This article is from Peter Cameron-Brown, a trustee of an active defined benefit pension scheme. It’s audience is primarily experts though it is sufficiently well written to be understood by someone like me. I recommend it to you.

 

Options with an existing Defined Benefit Pension Scheme

I am concerned that Employers with an existing Defined Benefit pension scheme, whether closed or open to accrual, are not being fully advised on the implications of the various alternatives open to them.  I consider that there is too much attention paid to a commercial insurance product “end game” for a DB pension scheme without adequate consideration of the future pension scheme arrangements and hence employment costs and future profitability of the sponsoring employer.

There appear to be six alternatives a Company should consider and weigh up the alternatives of each, and if material necessary taking external advice, before making any irrevocable decisions.  There may even be others which have not yet been widely considered, such as sharing sponsorship of the Pension Scheme with another organisation, such as an asset manager.  I have not included them in the analysis.  To me the current alternatives appear to be:

1. The company receives a taxable cash refund using a DB Pension Scheme past service “surplus”.
2. The DB Pension Scheme runs on/out while the Company pays DC contributions in respect of its current employees.
3. Using the “surplus” to pay DC contributions into a Master trust or a Group Personal Pension Plan.
4. Using the “surplus” to pay contributions into a whole life CDC Scheme.
5. Transferring Funds from a Pooled DB Fund to Individual DC Pots within the same Pension Trust Fund.
6. Reopening or maintaining DB accrual within the same Pension Fund.

In the following article I set out my thoughts on the issues with each of these which an employer should consider when considering all the options available.  I am aware that not everyone will agree with all my points, and indeed I may have missed points others consider to be important.  I would welcome this feedback.

I have also discussed the alternatives available where there is a past service “surplus” reported in the pension scheme, but the same points apply when there is a deficit reported.  The key message is that at all stages all alternative courses of action should be considered against the current and future profitability and competitive position of the employer by including in the overall consideration alternative scenarios for current and future pension provision for its current and future workforce.

Where appropriate, I have repeated the same points across the alternatives.

Peter Cameron Brown BA(Econ) LlB FCA

1.    The company receives a cash refund using a DB Pension Scheme past service “Surplus” and pays DC contributions in respect of its current employees.

1. Loss of Assets to a Tax Charge: The pension scheme has to deduct 25% tax on the amount refunded to the company.
2. Share of Surplus with Previous Employees: The Trustees of the pension scheme have to agree an “equitable” distribution of the surplus between the company and its previous employees who are pensioners or have deferred benefits in the pension scheme; and determine the amount of surplus to be retained as a reserve in the pension scheme fund. These decisions are Trustee decisions over which the Company has no control.
3. Effect on the Company’s Assets and Balance Sheet: Although increasing company cash by the net amount received, the company’s balance sheet and distributable reserves are reduced by

the loss to tax on the refund[1], plus

the reduction in the pension scheme asset from cash distributions to previous employees retaining benefits in the Scheme, and

the increased estimated valuation  cost of the enhanced future pension benefits of previous employees.

2. Effect on Future Years’ Profitability: Future years’ profit and loss accounts will reflect the loss of the interest on full reduction in the pension scheme asset arising from the refund, the tax on it, and the benefit enhancements to the scheme members. The pension fund also loses the future investment return on the cash refunded to the company or paid out to the members.
   1. Administration Costs Incurred: The Company has to bear the future administration costs of the pension scheme, either by contribution or out of residual surplus. NB: these costs are capitalised and effectively prepaid as a lump sum in a buy-out bulk annuity transactions.
   2. Future freedoms: It is appropriate for the company to consider whether it wishes the pension scheme surplus to be refunded now or for it to remain invested by the pension scheme for possible alternative future uses for its benefit.
   3. On going Pension and Employment Costs: The Company’s DC contributions continue to be a cash outflow and a Profit and Loss charge.
   4. Future Risks: While at present the DC contributions may appear to be a fixed cost, the company has to consider the likelihood of future legislative changes and employment practices and whether they are likely to increase the cost to the company. Possible increases are likely to come from increased Government and employees, or their representatives, attention to the adequacy of pensions provided from DC pots – Pensions UK is lobbying for a minimum of 12% annual contributions and the Australian “Super” system, often cited as a good example, already mandates a 12% employer contribution.  An employer may also wish to reflect on the possibility of a loss of or restriction on the tax reliefs available, e.g., from the 2025 Budget proposed future restriction on NI relief on salary sacrifice arrangements.
   5. Employment Contract Restrictions: As part of the employment contract, DC contributions once set cannot be reduced without a formal renegotiation of the employment terms of current employees.
   6. Benefit Efficiency: For a targeted level of annual pension benefit, the combined contributions required from employers and employees is likely to be something like 50% more with DC than those required with a CDC or DB arrangement.
   7. Employee and Member Considerations: Cash payments to the DB scheme members in excess of benefits available to them under the Deed at time of service are treated when received as unauthorised payments and are currently taxed at 55%, but following the 2025 Budget proposals will be taxed at the Employee’s marginal rate, as at present applies to any discretionary benefits paid under the terms of the Deed. Enhancements to deferred benefits will count against the current year’s Annual Allowance and could trigger an Annual Allowance (tax) Charge on the Member.

