On 24 July 2014 the statutory definition of "money purchase benefits" changed. A conventional money purchase benefit, where the member has a defined contribution (DC) account calculated by reference to underlying assets held by the scheme (such as units in pooled funds), which is then used to buy an annuity from an insurance company at retirement, is not affected by the change in the definition.
What benefits are affected?
The change affects two main types of benefit, neither of which is encountered very often in the current pensions market. These are:
- A DC account which provides a fixed or guaranteed rate of return but is not backed by an asset which provides the same return, or any other DC benefit which is calculated by reference to factors which are not related to actual investment performance. An example would be the old-fashioned type of benefit structure where an annual pension at retirement is derived by multiplying the value of the member's contributions by a fixed factor. These types of benefits are referred to in the new legislation as "cash balance benefits".
- Pensions in payment which are derived from DC accounts but which are paid out of scheme assets rather than being secured with insurance company annuities.
These benefits will cease to be classed as money purchase benefits.
Which schemes are affected?
Obviously, any scheme which provides benefits of these sorts will be affected. There is a small sub-category of scheme which will cease to be "money purchase schemes" (that is to say, schemes which provide only money purchase benefits) because of the change.
These schemes are particularly affected as they will become subject to the statutory scheme funding and employer debt requirements for the first time. This includes the small number of occupational DC schemes that provide pensions at retirement from within the scheme.
The pre 24 July 2014 definition allows certain types of benefit to fall outside the regulatory regime and statutory protection which applies to defined benefit pensions, leading to a concern that the United Kingdom is in breach of its obligations under European Union law.
This follows a decision in 2011 of the Supreme Court in Bridge Trustees v Houldsworth and another. In that case the Supreme Court decided that the use of actuarial factors or notional returns in a benefit calculation is not fatal to a benefit being money-purchase in nature.
Where a member's defined contribution account is used to provide a pension from within the scheme, rather than being used to purchase an annuity from an insurance company, the pension might still be a money purchase benefit. Similarly, during the period before the pension comes into payment the application of fixed returns or other factors which do not reflect actual investment performance is not fatal to the benefit being money-purchase in nature.
It follows that a benefit could be a money purchase benefit and yet not be fully funded within the scheme. In theory at least, there might not be sufficient assets in the scheme to provide the benefit if the scheme's employer was unable or unwilling to fund it and no Pension Protection Fund (PPF) compensation would be payable.
On the day of the Supreme Court's decision in 2011 the Department for Work and Pensions rushed out a press release committing itself to reversing the Bridge decision by changing the definition of money purchase benefits with retrospective effect right back to 1 January 1997. This change was brought into force on 24 July 2014.
The retrospective nature of the change was controversial and the cause of the significant delay in its being brought into effect. The retrospective impact of the change has, however, now been severely curtailed by regulations.
The new definition
Under the new definition -
- Pre-retirement, a benefit will only be a money purchase benefit if is calculated by reference to assets held by the scheme which will always be sufficient to provide that benefit.
- Post-retirement, only pensions provided through insured annuity policies or drawdown funds are classed as money purchase benefits.
It follows from the new definition that a "money purchase benefit" can never be underfunded and that the legislation relating to such matters as scheme funding and the PPF need not apply to it. The new definition therefore meets the DWP's policy objective.
What benefits fall outside the new definition?
As a result of the new definition, some benefits that were previously classed as money purchase in nature will no longer be classed in that way. These are (principally) -
- Benefits which are subject to a fixed or guaranteed rate of return before the pension comes into payment (unless it is backed by an insurance policy which provides the same return);
- Pensions in payment which are derived from members' DC accounts but which are provided out of scheme assets rather than being secured externally with an insurance company. This is sometimes called "internal annuitisation".
Any unconventional DC benefit will potentially fall outside the new definition.
What is the impact of the change?
The distinction between money purchase benefits and non-money purchase benefits is fundamental to pensions legislation. Where a benefit is re-characterised there will be consequent changes to the way that the benefit is regulated and to the technical and administrative requirements which apply to it. The most significant consequences are summarised in the table at the end of this note.[jumplink]
Statutory pension increases
Money purchase benefits have been excluded from the statutory pension increase requirements since 2005 and cash balance benefits since 2012. However, a scheme pension which is derived from money purchase benefits is not a money purchase benefit itself.
The DWP's intention is that statutory indexation requirements do not apply to a scheme pension derived from money purchase benefits. However, the legislation is not clear so this creates some uncertainty for schemes which have provided these types of benefit at any point since 2005. It is possible that this problem could be remedied by provisions under the Pension Schemes Bill which is currently going through Parliament.
