Merging pension schemes makes sense from a financial and practical perspective but advisers should think twice before recommending a move away from DB arrangements
Nearly all employers with a pension scheme for their employees are reviewing what they should do. Read any of the newspapers and all you can see is doom and sometimes gloom.
And it is true that for the moment pension schemes are having a bad time. It doesn't help that the stock market is still rather lower than it might be. Nor does the fact the minimum funding requirements that encourage investments in the wrong sector have still not been abrogated. Nor that the pernicious and misleading FRS17, although sensibly suspended for the indefinite future, is still threatening to return and require companies to put wind-up liabilities in the balance sheet, discriminating against pensions compared with all other liabilities. Nor that the regulator, although now promising to turn over a new leaf, is still an uncertain animal. Nor that the Pensions Ombudsman is trying to get even heavier with funds that make mistakes than ever before. The wonder is why more serious employers get involved in pensions at all.
The reason companies still do provide for their workforce's retirement is that despite the unpromising environment, pensions are still very much appreciated by the workforce, are an ideal recruitment and retention tool, and many of the horrific risks so gorily exposed by the newspapers are in fact manageable and rather modest.
Nonetheless, for the time being, employers are drawing their horns in. And one of the horns that is being withdrawn is the salary related scheme (although there are straws in the wind that it may return). One method of closing it down, and sometimes a less confrontational method is to merge it with another existing scheme of the employer.
This has a number of attractive advantages. First a merger does not trip the winding-up provisions that afflict the closure of schemes ' and a debt on the employer that he or she may not wish to face at a time of economic stringency. Secondly, the employees can more clearly understand that the employer is still committed to pensions even if the level and nature of the pensions expectation changes from for example a final salary system to a defined contribution arrangement. Third, mergers of schemes can reduce compliance, administration and professional adviser costs even when the benefits are not changed.
The change, however, needs careful management. There are legal and communication issues in particular ' and if the merger is carried out in the wrong way, some of the legislation could tripwire an expensive employer contribution. The first thing to check is the documentation. Although most modern scheme documents allow a full range of flexible options, some of the older arrangements (or even newer ones that are poorly drafted) may restrict the right of trustees to allow a scheme merger, especially if it is with a scheme with inferior benefits. Although the courts have in more recent years adopted a more constructive approach, older judges have sometimes made it difficult to overcome scheme restrictions on reconstructions and mergers.
This is because some judges are uncomfortable with pension promises being changed. However, changing these promises in a contract of employment is usually not too difficult as many employment contracts refer to the terms of the pension scheme deed and that in turn reserves the right to change the terms of the scheme at any time.
On takeovers, the Transfer of Undertakings Regulations (TUPE) allow a new employer to change the pension benefits in respect of future service without triggering a claim for unfair dismissal or redundancy. Although there have been suggestions that this will change in the near future, the Government announced earlier this year that the industry would have to wait for wider pensions law reform.
Almost as important is the financial position of the scheme. Although the press is full of horror stories about the deficits in pension schemes, sometimes justified, often exaggerated, there are still pension schemes with surpluses. Employers and trustees will have different approaches to changes depending on whether there is a deficit or surplus.
Merging a scheme with another might, unless carefully managed, trigger the crystallisation of a surplus, and under the regulations made under the Pensions Act 1995 that could result in the need for the employer to make an immediate payment to reduce or eliminate a surplus. On the other hand there may be concerns about using a surplus to reduce or eliminate a deficit in a sister pension surplus. If there is a surplus the members of the scheme with a surplus may object to those funds being used to subsidise members of a scheme suffering from a deficit. Likewise members of a receiving scheme, if they appreciate what is happening, may object to being swamped by members of a scheme with which hitherto they have had no connection.
Even more complicated are the regulations issued under the Pensions Act 1995 on the modification of pension schemes. In many cases, to facilitate a merger, the terms of one or more of the pension schemes will need to be changed to allow it to go ahead, otherwise there might need to be an expensive, time-consuming and unpredictable application to the courts, which might involve the breach of the now notorious section 67 of the Pensions Act. This section, intended to protect members' rights, has had an unintended effect of often doing the opposite. The Government is committed to its reform ' but again no date has been set.
But the most important element of any scheme merger is communication. Once the policy has been determined by the employer and if necessary agreed with the trustees it may be critical to communicate it to the workforce so as to avoid industrial relations issues. Pensions are now a sensitive issue with employees, and they will be unhappy if they see for example a reduction in the asset backing of a pension fund or a move to some form of non-salary-related pension scheme.
Following the perceived collapse of some high-profile pension systems in recent months many employees are wary of pension changes, especially if they feel that their rights may be at risk. In some ways, of course, a move to a defined contribution system might be perceived as a move to a lower risk arrangement ' but as scheme members become more sophisticated they appreciate that the risks are different and might be much lower with a well-supported defined-benefit scheme.
For advisers all this is made more complicated by the need to meet the compliance requirements under the FSA regime. The regulator has issued draft guidance to scheme sponsors in its usual impenetrable fashion indicating that they are at liberty to advise their members on the benefits available under a company scheme. For IFAs, the recent changes to the annuity advice rules provide an opportunity to give advice where scheme trustees are probably unable to.
Finally, advisers need to think twice about transforming schemes to DC from DB. Although it is presently fashionable to do so, and probably highly justifiable, longer term it may be that there could be a rebirth of DB-style schemes, perhaps along the lines of career-average bases. This development could be spurred by the opportunities offered by the forthcoming opportunities to establish schemes in other member states of the European Community under the recent European Pensions Directive. Whatever happens, and whether schemes close, merge or convert, there will be a need for advisers.
Pressures from regulatory requirements and poor market conditions are causing employers to merge salary-related schemes.
This route avoids winding-up provisions and shows employees the company is still committed to pensions while reducing costs.
Advisers need to meet FSA compliance requirements and should think twice before recommending a shift from DB to DC arrangements.
Three funds to watch