Looking for skeletons in your scheme closet

You could say that running a pension scheme is like owning an old house: both are intended to provide security in the future, but both have been around a long time so may have skeletons lurking in the closet. 

It’s not standard practice to go looking for issues in a house if no issues are immediately apparent. Nor is it usual to double check that the work you had done in the past (e.g. roof repairs) was done correctly and in line with applicable regulations. If there is a leaky pipe, of course you call in a plumber to get to the root of the problem and rectify it, but you generally wouldn’t start checking the rest of your pipework unless you thought there was a wider issue. 

The industry approach to running a pension scheme has not been dissimilar. Trustees are generally not obliged to revisit past decisions or proactively check for issues unless something has arisen which indicates that there is in fact an issue. It’s generally accepted that due to the long-standing nature of pension schemes and a plethora of changing rules and regulations, unknown benefit and administration issues exist in all pension schemes. However, unless there is a transaction relating to the pension scheme (such as a buy-in or a sale of the pension scheme sponsor), or there is a legal development or member claim, there is unlikely to be a reason to conduct wider checks to understand whether any material unknown liabilities exist in the scheme. 

The recent period of strong funding levels in defined benefit schemes has allowed many to consider a de-risking transaction sooner than expected. Before completing a buy-in, trustees will want to establish whether there are any unknown material liabilities in the scheme to ensure that the liabilities being insured match those of the scheme as far as reasonably possible. Sponsors will (or should) want to know what residual risks could be left behind once the scheme is wound-up so as to minimise the risk of any claims post wind-up. In addition, if residual risks cover is being obtained, the relevant insurer will undertake an extensive due diligence exercise in relation to the scheme and so the trustee and sponsor are forced to confront any issues in the scheme.  Each of these involves an inevitable change of mindset.

A key point is that there is no legal time limit on member claims for correct benefits (except where a forfeiture rule applies, and often these are very limited) unless and until a scheme has wound up.

Potential skeletons 

To give a flavour of the skeletons we come across, we have set out five issues that have the potential to significantly increase the scheme’s liabilities compared to the position as understood by the sponsor and the trustees before an investigation begins:  

1. Failure to correctly equalise retirement ages for men and women (known as closing the Barber window) – this issue arises where the scheme was not validly amended to provide for a common normal retirement age for men and women for pensionable service on and from 17 May 1990. This results in members having a period of pensionable service where they are entitled to benefits calculated by reference to a lower retirement age, typically by reference to age 60 instead of age 65. As NRD60 benefits are paid out earlier and for longer, they cost more to provide.
2. Closure to future accrual – we still see situations where schemes purported to close to future accrual but did not do so in accordance with the strict requirements of the power of amendment (perhaps because closure was done by member announcement). Also, where sponsors and trustees failed to appreciate that the wording of the amendment power required a link to be maintained to final salary. Both situations result in the potential for a claim for accrual of additional benefits.
3. Failure to comply with the formalities of a scheme’s power of amendment - past amendments to the scheme may be void (and so treated legally as if of no effect) if the amending deed did not comply with any formalities or restrictions in the amendment power or breached overriding statutory requirements.
4. Revaluation and pension increases – revaluation and pension increase rules are subject to statutory underpins which have changed over time. These changes in legislation also mean that scheme rules governing such increases may (whether or not amended) now have a different effect to that intended, and so be out of line with administrative practice. Failure to pay these increases in accordance with scheme rules and overriding legislation can result in under or over paid benefits. 
5. Administration vs legal entitlement – commonly we see a mismatch between the benefits being paid by the scheme’s administrators and the legal entitlement provided for under the scheme’s rules. Specifically, issues can arise in schemes with multiple benefit structures, particularly where there have been bulk transfers into a scheme from schemes with differing benefit structures – for example where the transfer agreement provides for mirror benefits but this has not been followed in full or in part. 

Unpacking the closet

If you discover a particular issue, resolving it can be challenging. For example: 

• If the issue is historic, there may be challenges in obtaining documents or data from that time period to find out what happened thereby allowing you to assess its significance and implications. Decision-makers and individuals involved at the time may no longer be around to help fill any knowledge gaps.  
• Whilst correcting benefits going forward is relatively straightforward, rectifying pensioner overpayments or underpayments can often be challenging, not only from a practical perspective but also from a legal and tax perspective.
• Assessing issues and rectifying them requires a number of decisions to be taken by the trustee and/or sponsor, often on professional advice. Addressing issues can be time-consuming and costly as defences, mitigations and practicalities are considered. 
• Former members who have died, commuted or transferred their benefits out of the scheme pose additional problems. There can be practical issues with paying uplifts due to or in respect of such members. Legal advice may be needed regarding the viability of relying on forfeiture provisions in the scheme rules and adopting a commercial de minimis to reduce or cut off individual claims. 
• If the scheme has completed a partial buy-in, you will need to interrogate the insurance contract to understand whether you have the right to amend the benefits insured and the likely costs of doing so. If an issue has emerged after an insurance transaction, the scheme will not have any competitive tension with the insurer and so may end up paying over the odds to amend the benefits unless a pricing mechanism is already contained in the insurance contract. 
• If pensioner benefits have to be changed, members will have to be contacted. As many issues are complex and difficult to explain in simple terms, members may be alarmed to receive a communication saying that their benefits need to be amended. Therefore, a careful communication strategy with members will be needed. 

Should trustees and sponsors think differently? 

This raises the question of whether trustees and sponsors should adopt a different mindset and start proactively looking for issues. 

If your scheme’s long-term strategy is to buy-out benefits with an insurer, trustees and sponsors should ensure they are aware of the risks and issues that can emerge as a result of conducting due diligence in anticipation of a de-risking transaction and ensure a plan for dealing with this risk is agreed at an early stage. 

If a significant issue emerges, it can materially impact the funding level of the scheme and take a significant period to resolve. This could mean that, due to the funding impact, transaction affordability is prejudiced and/or the timescale to buy-in may need to be adjusted significantly to allow for proper investigation and rectification of the issue. Alternatively, in a worst-case scenario, the desired de-risking transaction may no longer be viable.

From a practical perspective, discussion, planning and alignment between the trustees and sponsor is key. Establishing the risk appetite of each party and ensuring they understand the implications of conducting full due diligence vs minimal due diligence is vital. The agreed approach to due diligence will likely be driven by a range of factors including the complexity of the scheme’s benefit structure, the history of the scheme, the quality of administration, the amount of historic legal advice taken by the scheme and the level of member complaints received over the years. Where possible, it would be sensible to build a timing and funding buffer into the overall project to allow for resolving any issues discovered during the due diligence process. 

For schemes planning to run-on, trustees and sponsors may remain reluctant to go digging for issues without a reason to do so. However, with the Pensions Regulator’s increased focus on data quality and the impending launch of the Pensions Dashboards, trustees and sponsors may want to ask themselves whether those closets should be checked for skeletons sooner rather than later.