What guidance have the DWP and HMRC provided?

Following the judgment in Lloyds ^[1], trustees, employers and pension professionals awaited guidance from:

• the Department for Work and Pensions (the DWP) on the use of Guaranteed Minimum Pensions (GMP) conversion legislation; and
• HM Revenue and Customs (HMRC) on dealing with the tax issues on GMP equalisation projects.

Now that some of this has been provided, this Insight provides a key point summary of the guidance along with setting out detail what the DWP and HMRC have said and what it means for trustees and employers of occupational pension schemes who are dealing with GMP equalisation.

This Insight is the third in our updated series of Insights on GMP equalisation. You can navigate between these Insights using the links below.

1. GMP equalisation - what is the problem with GMPs? This Insight will provide an explanation of what GMPs are, how they work in practice and why they are unequal.
2. What did the Lloyds case say? What did the judgment say about the legal requirement to equalise GMPs and how to do this in practice?
3. What have the DWP and HMRC provided in terms of guidance? Both the DWP and HMRC have produced guidance on GMPs. This Insight provides the key details and assesses what they mean for occupational pension schemes.
4. What should pension schemes be doing now on GMP equalisation? GMP equalisation is a daunting prospect for many. It doesn't need to be, with the full attention of trustees and employers, the right advisers in place and a project plan, each element can broken down.

DWP guidance on the use of the GMP conversion legislation

In this Insight, we set out a summary of the key points and issues arising from the DWP's 'Guidance on the use of the Guaranteed Minimum Pensions (GMP) conversion legislation' (18 April 2019) (the Guidance) on the use of the GMP conversion legislation. This Insight does not:

• explain why GMPs create inequality in overall scheme benefits (see our Insight GMP equalisation - what is the problem with equalisation); or
• unpack the Lloyds decision (see our Insight GMP equalisation - what now for trustees and employers).

Unsurprisingly, the Guidance does not give all the answers on GMP equalisation. Instead, it should be seen as a step towards the ultimate destination, but with a lot of work to do to get there.

Nine key points from the guidance

1. No single method for equalisation

The government has not asserted that there is a single method that will be appropriate for all schemes in order to equalise benefits for the effect of GMPs. The Guidance simply puts forward one possible method for equalising benefits.

2. Trustees will need to take advice and make decisions

It is for the trustees of each scheme to decide the methodology that is most appropriate for their scheme, having taken advice.

3. The DWP has proposed a method which uses the conversion legislation

For the purpose of equalisation, this method:

• places an actuarial value on benefits accruing between 17 May 1990 and 5 April 1997;
• takes the higher of the value of a member's benefits and the value it would have been had the member been of the opposite sex during the period; and
• converts this higher value into benefits that are no longer subject to the (unequal) requirements of the GMP legislation.

4. DWP have provided a step process for conversion

Should trustees decide to pursue the conversion route, the Guidance sets out a 10 stage process.

5. Past arrears are not dealt with in the Guidance

The method set out in the Guidance does not deal with the past arrears due to pensioners. This is a difficult area and one in which legal advice will be needed (especially if conversion is the chosen equalisation method for future instalments).

6. The methodology will result in scheme amendment

Under the DWP's methodology, a scheme is amended so that it no longer contains benefits subject to the GMP rules in respect of some or all members with GMP entitlements.

7. All GMP and the benefit which accrued alongside will need to be converted

For a selected member, all of their GMP and the benefits which accrued alongside this GMP need to take part in the conversion process, not just those relating to accrual between 17 May 1990 and 5 April 1997.

8. Trustees do not need to convert GMPs for all members

The employer and the trustees can decide which members will have their benefits converted. The Guidance provides an example of deferred and pensioner members being converted first, and then waiting until the active members become deferred members before converting their benefits.

9. A number of points remain unresolved

The Guidance does not cover all of the questions that have been asked by the pensions industry. For these issues, trustees will need to take advice and/or wait for further guidance.

The guidance in more detail

What is the aim of the guidance?

The Guidance describes how schemes could use the GMP conversion legislation to achieve equality going forwards but it is important to note that the method described in the Guidance is not the only possible way of effecting equalisation and it should not be seen as prescriptive.

What is not covered in the Guidance?

The DWP is not:

• placing any obligation on schemes to use the method described in the Guidance;
• providing advice to schemes on how to equalise; or
• providing a definitive statement of how equalisation should be effected.

What is the relevance of the Guidance?

