My good friend “Pension Oldie” picked up on my blog yesterday about the pension surpluses currently being enjoyed by the trustees but not the sponsors or members of the BP and Shell pension schemes – and many more (mine included).
Sometimes there is no provision in the scheme rules to provide discretionary benefits to members but rarely did a Defined Benefit scheme set out to provide anything less than inflation protection.
Pension Oldie makes some very important points about this in his comment (in full below).
I doubt lawmakers will wish to interfere with the principles of equity and the exercise of discretion, whether under an “Imperial Duty” or not, that are so central to Trust nature of a DB Pension Scheme.
However one way legislators could encourage provision of pension benefits that maintain the real value of pensions is through a differential rate for the Authorised Payments Tax Charge under s207 of the Finance Act 2004 (currently being reduced from 35% to 25% in the Budget).
My suggestion would be that the lower 25% rate would only apply where the scheme had already revalued all accrued pension rights and pensions in payment in line with with the Pensions Increases Act (as used for calculating the Annual Allowance) and had secured the benefit for members by hard coding into future increases in the terms of any buy-out.
Failing to secure the real value of the pension benefits would then carry a higher tax rate (say 35%).
Where companies like BP and Shell have not protected the real value of their pension promises they would need to reflect the higher potential tax rate in their deferred tax liability provision against any reported surplus.
The justification for the penalty tax rate is that I understood one of the justifications for the Corporation Tax deduction for payments to authorised pension schemes plus the capacity of the scheme to avoid tax on its investment income was that the provision of inflated protected pensions would reduce dependence on means tested benefits in later life and in the case of pensioners not requiring means tested benefit, the pension was taxable on receipt.
Oldie, as is his right as a former Finance Director, commits his ideas in a formal way that need a little explanation.
The Government proposals for the extraction of surplus from a DB plan – would allow schemes to take money out on roughly neutral terms to those that they put it in. Corporation Tax relief and surplus tax paid cancelling themselves out. The fund while invested, while suffering some withholding tax, was largely exempt, so corporations getting their deficit repayments back with a tax deduction of 25% probably consider this fair.
But do members?
Oldie’s proposals say that a scheme can only be wound up or start returning surplus to employers once money has been put aside to meet proper inflation proofing of member benefits. By “proper”, Peter is suggesting the rate introduced in Pensions Increases Act (as used for calculating the Annual Allowance) – full inflation protection.
This is quite a radical idea. Not only would it have a profound impact on the valuation of pension scheme liabilities (for the purposes of efficient surplus extraction, but it would stop the practice of selling potential increases to insurers , for the short-term benefit of shareholders.
It would of course mean that schemes with little hope of paying more than statutory increases on pensions and no hope of buying-out, would not be impacted.
I am not expecting this to do down well with insurers or with employers currently eyeing a tax-privilidged windfall. But I think “Oldie’s” proposal is fair.
If an employer is to take money , they can only expect to take 65p in the pound until they have reached a fair settlement with members. If they have reached that fair settlement, then they can get 75p in the pound on money send to them by their trustees.
This proposal’s what I call “putting members first” – that’s what trustees are supposed to do, that’s why pension schemes were set up in the first place.
This is one time you might take into account the experience in the United States. If you don’t permit reversions without excessive taxation, for those assets in excess of the amounts needed for the specific contractual obligations of the plan (excluding discretionary post-retirement increases), you end up convincing private plan sponsors to underfund their defined benefit plans, and later, should there be an issue, consider termination before increasing funding. That was our experience in the states. See:
https://www.soa.org/globalassets/assets/Files/Research/Projects/Reversion.pdf
That is indeed a risk if the DB plan is still open but the s207 tax charge is only charged on surpluses being refunded to the employer where the Trustees acting independently from the employer believe that it is in the interest of Members to do so or after the last member has left the scheme. By and large UK DB Schemes have already been terminated – not necessarily due to a previous failure to fund appropriately (hence there is now a surplus in the scheme) but because of the fear and demands for additional deficit contributions being demanded by TPR based on a risk model based on valuation assumptions which have proved (with the benefit of hindsight?) to be over-prudent.
That is a risk if the Company was considering re-opening the Pension Scheme to DB accrual, but the Auto-enrolment Regulations set minimum contribution levels. The question for the Company therefore what is level of benefits it should promise against the contributions being paid including member contributions (the minimum DB benefit is 1/120th (of final salary or revalued average salary) with Minimum Rate (,2.5%) guaranteed revaluations and increases. The minimum cash contribution is currently 8% but targeted to be 12% in the future, It does appear that based on long term investment returns 12% of relevant earnings should be sufficient to fund a pension benefit well in excess of 1/120th. The overfunding should then provide the full inflation protection for the Members.
In the states, even when the DB is overfunded, most won’t reopen – with exceptions like IBM who suspended employer contributions to DC plans. Instead, we have the kerfuffle of Pension Risk Transfer litigation.
The incentive here is quite limited. If the cost of benefit enhancement exceeds 13.3% of the surplus then the sponsor is worse off than under the all taxed at 35% regime
I only used 35% because of the budget change.
However the key future decisions which determine the amount of any refund lie solely with the Trustees:
The timing of and whether it is fair and equitable to refund any surplus to the employer. (I understand the current DWP consultation is about providing guidance to make it easier for trustees to make partial refunds during scheme run-on.)
The terms of any buy-out policy (full or only partly inflation protected) both in respect of accrued past benefits and for the future.
Under IAS19 both of these should be reflected in the calculation of an “asset ceiling value” as IAS 19 requires the employer to consider the recoverability of any surplus and there must be economic benefit (for example reduced contributions or a cash refund) available to the company to enable this recovery. The employer should therefore assess how these future decisions affect the calculated asset value and if it assesses that past restrictions on benefits provided under the Deed will be made good in the future, the reported asset value should be reduced. This would be a matter for discussion between the Company and its auditors.
What we are trying to influence is the exercise of the employer’s discretion when the Deed (which was an employer’s document) provides for a pension increase subject to the employer’s consent. If it decides to withhold consent then it could expect the deferred tax liability to reflect the increased tax charge on the possibly already restricted asset value, reducing the overall asset value of the Company.