensure that the benefits provided to each member for that period were at least as good as the GMP.
108. The law also provided that GMPs in payment which were attributable to service completed since 6 April 1988 had to be increased each year by the lesser of the retail prices index and 3%.
109. GMP entitlement was calculated according to a pension scheme member’s ‘earnings factors’ during the relevant period – which were derived from an individual’s earnings between the lower and upper earnings limits specified in legislation, revalued in accordance with the increase in the earnings index over the relevant period. A member was only entitled to GMPs in respect of periods of contracted-out pensionable service where the member’s earnings exceeded the lower earnings limit.
110. The basis on which the GMP earnings factors were calculated changed in 1988 and so separate calculations for each individual must be made in respect of service prior to and after this date. The method of calculation was:
- for those within twenty years of state pension age on 6 April 1978, 1.25% of their revalued earnings factors for each year between 6 April 1978 and 5 April 1988 plus one per cent of their revalued earnings factor for each year between 6 April 1988 and 5 April 1997; and
- for others, 25% of their revalued earnings factors for each tax year between 6 April 1978 and 5 April 1988, divided by the number of complete tax years after 5 April 1978 (or the start of working life) up to state pension age, plus 20% of their revalued earnings factors between 6 April 1988 to 5 April 1997, divided by the number of complete tax years after 5 April 1978 (or the start of working life) up to state pension age.
111. Thus, while GMPs were broadly equivalent to SERPS entitlement, they were not calculated in the same manner.
112. A scheme member would be treated as having terminated contracted-out employment:
- where their contract of employment expired or was terminated; or
- in the absence of such a contract, where the employment had itself been terminated; or
- where the individual had ceased to be a member of a contracted-out scheme; or
- where the certificate by virtue of which the individual’s employment had been contracted-out of the additional state pension had been surrendered or cancelled; or
- where the relevant certificate had been varied in such a way that it no longer covered the particular employment of that individual; or
- where the employment could not be treated as continuing in circumstances in which a firm was taken over or otherwise ownership or activity were substantially altered.
113. Where a member’s pensionable service terminated after they had completed two years of qualifying service, that individual was entitled to a preserved benefit under the scheme which had to be appropriately secured. If an individual left pensionable service prior to the completion of two years, then they would normally only be entitled to a refund of their own contributions.
114. The options available for securing the contracted-out rights of early leavers were fourfold:
- reinstatement into the state additional pension – by means of a contributions equivalent premium (although after 6 April 1997, it was only possible to buy an employee back into SERPS if they had served less than two years and had received a refund of their own contributions on leaving the scheme – prior to this, it was possible to buy any member back into SERPS by way of a State Scheme Premium);
- the purchase of a deferred annuity from an insurance company;
- retention of liability within the scheme – where the member became a deferred member of the scheme; and
- transfer to another contracted-out pension arrangement – whereby the individual’s accrued rights were secured outside the scheme by membership of another occupational or personal pension scheme.
Key aspects of the relevant regime
115. A winding up of a final salary occupational pension scheme occurs when a scheme is terminated and its assets are used to secure the scheme’s benefits through other means.
116. Final salary occupational pension schemes may be wound up for four principal reasons: first, as a result of a decision to do so by scheme trustees; secondly, as a consequence of the merger or restructuring of the sponsoring employer(s); thirdly, due to a decision to discontinue the provision of an occupational scheme by the sponsoring employer; and, finally, as a result of the insolvency of the sponsoring employer.
117. The subject matter of this investigation is related to schemes which have either wound up due to a decision by the sponsoring employer or as a result of the insolvency of that employer.
118. The events which will trigger the voluntary winding-up of a scheme depend on the scheme’s governing trust deed and rules but typically involve formal notification by the employer to the trustees that it requires the scheme to be wound up. Where a scheme is wound up due to the failure of an employer, this is triggered when a relevant insolvency event – for example, the commencement of the employer’s bankruptcy or the liquidation of it – occurs. Where winding-up began after 5 April 1997, statutory provisions related to the winding-up process over-ride any particular scheme rules which are not consistent with those provisions.