Conclusions

Although there is an asset transfer from the pension fund to the company, the company cannot control the outcome and there are considerable leakage to taxes and also adverse effects on reported company strength and profitability.  The company is also committed to making future contributions into the DC pots of its current and future employees in accordance with employment terms and future legislative requirements. Members receiving enhanced benefits may suffer significant tax charges.

2.    The Pension Scheme runs on/out while the Company pays DC contributions in respect of its current employees

1. Option considered: This is effectively a deferral of the cash refund option but the deferral of the reduction in the pension scheme asset allows the investment return on the scheme assets and the actual pension scheme experience to increase the assets available for ultimate refund.
2. Loss of Assets to a Tax Charge: The loss to tax is deferred until the ultimate refund.
3. Effect on the Company’s Assets and Balance Sheet: The Company’s Balance Sheet and distributable reserves reflect an increasing pension scheme asset. That asset being itself enhanced by investment returns in excess of the (low dependency) valuation assumptions and also actual pension scheme experience against valuation (mortality) assumptions.  The company may reasonably assume that in combination these are more likely to be positive than negative to the net asset value; and even if negative the effect is spread into the indefinite future.
4. Effect on Future Years’ Profitability: The company retains a profit and loss credit on the total net assets of the Pension Scheme, while the company’s DC contributions continue to be a cash outflow and a Profit and Loss charge.
5. Future Risks: While the present DC contributions may appear to be a fixed cost, the Company has to consider the likelihood of future legislative changes and employment practices and whether they are likely to increase the cost to the Company. Possible increases are likely to come from increased attention to the adequacy of pensions provided from DC pots – Pensions UK is lobbying for a minimum of 12% annual contributions and the Australian “Super” system, often cited as a good example, already mandates a 12% employer contribution.  An employer may also wish to reflect on the possibility of a loss of or restriction on the tax reliefs available, e.g., from the 2025 Budget proposed future restriction on NI relief of salary sacrifice arrangements.
6. Employment Contract Restrictions: As part of the employment contract DC contributions once set cannot be reduced without a formal renegotiation of the employment terms of current employees.
7. Benefit Efficiency: For a targeted level of annual pension benefit, the combined contributions required from employers and employees is likely to be something like 50% more with DC than those required with a CDC or DB arrangement.
8. Timing of benefit sharing with Past Employees: The pension scheme Trustees are not required to consider the equitable distribution of a surplus between the company and the reducing cohort of past employees retaining benefits in the pension scheme until the time of the ultimate refund.
9. Administration Costs Incurred: The Company has to bear the future administration costs of the pension scheme, either by contribution or out of residual surplus. NB: these costs are capitalised and effectively prepaid as a lump sum in a buy-out bulk annuity transactions (the capitalised cost should diminish over time in a closed scheme).
10. Future freedoms: The company retains the flexibility to pursue other options, including the reopening of DB accrual within the same scheme (option 6 below), at any time in the future.

Conclusions

Although there is loss of a short term cash transfer to the company, the company is likely to benefit over the long term from the deferral of tax and the investment return on the pension scheme assets.  The company is able to control the timing of the Trustees’ consideration of the split of pension scheme surplus between a refund to the company and the enhancement to benefits of past employees.  Flexibility to switch to an alternative option in a possibly significantly changed future environment is retained.  However the Company is still subject to the restrictions associated with its contractual DC contributions and the transfer of assets out of the company’s domain, which includes the pension scheme, into the individual DC pots of its then current employees.