Following Lloyds, conversion of GMPs has been seen as one of the more attractive ways of addressing GMP equalisation. As a result, the Guidance is likely to be of interest to most trustees. Even if, in the end, trustees decide not to adopt the DWP's approach to equalisation, they will need to understand all of their options.

In a nutshell: how does the DWP methodology work?

The DWP method:

• places, for the purpose of equalisation, an actuarial value on benefits accruing between 17 May 1990 and 5 April 1997;
• takes the higher value of a member's benefits and the value it would have been had the member been of the opposite sex during the period; and
• converts this higher value into benefits that are no longer subject to the (unequal) requirements of the GMP legislation.

The scheme is amended so that it no longer contains benefits subject to the GMP rules in respect of some or all members with GMP entitlements. The result is that the GMP rules, which create inequality between the sexes, are removed for the relevant members going forward.

How does the DWP's method compare with the default method under Lloyds?

The judge in Lloyds set out a default method for equalising GMPs, which he called 'Method C2'. For those who are familiar with Lloyds jargon, the DWP method is equivalent to Method D2. Unlike Method C2, it can only be adopted with employer agreement.

Method C2 involves adjusting the pension continually throughout the time when it is in payment, to ensure that the amount received by the member is no less than they would have received if they had been of the opposite sex during the period from 17 May 1990 to 5 April 1997. The DWP method, with its use of conversion, avoids that complexity, because it is a one-off adjustment to benefits. However it achieves that simplicity at the cost of doing greater violence to the original benefit design that members were promised.

Although it will not be the right solution for everyone, we expect the DWP's method to be popular with many schemes and employers, because it avoids the complexities and costs of operating Method C2. The nature of the reshaping of the benefit under the DWP's method is therefore an important decision for trustees, on which legal advice will be required. Trustees will need assurance that whatever reshaping they adopt is consistent with their legal duties and safe from member challenge.

GMP conversion also creates possible opportunities to reshape benefits in a manner which facilitates the scheme's objectives more generally - again, schemes will need legal and actuarial advice on this.

How does the DWP methodology work?

Before trustees start resolving inequalities, it is important that they are satisfied that they hold the correct GMP figure. The Guidance sets out a 10 stage process which results in an adjustment to an individual's benefits to compensate for post 16 May 1990 GMP inequalities as well as conversion of all of the individual's GMP. The 10 stages of the process for resolving GMP inequalities through GMP conversion are summarised below.

Stage 1 - Reach agreement with the employer

The trustees agree with the employer that GMP conversion is to be undertaken and the terms on which benefits are to be converted as part of the conversion exercise (see stage 2).

Agreement has to be with the employer in relation to the scheme. This means that where the participating employers have changed over the years, legal advice will be needed as to how (or whether) the consent requirement applies.

Stage 2 - Select the members for conversion and agree which benefits are to be converted and the form of the new benefits

In practice there are three elements to stage 2:

Selecting the members

It is not necessary to convert benefits for all members, nor to convert at the same time. Therefore, the trustees and the employer need to identify and agree which members will have their benefits converted. Members who trustees and employers may want to consider including in the conversion process are:

• those members with service between 17 May 1990 and 5 April 1997, even if no equalisation uplift is required;
• survivors in receipt of GMP survivors' pensions following the death of a previously contracted out member; and
• members who left active service before 17 May 1990 (but for them there will be no need to undertake an equalisation step).

Agreeing the benefits to amend as part of the conversion process

The trustees and employers will also need to decide which benefits will be amended as part of the conversion process. The trustees are required to remove the GMP rules relating to the selected members.

For pre-1990 service, the Guidance explains that it is not necessary to reshape either the GMP or the Excess, as both can remain unequal.

The Guidance does, however, make it clear that for a selected member, all of their GMP and the benefit which accrued alongside this GMP need to take part in the conversion process, not just that relating to 17 May 1990 to 5 April 1997 accrual.

Deciding the form of the post conversion benefits

A decision regarding the form the post-conversion benefits will take will also be required. The form of these is constrained by legislation. In particular, the post conversion benefits:

• must be actuarially at least equivalent to the pre conversion benefits;
• must not include money purchase benefits, apart from those provided under the scheme immediately before the conversion date;
• must include survivors' benefits in accordance with legislative requirements;
• for pensions in payment, the amount of pension to which a member had an immediate entitlement before the conversion must not be reduced as a result of the conversion.