119. Where any scheme winds up, trustees must take action to secure all a scheme’s assets – that is, to realise its investments and to ensure that all contributions due to it have been made – and then to discharge its liabilities to beneficiaries of the scheme.
120. In some schemes, winding-up can be achieved by securing the pensions of those already retired through the purchase of annuities and by providing a full cash transfer value to – or by the purchase of a deferred annuity on behalf of - non-pensioner members. Where a scheme winds up under-funded, it may not be able to secure the full accrued benefits. The schemes which form the focus of this report are those in which there are not enough assets to meet all of the scheme’s liabilities.
121. There are two aspects of the statutory regime related to final salary occupational pension schemes, not described above, which are relevant to the subject matter of this report. These are:
(i) that relating to the insolvency of sponsoring employers and the realisation of a pension scheme’s assets; and
(ii) that relating to the winding-up of schemes and the discharge of their liabilities.
Realising a scheme’s assets
122. Where a scheme seeks to realise its assets, its investment managers may liquidate the scheme’s investments which will then be valued by the scheme auditor. The scheme actuary will then calculate whether monies are due from the sponsoring employer(s) in order to bring the scheme up to funding at the MFR level.
123. If the value of the scheme’s assets was certified by the scheme actuary as being less than the value of its liabilities as defined in legislation and as measured with reference to the MFR, the difference became a debt due from the employer to the scheme trustees.
124. Where the sponsoring employer is still trading, trustees may take legal action to enforce the debt.
125. Where the employer is insolvent, the law provides for the way in which such an employer’s assets must be apportioned between its various creditors.
126. Prior to 15 September 2003, the assets of companies that were being wound up were discharged according to the following order of priority:
(i) first, to meet the costs and expenses of winding the company up;
(ii) secondly, to meet debts due to preferential creditors;
(iii) thirdly, to meet debts due to ordinary creditors;
(iv) fourthly, to pay post-liquidation interest on debts due to preferential and ordinary creditors;
(v) fifthly, to meet debts due to deferred creditors; and
(vi) finally, to make payments to members of the company in accordance with their rights.
127. Priority was given to secured debts, that is, those loans, mortgages and other debts that were secured on the assets of the company.
128. During this period, the preferential creditors were, in order of priority: debts due to the (former) Inland Revenue in respect of employees’ tax deductions; debts due to (the former) HM Customs and Excise in respect of VAT and other excise duty; outstanding national insurance contributions; certain unpaid contributions due to an occupational pension scheme in the year prior to the insolvency; outstanding payments to a company’s employees; and levies due to the EU for industrial production.
129. Where insufficient funds were available to meet all a company’s liabilities, the secured debts were discharged in full before discharging those unsecured debts given preference and, if any monies were remaining, ordinary creditors would receive a proportion of the remnant.
130. Legislative change that had effect from 15 September 2003 abolished the Crown’s preferential rights in all insolvencies and made provision to ensure that unsecured creditors received a larger proportion of the assets being discharged in the insolvency proceedings.
Discharging a scheme’s liabilities
131. Where there are insufficient assets to secure all the liabilities of a pension scheme, there is a statutory order in which a scheme must discharge what assets it has. The priority order was modified following commencement of the 1995 Act’s provisions and this modified priority order was supposed to be in place during a transitional period from April 1997 to April 2007. However, this order has, with the commencement of the 2005 Act’s provision, now been replaced as part of the reform of the statutory provisions governing final salary schemes in wind-up.