3.    Using the surplus to pay DC contributions into a Master trust or GPP:

1. Loss of Assets to a Tax Charge: The pension scheme has to deduct 25% tax on the payments into employees’ DC pension pots as under present legislation and accounting rules they are treated as a refund to the employer from the pooled fund.
2. Effect on Profitability: The company has to report the full cost of the company’s DC contributions funded in this way as a pension scheme cost in the Profit and Loss in the same way as if it had paid them in cash.
3. Share of Surplus with Previous Employees: The Trustees of the pension scheme have to agree an “equitable” distribution of the surplus between the company to be used in this way and its previous employees who are pensioners or have deferred benefits in the pension scheme; and the amount to be retained as a reserve in the pooled pension scheme fund. These decisions are Trustee decisions over which the Company has no control.
4. Effect on the Company’s Assets and Balance Sheet: Although increasing company cash by the net amount received, the company’s balance sheet and distributable reserves are reduced by

the loss to tax on the refund[2], plus

the reduction in the pension scheme asset from cash distributions to previous employees retaining benefits in the Scheme, and

the increased estimated valuation  cost of the enhanced future pension benefits of previous employees.

1. Effect on Future Years’ Profitability: Future years’ profit and loss accounts will reflect the loss of the interest on full reduction in the pension scheme asset from the DC contributions paid, the tax on them, plus the benefits enhancements to the DB scheme members.
2. Administration Costs Incurred: The company has to bear the future administration costs of the DB pension scheme, by contribution, or out of residual surplus, or by the capitalised cost in a buy-out transaction.
3. Benefit Efficiency: For a targeted level of annual pension benefit, the combined contributions required from employers and employees is likely to be something like 50% more with DC than those required with a CDC or DB arrangement.
4. Future Risks: While at present the DC contributions may appear to be a fixed cost, the company has to consider the likelihood of future legislative changes and whether they are likely to increase the cost to the company. Possible increases are likely to come from increased attention to the adequacy of pensions provided from DC pots – Pensions UK is lobbying for a minimum of 12% annual contributions and the Australian “Super” system often cited as a good example already mandates a 12% employer contribution.  An employer may also wish to reflect on the possibility of a loss or restriction on the tax reliefs available, e.g., from the 2025 Budget proposed future restriction on NI relief of salary sacrifice arrangements.
5. Employment Contract Restrictions: As part of the employment contract DC contributions once set cannot be reduced without a formal renegotiation of the employment terms of current employees.
6. Employee and Member Considerations: Cash payments to the DB scheme pensioners in excess of benefits available to them under the Deed at time of service are treated when received as unauthorised payments and are currently taxed at 55% but following the 2025 Budget proposals will be taxed at the Employee’s marginal rate, as at present applies to any discretionary benefits paid under the terms of the Deed. Enhancements to deferred benefits will count against the current year’s Annual Allowance and could trigger an Annual Allowance (tax) Charge on the Member.

Conclusions

Although there is a short term cash flow benefit to the company, the company cannot control the outcome and there are considerable losses to taxes and also adverse effects on reported company strength and profitability.  Over the longer term, the company is left with a fixed or increased cash outflow and Profit and Loss charge in the form of DC contributions. It is also highly inefficient in terms of the improvement in the DC members’ benefits for the amount of surplus being given up.

4.    Using the surplus to pay contributions into a whole life CDC Scheme:

1. Loss of Assets to a Tax Charge: The pension scheme has to deduct 25% tax on the payments into the CDC Scheme as (at present) they are treated as a refund to the employer.
2. Effect on Profitability: The Company has to report the full cost of the company’s CDC contributions funded in this way as a pension scheme cost in the Profit and Loss in the same way as if it had paid them in cash.
3. Share of Surplus with Previous Employees: The Trustees of the pension scheme have to agree an “equitable” distribution of the surplus between the company and its previous employees who are pensioners or have deferred benefits in the pension scheme and the amount to be retained as a reserve in the pension scheme fund. This is entirely outwith the company’s control.
4. Effect on the Company’s Assets and Balance Sheet: Although increasing company cash by the net amount received, the company’s balance sheet and distributable reserves are reduced by

the loss to tax on the refund[3], plus

the reduction in the pension scheme asset from cash distributions to previous employees retaining benefits in the Scheme, and

the increased estimated valuation  cost of the enhanced future pension benefits of previous employees.

