Pension schemes merge for a number of reasons, usually to enjoy the benefits of economies of scale. They tidy up an employer's legacy arrangements and can ensure greater efficiency in governance and costs, by removing duplication of service providers. They also enable the trustees to access potentially better investment returns, by increasing their size in the market.

The Government is proposing to make regulations that will remove current obstacles involving contracted-out rights. Some scheme mergers currently not possible could soon be an option again, enabling cost savings for employers and trustees.

Key action points

1. When do you bulk transfer defined benefit pensions?

Pension schemes carry out bulk transfers of defined benefit pensions for a number of reasons, one of the most common being scheme mergers.

2. Why merge?

Scheme mergers are attractive to employers and trustees, because they can enable greater efficiency in governance and costs, and an increase in investment performance, via economies of scale.

3. Consequential advantage is a winding-up lump sum payment reduces liabilities

Scheme mergers also allow the transferring scheme to be wound up and to reduce its liabilities by the payment of winding-up lump sums to all members whose benefits are worth up to £18,000.

4. Abolition of contracting-out made such exercises more difficult but April 2018 changes that

Contracted-out rights can only be transferred without consent to a scheme that was contracted-out. Because no more schemes can contract out, that is a closed group. However in April 2018, this is expected to be relaxed.

5. Consider scheme merger

Now is a good time for employers and trustees to consider if they have more than one legacy pension scheme what efficiencies and savings may be available to them from carrying out a scheme merger.

Why bulk transfer defined benefits pension rights without consent?

There are various reasons that may make it desirable for pension schemes to be merged or demerged. The most obvious is corporate activity, when sponsoring employers are bought and sold. However, as we will see below, pension scheme mergers may be attractive for other reasons also.

A merger or demerger involves assets and liabilities moving from one scheme to another on a bulk basis where it is not practical to ask every affected member to consent. Legislation permits these "bulk transfers" without consent, but imposes numerous conditions to ensure that members' interests are protected.

The abolition in 2016 of "contracting-out" (i.e. schemes contracting out of the State second pension in return for committing to provide benefits that meet a broadly similar standard) has caused one of those conditions to become practically impossible, however, and this has impeded bulk transfers of defined benefit pensions.

Fortunately the Government is planning to address this in April, meaning that transfers that are currently impossible may once again be possible. See below for more detail.

Where this is likely to have particular benefits to employers in particular is in pension scheme mergers, as these can enable greater efficiency in governance and significant cost savings, both in fees and also by reducing the liabilities themselves.

Why carry out a pension scheme merger?

Pension schemes merge for a number of reasons, usually to enjoy the benefits of economies of scale. They tidy up an employer's legacy arrangements and can ensure greater efficiency in costs, by removing duplication of service providers. They also enable the trustees to access potentially better investment returns, by increasing their size in the market.

A less obvious, but important, advantage is that one or more of the legacy schemes can be wound up, enabling smaller benefits to be discharged via a "winding-up lump sum", often known as a "WULS". This is an important exception to the usual position in the tax legislation, which normally only allows benefits to be commuted for triviality if the member is over a certain age (usually 55) or is in ill-health.

Winding-up lump sums can be paid to a member of any age, provided that the value of his benefits does not exceed £18,000, and provided that the scheme that pays them is being wound up. There are other conditions too, which we do not go into here. A scheme merger involving a WULS exercise can have a beneficial effect on liability management as well as cost-saving.

There are tax penalties for winding up a pension scheme "wholly or mainly" for the purpose of paying winding-up lump sums, but in reality, it is uncommon for a pension scheme to be merged and wound up with winding-up lump sums as the primary motivation. It is unlikely that the trustees would agree to the merger if this were the situation. What usually happens is that the ability to pay winding-up lump sums is an attractive by-product of something that was already desirable for other reasons. There is nothing wrong with that from a tax perspective (or any other), and the effect on the liabilities can be very favourable.

What is the contracting out problem?

Since the abolition of contracting-out in 2016, however, there has been a problem.

As noted above, most mergers take effect by one scheme bulk transferring all its assets to the other scheme, and the receiving scheme, in return, agreeing to assume responsibility for the transferring scheme's liabilities. For obvious practical reasons, this transfer needs to happen without the consent of the individual members, and to enable this, legislation imposes various protections so that members are not disadvantaged by such transfers.

One of those protections is designed to protect rights that accrued on a "contracted-out" basis, if the transferring scheme had ever been contracted-out of the State second pension (SERPS or S2P).

For bulk transfers out of such schemes without consent, it was a statutory requirement that the receiving scheme also be a contracted-out scheme.

When contracting-out was abolished, the statute was amended to a requirement that the receiving scheme must have been a contracted-out scheme in the past, prior to the abolition of the concept.

Whilst it appears logical, there is a problem. If in fact the receiving arrangement was not a contracted-out scheme, in the days when contracting-out still existed, it was fairly easy to make it into one, by having some members accrue benefits in it on a contracted-out basis.

However, it is not possible to make a scheme into one which used to be contracted-out. It either is or it is not. So the pool of schemes which are able to receive bulk transfers without consent including contracted-out rights is a closed group.

This has proved to be a significant impediment.

What is changing?

The Government accepts that the current law is unnecessarily restrictive and proposes to change it with effect from 6 April 2018. If the change goes ahead as planned, it will be possible to carry out a bulk transfer, without member consent, of contracted-out rights to a scheme that has never been contracted-out.

As is to be expected, the amending regulations (published in draft) will include measures designed to protect members' interests, but those are uncontroversial: in broad terms, the receiving scheme will need to honour the nature of the contracted-out rights and give them the same level of protection that it would be required to provide if it were a former contracted-out scheme itself.

We consider that the new regulations will solve the current problem and that the new protections will not inhibit any legitimate activity.

Therefore, now would be a good time for employers and trustees to consider whether any savings may be available to them by merging legacy pension arrangements into one.