Because of the legislative constraints on the form for the post-conversion benefits, this is an area in which trustees will need specific legal advice.

Stage 3 - Set the conversion date

The trustees and the employer agree the date at which conversion is to be effected (the "conversion date").

Stage 4 - Pre-conversion consultation

The trustees need to write to the selected members to inform them of the proposed conversion and seek their views. Trustees are required to take all reasonable steps to consult members. Consultation should be at a high level. The Trustees will be required to send more personalised information once calculations have been concluded and benefits adjusted.

Stage 5 - Valuation

The trustees then need to instruct the scheme actuary to value for each selected member an amount A and amount B:

Amount A - this is the member's benefits to be converted (along with attaching survivor benefits) - typically those in respect of that part of pensionable service up to 5 April 1997 during which the GMP that is being converted accrued. Amount A is effectively the pre conversion, pre GMP equalisation value of these pre 1997 benefits.

Amount B - this is the member's benefits (along with attaching survivor benefits) in respect of the same part of pensionable service (so typically up to 5 April 1997 during which the GMP that is being converted accrued), but assuming that for the period from 17 May 1990 to 5 April 1997 the GMP entitlement had been calculated as if they were of the opposite sex, with the excess over GMP being adjusted accordingly.

Both amounts A and B need to be calculated as at the conversion date and on the same basis.

It will be necessary to value and compare the whole (non-money purchase) benefit accrued in the selected period, not just the GMP, because members with a higher GMP will have a lower excess over GMP.

The trustees are responsible for determining the actuarial equivalence of the pre and post conversion benefits. In doing so, they must arrange for the scheme actuary to calculate the actuarial values of the pre and post conversion benefits.

The trustees are required to obtain and consider advice from the scheme actuary in deciding what assumptions are appropriate. The Guidance points out that the choice of approach may substantially affect some members' benefits, in particular where benefits increase at different rates pre and post conversion.

The Guidance says that the scheme's cash equivalent transfer value (CETV) basis will often be an acceptable starting point for a basis to calculate amount A and B. Points which will require consideration include:

• whether the current CETV basis should be reviewed;
• the use of assumptions which are non-unisex;
• the state of the pension scheme's data in respect of pensioners;
• how to 'roll back' the pension to when the individual left pensionable service (if this is required); and
• how to value benefits for active members.

Stage 6 - Equalisation

The trustees adjust for the effects of unequal GMPs by using a conversion value for each selected member: this is the higher of amount A and amount B from stage 5 above, so the more valuable of the male or female benefit structure.

Stage 7 - Conversion

Determining the post conversion benefit: once the conversion value for the selected member has been determined, this forms the budget from which new benefits are costed to replace those benefits in which GMP accrued. So this amount is turned back into a revised pension benefit. A consistent approach to the Stage 5 valuation should be used. For pensioners, the conversion approach only assesses the effect of GMP equalities from the conversion date- the trustees will need to use another equalisation method to deal with past payments.

Stage 8 - Certification

The actuary needs to certify that the calculations have been completed and that the post conversion benefits are actuarially at least equivalent to the pre conversion benefits as equalised for the effect of GMPs. The certificate must be sent to the trustees no later than 3 months after the calculations have been completed.

Stage 9 - Modification of scheme to effect conversion

The trustees need to choose how to effect conversion. They may use:

• the statutory power to resolve to effect the conversion on the agreed basis; or
• the scheme's amendment power to enable GMP conversion, in which case Sections 67 to 67I of the Pensions Act 1995 are disapplied.

Stage 10 - Post conversion notifications

The trustees must take all reasonable steps to notify the members and survivors (in the latter case, those with an immediate entitlement to benefits) whose benefits have been converted either in advance or as soon as reasonably practicable after the conversion date. At this stage, members and survivors should be told what this means in terms of the amount and the shape of the benefit going forward.

HMRC also needs to be notified on or before the conversion date that the individual's GMPs have been or will be converted.

Where does the Guidance leave trustees and employers?

The Guidance does not answer all the questions but it gives a clear framework which trustees can use to engage with employers and start seeking appropriate actuarial and legal advice.

As the Guidance notes, there are a number of unresolved issues. These include:

• Pensions tax issues - HMRC is providing information and guidance.
• Which employer needs to agree to the conversion of GMPs (an issue that will be especially relevant for schemes with complicated histories).
• How to deal with GMP underpins in defined contribution schemes.