1. Effect on Future Years’ Profitability: Future years’ profit and loss accounts will reflect the loss of the interest on full reduction in the pension scheme asset from the CDC contributions paid, the tax on them, plus the benefit enhancements to the DB scheme members. The rate of employer contributions is a key design feature of the CDC scheme and are contractually fixed, but subject to any over-riding legislation.
2. Administration Costs Incurred: The Company has to bear the future administration costs of the DB pension scheme, by contribution, or out of residual surplus, or by the capitalised cost in a buy-out transaction.
3. Benefit Efficiency: For a targeted level of annual pension benefit, CDC should require 33% less total employer and employee contributions compared with a DC arrangement. As CDC scheme members, as opposed to DB scheme members, bear the administration costs of the CDC scheme, the benefit Efficiency of the contributions paid in is poorer than with DB, but better than with DC to a Mastertrust or a GPP arrangement.
4. Employee and Member Considerations: Cash payments to the DB scheme members in excess of benefits available to them under the Deed at time of service are treated when received as unauthorised payments and are currently taxed at 55% but following the 2025 Budget proposals will be taxed at the Employee’s marginal rate, as at present applies to any discretionary benefits paid under the terms of the Deed. Enhancements to deferred benefits will count against the current year’s Annual Allowance and could trigger an Annual Allowance (tax) Charge on the Member.

Conclusions

Although there may be a short term cash flow benefit to the company, the company cannot control the outcome and there are considerable losses to taxes and reported company strength and profitability.  Over the longer term, the company is left with a fixed or increased cash outflow and Profit and Loss charge in the form of contractually fixed CDC contributions. It is however more efficient in terms of the improvement in current employees’ retirement income for the amount of surplus being given up than a transfer to individual DC pots.

5.    Transferring Funds from the Pooled DB Fund to Individual DC Pots within the same Pension Trust Fund

1. Loss of Assets to a Tax Charge: As there is no real or notional refund to the employer, the pension scheme does not have to levy a refund tax charge.
2. Availability of this option: This will only be possible if the power to transfer from the pooled fund into the notional DC pots of individual members is permitted within the Trust Deed. Such a Deed is likely to specify the situations in which this will be possible.
3. Possibility of change: It is unlikely a new DC section could be introduced into an existing DB Trust which allows the existing pooled DB fund partly funded by members’ contributions to be transferred into the individual notional DC pots of employees who were not also members in the DB fund. The precedent case (Standard Life) where the permission of the Courts was obtained to amend the Deed to permit a DB pool to be used for DC benefits recognised that the donor DB scheme had been almost entirely employer funded.  In any event, it is likely that considerable legal costs will be incurred in pursuing this option.
4. Share of Surplus with Previous Employees: The Trustees of the pension scheme have to agree the amount to be retained as a reserve in the pooled DB fund and an “equitable” and Deed permitted distribution of the surplus between enhancing the benefits the previous employees who are pensioners or have deferred benefits in the DB section and increasing the individual DC pots in the DC section. This is entirely outwith the company’s control.
5. Effect on the Company’s Assets and Balance Sheet: The company’s Balance Sheet and distributable reserves are reduced by the full amount of the transfer from the pooled fund into the individual employees’ DC pots.
6. Effect on the Company’s P&L A/c in the transfer years: The P&L A/c will reflect as a charge the full amount of the contributions out of the pooled fund into the individual DC pots even though there was no cash flowing from the company.
7. Effect on Future Years’ Profitability: Future years’ Profit and Loss will reflect the loss of the interest on full reduction in the pooled pension scheme asset from the transfer into the individual employees’ DC pots and also by DC contributions fixed or increased by employment contracts or legislation.
8. Employee and Member Considerations: The transfer into the Members’ individual DC pots will be treated as a pension contribution during the year subject to the Annual Allowance is the same way as they had been contributed by the company.
9. Administration Costs Incurred: The company has to bear the future administration costs of both the DB and the money purchase sections, either by annual contribution, or out of residual surplus in the DB asset pool, or by meeting the capitalised cost in a DB benefit buy-out transaction.

Conclusions

Although there is a short term cash flow benefit to the company and no loss to tax, over the longer term, the company is left with a fixed or increased cash outflow commitment and P&L A/c charge in the form of future DC contributions and the loss of investment return from a decreased asset base in the pooled fund. It is however more efficient in terms of the improvement in current employees’ retirement income for the amount of surplus being given up than a transfer to individual DC pots resulting from pooling the investments and no forced sale of assets.