This does not affect pensions in payment derived from additional voluntary contributions, as there is a clear exemption from the statutory increase requirements in relation to such pensions, and that exemption is not undermined by the new definition.
What about retrospectivity?
The effective date of the new definition is 1 January 1997, but the retrospective effect of the change is almost entirely negated except in very limited circumstances.
In fact, many of the changes will now only start to apply from dates in the future (see the table below in relation to PPF eligibility, valuations and levies, for example).
Only a minority of pension schemes will be materially affected by the change. The key actions for trustees are set out below.
If the scheme provides "cash balance" or unconventional DC benefits -
- Inform the Pensions Regulator by 31 March 2015 that the scheme contains benefits of this sort.
- Consider the likelihood of the scheme going into the PPF on winding up. If the scheme does enter the PPF, these benefits may be scaled back in line with PPF compensation limits. Members may need to be informed of this.
- Ensure the actuary and administrators are aware of the impact on transfer value, pension sharing and section 75 debt calculations and ask the actuary to confirm whether there will be any impact on funding.
- Generally, discuss with the employer the merits of continuing to provide these benefits under the new regime and whether benefit changes can and should be proposed.
The "action points" are broadly the same for schemes that provide pensions derived from DC accounts which are paid from within the fund, except that -
- The impact of PPF entry would be more marginal because of the relatively favourable treatment of pensioners under the PPF compensation rules. That said, members are normally given the option at retirement of taking either a scheme pension or buying an annuity, and the possibility of benefits being scaled back in the PPF will be material to that decision.
- As a pensioner is not entitled to a statutory transfer value, the impact on transfer value calculations need not be considered.
- Pending resolution of the indexation issue, review whether pensions paid out of the scheme but derived from money purchase accounts (other than additional voluntary contributions) have been set up with "statutory" increases in the period since 2005. Consider the basis on which such pensions should be set up in the future.
Main implications of the change to the definition
Winding-up / PPF compensation
Before 24 July 2014 these benefits would be secured in full prior to the application of the statutory priority order. They would not be transferred to the PPF.
From 24 July 2014:
If the scheme goes into the PPF
The benefits would be replaced by PPF compensation. Where a PPF assessment period started before 24 July 2014, the PPF has a discretion to treat as a money purchase benefit any benefit which was treated in that way by the scheme trustees before that date.
The PPF has a further discretion to require a pension in payment to be discharged as a money purchase benefit (ie on the pre-24 July 2014 basis) if the assessment period started on or after 24 July 2014 and:
- pensions in payment of this sort were treated as money purchase benefits before that date
- the pension is derived from AVCs
- it comes into payment before 1 April 2015.
If the Scheme does not go into the PPF
Under the statutory priority order, the scheme would first need to secure benefits up to the appropriate level of PPF compensation (see above). Benefits in excess of that would then be secured.
Depending on the funding level of the scheme there is a risk that these benefits would not be secured in full. The exception noted above for pensions derived from AVCs which come into payment before 1 April 2015 applies also here (but it is a trustee discretion).
PPF valuations and levies
Benefits re-characterised as non-money purchase in nature will be included as liabilities when undertaking the PPF valuation.
If a scheme provides such benefits, the trustees must inform the Pensions Regulator by 31 March 2015. The PPF has power to order an out-of-cycle valuation and adjust the levy where it considers that to be appropriate (but not for financial years before 1 April 2015).
Where a scheme becomes eligible for the PPF for the first time (because previously all benefits were money purchase benefits), the first PPF valuation must be submitted by 31 March 2015. The scheme becomes liable to pay the levy and eligible for PPF entry on 1 April 2015.
Section 75 debts
Where some benefits are being re-characterised there should be no impact on the total section 75 deficit within a scheme, but the way in which that deficit is split between employers in a multi-employer scheme will be affected. This will be relevant when a section 75 debt is triggered either on winding up or when an employer stops participating in a scheme.
The small number of schemes that contain only benefits that are being re-characterised will become subject to the statutory scheme funding requirements and will need to prepare actuarial valuations with effective dates before 24 July 2015. A scheme actuary will need to be appointed by 6 October 2014.
If a scheme is already subject to the statutory scheme funding requirements, it would be prudent to discuss with the scheme actuary the way in which any re-characterised benefits have been valued historically and whether any increase in liabilities is anticipated. Where assets and liabilities have been assumed to be money purchase in nature it will not be necessary to re-visit historic valuations.
Statutory right to transfer benefits
Trustees will have the ability to reduce the cash equivalent transfer value of a cash balance benefit to reflect underfunding in the scheme.
Pension sharing on divorce
Benefits will need to be valued using the non-money purchase method for pension sharing purposes (in the same way as a cash equivalent transfer value).