The Government is considering changes to the GMP conversion legislation to clarify certain issues and the Guidance will be updated from time to time to reflect any changes to legislation that take place.

HMRC guidance on tax issues on GMP equalisation

The Lloyds case ^[2] confirmed that there is a legal requirement for occupational pension schemes to address the inequality between men and women in the design of guaranteed minimum pensions (GMPs). Few pension schemes have done so, partly because of uncertainty over the tax consequences. HMRC has now sought to address this uncertainty by publishing the first in a series of newsletters on the subject.

Key points on the HMRC guidance

1. GMP equalisation should be an active project

Schemes that do not have a pressing need to complete GMP equalisation in the short term have generally stopped short of implementing an equalisation method for future pension payments, pending clarity from HMRC on the tax treatment of the various equalisation methods. However, there are some actions that all pension schemes containing GMPs should be carrying out now, supported by their legal and actuarial advisers.

There is also going to be a further court hearing on past transfers and guidance from the GMP Equalisation Working Group, the likely timings of which will form part of any project plan. This section, however, focuses on the tax questions.

2. HMRC guidance provides some useful answers...

For schemes that have ruled out GMP conversion as a solution, the latest guidance will be helpful. Broadly, it confirms that there should be no annual allowance or lifetime allowance difficulties if schemes adopt the default equalisation method set out in the Lloyds Bank case ('Method C2').

3. But it leaves other questions unanswered and creates some problems...

It also states that trustees may need to revisit past lifetime allowance calculations, back to 2006. This may be difficult, or impossible, for many pension schemes, whose trustees will need to discuss with their administration service providers and their legal advisers.

Individuals who were close to, or already above, the lifetime allowance will also potentially face additional taxation.

4. Schemes considering GMP conversion still have a dilemma

GMP conversion is a potentially attractive solution to GMP equalisation, because it can be done as a one-off exercise without requiring the administration team to run dual records, as well as enabling the benefit design to be simplified.

However, it gives rise to particular tax problems, which are not addressed in this guidance - HMRC suggests that separate guidance may follow on this, but there is no timeframe.

There are potentially significant tax risks in proceeding with GMP conversion in the meantime. These do not normally pose an insuperable obstacle if schemes have a pressing need to complete the exercise, but other things being equal, it would be better to wait for the HMRC conversion guidance to be published. Schemes that need to move ahead because of an impending buy-out will need to engage with their insurers at an early stage.

Schemes that are keeping GMP conversion open as an option and which do not have a pressing reason to get started with the exercise are therefore in a bind, because they are under a clear legal obligation to equalise GMPs, and are underpaying pensions every month, for as long as they do not equalise. Such schemes should be in active discussion with their legal and actuarial advisers to ensure that there is an acceptable plan for when and how to commence the exercise, in order to protect themselves from member claims.

Why is tax an issue with GMP equalisation?

Because public policy is to encourage retirement saving, registered pension schemes enjoy a range of tax privileges. In order to maintain these privileges, it is necessary for benefits to stay within certain limits.

For present purposes, the relevant tax limits are as follows:

• the annual allowance, which limits the amount of pension saving an individual can make in any given tax year, and
• the lifetime allowance, which limits the overall value of tax-privileged saving over an individual's life.

The amounts have changed, but these limits have existed since the pensions tax system radically changed on 6 April 2006. Exceeding the allowances causes penal tax charges, known respectively as the "annual allowance charge" and the "lifetime allowance charge".

The following features of these allowances are particularly relevant.

The annual allowance is targeted primarily at members who are still accruing pension. Deferred members are largely excluded from the annual allowance, even though the value of their benefits will usually increase every year through inflation-proofing. The legislation provides that such increases, provided that they stay within specified limits, do not count towards the annual allowance. This exclusion is often called the "deferred member carve-out".

Benefits are tested against the lifetime allowance when they "crystallise", on what is known as a "benefit crystallisation event". The most common benefit crystallisation event is the pension coming into payment for the first time, i.e. when the individual retires, although there are others.

To avoid retrospective taxation when the lifetime allowance was introduced, members whose benefits were already above the allowance were given the option of electing to have a higher lifetime allowance in return for committing not to accrue any further benefits in a registered pension scheme. Accruing further benefits would cause the protection to be lost. A similar system was used on the occasions when the lifetime allowance has been cut. These protections are called "enhanced protection" and "fixed protection" ^[3].