6.    Reopening or maintaining DB accrual within the same Pension Fund

1. Availability of this option: Apart from the mandatory employee consultation, an employer is entirely free to introduce a new section of DB benefits for future service into an existing DB pension fund. The benefits need not reflect those previously provided by the Scheme.
2. Effect on the Company’s Assets and Balance Sheet: The entire pool of scheme assets including those contributed by both the company and employees in respect of both past and current service are available to fund all the benefits accrued. The capacity to fund the benefits of the historic section from current contributions gives significant investment freedoms not available to a closed scheme and thereby reducing the future cost to the employer under the balance of cost arrangement.
3. Effect on Valuation Surpluses or Deficits: The scheme will be regarded as a single entity for valuation purposes. This will progressively push forward the “significant maturity” date (subject to employer’s longevity covenant).  This will provide considerable protection against short term market risks affecting either asset values or the liability valuation assumptions.
4. Loss of Assets to a Tax Charge: There is no loss to tax as no surplus is being refunded to the company.
5. Share of Surplus with Previous Employees: The Trust Deed instructions to Trustees remain under the control of the company. Trustees are not required to consider a shared distribution of surplus between the company and pension scheme members who were previously in pensionable service with the company or its predecessors. (Although in Equity, Trustees may wish to consider using existing discretionary powers under the Deed to maintain real values of pension benefits before agreeing a Schedule of Contributions with a full or partial employer contribution holiday)
6. Future freedoms: Under the balance of cost arrangement, the surplus can be returned to the company through reduced future employer contributions. There are no minimum contributions set for DB schemes under the auto-enrolment regulations (there is a minimum benefit accrual rate of 1/120^th of “qualifying earnings”).
7. Effect on Future Years’ Profitability: The company’s Profit and Loss will reflect the current service cost of the current DB benefit accrual (calculated using the opening AA bond yield) offset by an interest credit on the opening surplus (calculated using the same basis). With realistically stronger investment performance than the valuation assumption, it is therefore quite feasible for the net pension cost to become negative and the pension fund to be a contributor to company profitability.
8. Competitive Considerations: The cash flow and reported profitability advantages should give the company providing DB accrual a competitive advantage against competitors who are providing DC pension benefits. This would be particularly marked against competitors who are following a high cost buy-out strategy for their pension scheme.
9. Employer Covenant Considerations: Provided the current service cost is being fully funded, the employer’s covenant towards the pension scheme should be enhanced by the continuing accrual of DB benefits.
10. Administration Costs Incurred: The company has to bear the future administration costs of the pension scheme, either by payment, or out of surplus in the total asset pool. However these costs are relatively fixed with regard to the increasing number of members in the scheme and total asset values.
11. Recruitment and Retention Benefits: There are the recruitment and retention benefits of an employer providing a “gold plated” DB pension promise. The current employees have a guaranteed pension in retirement, protected by the PPF, without the uncertainty and potential stresses of a DC arrangement. Given that the employer directly or indirectly funds the administration costs, the value for money of the employee and employer contributions should be greater than that provided by a CDC arrangement, itself significantly greater than that provided by the equivalent contributions into a DC arrangement. As the employer defines the pension terms for its employees, there is no need to consider inter-personal “fairness” associated with a wealth generating pension savings vehicle.

Conclusions

Compared with the other alternatives, it does appear that providing DB accrual to current employees may be the most cost effective and lowest risk alternative for an employer with an existing DB scheme in surplus (and also potentially for employers whose pensions scheme is not yet fully funded).

The Taxpayer’s Point of View

This paper is written from a company point of view with reference to a “loss to tax” where relevant.  This does not necessarily mean that there is a cost to other tax payers when measured over the longer term:

If a company with a DB pension scheme in surplus uses that surplus to fund further pension accrual, the Exchequer gains from the unused tax relief on the future contributions which otherwise would be paid.  This results in increased Corporation Tax paid by the Company and the Income tax and National Insurance Contributions paid by the Employee respectively. The taxes at issue are 25% on company contributions, 20%, 40%, or possibly 55% marginal rate on employee contributions plus employee National Insurance at 8% or 2%, plus in some circumstances 15% Employer NI.

General Conclusion

It is important that advisors should fully explore all options with employers, whether or not the employer has already commenced a strategy designed to achieve an eventual buy-out.  A failure to do this is likely to lead to a further degradation of the UK industrial and commercial base.

Details

[1] Balance Sheet totals may reflect a release of a previous provision for deferred taxation to the extent that it is no longer required.

[2] Balance Sheet totals may reflect a release of a previous provision for deferred taxation to the extent that it is no longer required.

[3] Balance Sheet totals may reflect a release of a previous provision for deferred taxation to the extent that it is no longer required.