132. After meeting scheme expenses and debts to third parties, the transitional order of priority was:
(i) pensions in payment (excluding increases in those pensions) and any liabilities for pensions or other benefits derived from voluntary contributions;
(ii) pensions or benefits paid by insurance contracts purchased before April 1997 that cannot be surrendered or where the surrender value does not exceed the liability secured by the contract;
(iii) a transfer value for non-pensioners (derived on an MFR basis) of Guaranteed Minimum Pension (GMP) entitlements and post-April 1997 contracted-out rights;
(iv) increases on pensions in payment;
(v) increases in the value (on an MFR basis) of non-pensioners’ GMP and post-April 1997 contracted-out rights;
(vi) a transfer value (derived from the MFR) of pre-April 1997 accrued pensions not derived from GMPs; and
(vii) the residual buy-out costs of other deferred benefits.
Reconciling contracted-out entitlements on wind-up
133. In order to be able to discharge a scheme’s liabilities to its beneficiaries, the trustees of a scheme in wind-up must calculate the entitlements of each scheme member within each category.
134. When a scheme ceases to contract-out, the scheme administrators or trustees must notify Her Majesty’s Revenue and Customs in writing. Prior to May 2003, notification of cessation was directed to NICO Elections Section. However, as part of the Government’s ‘Joint Working Initiative’, NICO Elections work was merged with and transferred to Her Majesty’s Revenue and Customs’ Savings, Pensions and Share Schemes section, which had been responsible for granting tax approval for pension schemes. The merger introduced a single point of contact for its customers on contracting-out election and tax approval matters.
135. On receipt of written confirmation that a pension scheme has ceased to contract-out, Her Majesty’s Revenue and Customs writes to the employer, trustees and pension provider to confirm the cessation date. They then cancel the relevant contracting-out certificate and associated tax relief certificates and notify NICO of the cessation/wind-up event.
136. This formal notification is the trigger for NICO’s ‘initial action’, which is to to raise a file and enter the scheme details on the NIRS2 Benefit Scheme Provider file. NIRS2 – NICO’s computer system - identifies all individual scheme members in respect of whom the employer or scheme administrator had previously informed NICO of their details.
137. Scheme enquiry lists are created and appropriate pension calculations are produced and re-input schedules supplied for each individual current member if all of the earnings and contributions details are available.
138. These are then provided to the scheme administrator who, with trustees, will seek to reconcile the records held by the scheme with those held by NICO in respect of national insurance contributions.
139. Once reconciled, agreed re-input schedules are used to notify NICO formally of the methods by which the rights are to be preserved or protected. It is not necessary to secure every member’s pension rights by the same method. Trustees must provide members with information about their pension rights within the scheme and options available for preserving them. Scheme administrators must inform NICO once a decision has been taken about the arrangements that have been made, detailing the appropriate methods of preservation.
140. There are two main areas where queries arise: scheme administrators frequently dispute both members’ periods of contracted-out employment and pension calculations undertaken in respect of individual members. This may be a consequence of incorrect or conflicting contributions information being submitted to NICO from either the scheme administrator or the employer over a number of years.
141. NICO has introduced a system of ‘Customer Account Management’ and a series of roadshows and face-to-face meetings with pensions professionals in order to improve the service it provides.
142. NICO is also responsible for work to deal with requests for ‘deemed buyback’ calculations for members of final salary schemes in wind-up, which would restore those members into the state additional pension scheme.
143. An individual may be eligible for deemed buyback where the funds available to the scheme in respect of the member are less than the amount required to restore their state scheme rights for the period of contracted-out employment, where the scheme has insufficient resources to meet the MFR level, and where the amount available in the scheme in respect of the member is less than the amount which would have been available had the scheme wound up 100% funded.
144. If the criteria are met, NICO will on request perform and issue provisional deemed buyback calculations either for samples or for the whole membership of schemes.
145. NICO says that, at the time of writing, 109 schemes have met the criteria for deemed buyback. 20 schemes have been issued with full scheme calculations, 66 schemes have been issued with sample calculations and work on 8 schemes is still in progress. Of the 86 schemes that have been issued with either sample or full scheme calculations, 15 schemes have confirmed that they have no qualifying members and therefore they will not be pursuing deemed buyback.
146. Since November 2003, NICO have issued over 7,000 deemed buyback calculations to customers. However, to date, only 58 members have opted to pursue deemed buyback.