GMP equalisation raises numerous tax questions, but the biggest ones are:

• if the pension entitlement of deferred members is increased, to compensate them for GMP inequality, does this increase take their benefits outside the deferred member carve-out, such that their benefits may be hit by an annual allowance charge?
• if members have enhanced or fixed protection, does conferring additional benefits to compensate them for GMP inequality cause the protection to be lost?

What answers has HMRC provided?

HMRC has confirmed that it views a right to compensation for GMP inequality as a benefit that accrued at the same time as the GMP itself, i.e. between 1990 and 1997, not as a new entitlement arising as a result of the 2018 court case.

The Good News

As the 1990-1997 period predates the introduction of the annual and lifetime allowances, it follows that equalising benefits, provided that a scheme does not go beyond the minimum necessary, does not cause the annual allowance to be exceeded in any tax year, nor does it cause a member with lifetime allowance protection to lose the protection.

Insofar as existing pensioners are concerned, HMRC has also confirmed that they can be paid an arrears payment to equalise past instalments of pension as a one-off lump sum. Although this will be subject to income tax, members can claim back excess tax from HMRC if it results in them paying more tax than they would have done had they received the money at the correct time.

In addition, further guidance issued by HMRC has addressed lump sum and death benefit payments. These are summarised in HMRC's 'Guaranteed Minimum Pension (GMP) equalisation newsletter – July 2020'.

The Bad News

Any current pensioner who took their pension under the current tax system, i.e. from 6 April 2006 onwards, will have had the value of their pension tested against the lifetime allowance, on the benefit crystallisation event. However, if he or she is due an uplift to compensate for GMP inequality, and if the uplift accrued in the 1990-1997 period, then it follows that the value of it ought to have been taken into account at the benefit crystallisation event, because it was already an accrued right at the time of the benefit crystallisation event.

HMRC's guidance implies that schemes need to correct this, in order to ensure that the lifetime allowance test is accurate. In practical terms, revisiting benefit crystallisation events that are up to 14 years old is, for many schemes, going to be either difficult or impossible. Such schemes will need to consult their administrators and their legal advisers to understand what to do about this.

Correcting past benefit crystallisation events also means that individuals who were over, or close to, the lifetime allowance face a potential lifetime allowance charge as a result of GMP equalisation increasing the value of their benefits.

What questions remain unanswered?

The biggest unanswered question relates to GMP conversion.

GMP conversion is a statutory power that allows pension schemes to reshape the pensions they provide, so that GMPs are no longer treated as a special class of benefit with their own rules. This is conditional upon the actuarial value of the benefits not being reduced.

GMP equalisation can be built into a GMP conversion exercise. An explanation of the possible attractions of conversion compared to the other methods for equalising GMPs can be found here.

There are several tax pitfalls to avoid when it comes to GMP conversion, but a particularly acute problem relates to deferred members if the scheme provides "fixed rate revaluation" of GMP in deferment. The issue, in a nutshell, is how to avoid creating increased exposure to the annual allowance charge.

If the fixed rate revaluation is included in the post-conversion benefits, the conversion is likely to take it outside the deferred member carve-out.

If the fixed rate revaluation is not included post-conversion, though, the deferred pension may need to increase in order to maintain actuarial equivalence, and this increase is also unlikely to be covered by the deferred member carve-out.

Lifetime allowance protections also pose a problem.

There are solutions to these problems, but it would have been helpful if HMRC had indicated either that no tax would be levied (HMRC has the power to make extra-statutory concessions in certain circumstances, e.g. where there are gaps in the law) or that the Government has plans to legislate to address these issues.

There has been nothing to date on GMP conversion in guidance from HMRC. In its last newsletter, HMRC noted that: 'Any schemes wishing to use the conversion method should consider any tax implications that may arise in accordance with the existing legislation and guidance within the PTM and seek advice as appropriate.'

Footnotes

[1] Lloyds Banking Group Pensions Trustees Limited v Lloyds Bank plc and others [2018] EWHC 2839 (Ch) (28 October 2018)
[2] Lloyds Banking Group Pensions Trustees Limited v Lloyds Bank plc and others [2018] EWHC 2839 (Ch) (28 October 2018)
[3] Other forms of protection exist but are beyond the scope of this Insight.

Download our guide to GMP equalisation and how to deal with it, for a complete summary of our thinking around this issue. The guide provides important background, outlines key points from DWP guidance and highlights next steps for trustees.