Section on Employer pension duties: auto-enrolment and NEST updated to reflect the repeal of the stakeholder designation requirements with effect from 1 October 2012.
Employer pension schemes: a quick guide
What are the basic types of schemes that employers can provide?
Employers can provide:
Defined benefit (DB) schemes (www.practicallaw.com/0-107-7545) (also known as final salary schemes). These provide a guaranteed pension, usually calculated as a fraction of the employee's salary immediately before retirement or the employee's career average (www.practicallaw.com/8-235-6985) earnings. The employer and (usually) the employee pay contributions which are invested on behalf of the scheme. The employee's contributions are fixed and the employer pays the balance needed to provide the guaranteed benefits.
Defined contribution (DC) schemes (www.practicallaw.com/6-107-6072) (also known as money purchase schemes). The employer and employee pay fixed contributions. The employee receives a pension or annuity (www.practicallaw.com/1-107-6404) at retirement, the size of which depends on the contributions paid and the investment return on those contributions over the member's working life.
Hybrid schemes (www.practicallaw.com/7-206-1984). These contain elements of both DB and DC benefits.
How are these benefits provided?
Employers can provide benefits through either:
- Occupational pension schemes (www.practicallaw.com/8-107-6900). This term refers to any pension arrangement that an employer provides for an employee in any trade, business, profession, office or vocation. Most are set up under a trust, the governing deed of which sets out the powers and obligations of the employer. Accompanying rules set out the benefits to which scheme members are entitled. An employer can provide DB, DC or hybrid benefits through an occupational scheme.
- Personal pension schemes (www.practicallaw.com/4-107-7001). These are individual arrangements set up by a contract between an insurance company and an individual. Personal pension arrangements only provide DC benefits. Group personal pension plans (GPP) (www.practicallaw.com/7-107-6670), personal pension plans and stakeholder pension schemes (www.practicallaw.com/6-107-7302) are all personal pension arrangements (although depending on the circumstances, some stakeholder pension schemes count as occupational schemes).
Employer pension duties: auto-enrolment and NEST
To encourage individual saving, the government introduced new employer pension duties from 1 October 2012. These will eventually require all employers in the United Kingdom to automatically enrol eligible workers in a pension scheme. Employers will be able to use their own qualifying occupational or personal pension scheme, provided it meets certain statutory requirements. Alternatively, they can enrol eligible jobholders in NEST (www.practicallaw.com/7-501-1896), a central scheme set up by the government.
A jobholder will be free to opt out of either type of scheme once he has been automatically enrolled. But while he remains an active member, his employer will be required to pay a minimum level of contributions (although this requirement will be phased in over several years).
Before the introduction of auto-enrolment, there was no requirement in UK law for employers to contribute to a pension scheme for employees. However, between October 2001 and October 2012, most employers were required to ensure that employees had access to a stakeholder pension and arrange for employees' contributions to be deducted and paid to the scheme. Stakeholder schemes were normally contract-based arrangements and had to satisfy a number of minimum standards.
The requirement to designate and facilitate access to a stakeholder pension was repealed on 1 October 2012 in the light of the introduction of employer auto-enrolment duties (see Legal update, Stakeholder pension designation requirements repealed on 1 October 2012 (www.practicallaw.com/1-521-6283)). However, an employer can continue to operate an existing stakeholder scheme for the time being.
What concerns are there for an employer when choosing between a DB or DC scheme?
A DB scheme is generally regarded as providing better and more secure benefits for employees, provided the employer funds the scheme properly. But there are greater costs and risks associated with a DB scheme:
- Funding. Employer and employee contributions to a DC scheme are defined, so an employer knows how much it will need to pay into a DC scheme in any given period. By contrast, the employer has to pay the balance of costs to a DB scheme. As the exact cost of providing the benefits will not be known until the last beneficiary under the scheme dies, a DB scheme represents an open-ended risk to the employer.
- Regulatory regime. The burden on an employer is greater with a DB than with a DC scheme. The Pensions Regulator (www.practicallaw.com/9-201-5137) ensures that employers and trustees of pension schemes comply with the regulatory regime.
- Employer responsibility. An employer will usually have greater responsibility under a DB than a DC scheme, both under statute and under the rules of the scheme.
- Company accounts. Employers providing DC schemes have to reflect their annual contribution to the scheme in their balance sheet. Under Financial Reporting Standard 17 (FRS 17) (www.practicallaw.com/5-204-1096), DB scheme employers must show their annual contribution to the scheme, plus any scheme deficit, in the balance sheet. This can have a dramatic impact on the company's balance sheet, affecting how potential investors view the employer.
- Pension Protection Fund. Following widespread concerns about members losing their pensions when DB schemes wound up underfunded, the government introduced a statutory insurance fund in 2005, the Pension Protection Fund (PPF) (www.practicallaw.com/7-205-4059). Members of DB schemes that wind up in deficit or whose employers become insolvent can receive compensation from the PPF. But DB employers have to pay substantial levies to the PPF to fund this compensation.
Identifying your pension scheme from its documents
The members' booklet will usually say whether the scheme is DB or DC. You should also be able to tell from the contribution rule and the benefit structure in the scheme's trust deed and rules if your scheme is DB or DC. The scheme's actuarial valuation (www.practicallaw.com/3-206-2061) and trustee report and accounts will also indicate this. Insurance companies providing personal pension schemes produce key features documents which should indicate whether the scheme is a GPP or a stakeholder pension scheme (although a stakeholder scheme can be an occupational pension scheme depending on whether it is set up under trust or contract and whether the employer contributes to it).
Personal pension plans are often overlooked as they are set up by the employee, with the employer agreeing to contribute. You should check the employee's contract of employment about this or consult payroll records.
The employer's staff handbook should also summarise the pension schemes on offer to employees.
Potential headaches: a checklist
- Check your scheme's status. Your scheme may be open or closed to new employees; existing members may not be able to accrue further benefits, or the scheme may be winding up. This will not always be clear from the deed and rules. You should check any amending deeds, member announcements and annual scheme returns submitted to the Regulator. The employer's liability to the scheme will be determined by the status of the scheme. For instance, employers of schemes that are winding up have to pay their share of the full deficit in the scheme calculated on a buyout (www.practicallaw.com/8-206-2068) basis, which can be considerable.
- Multi-employer schemes. Check how many employers participate in the scheme. There are complex rules regarding multi-employer schemes (www.practicallaw.com/3-206-1085), particularly if an employer stops contributing to a scheme as a result of a corporate reorganisation and an employer debt (www.practicallaw.com/0-206-2072) has crystallised.
- DB scheme funding and employer liability. The most recent actuarial valuation of the scheme and the schedule of contributions (www.practicallaw.com/1-206-2967) should tell you how much the employer has agreed to pay into the scheme. Check whether the scheme is in deficit and, if it is, whether a recovery plan (www.practicallaw.com/9-206-1964) is in place and how much the employer has agreed to pay under the plan. Also, check the company accounts for the impact of the employer's pension costs on the balance sheet.
- HMRC. Check if the scheme complies with HM Revenue & Customs (HMRC) (www.practicallaw.com/6-200-6399) requirements. Schemes must only make payments that are authorised by HMRC. Unauthorised payments (www.practicallaw.com/5-207-2097) attract significant tax charges.
- Commercial transactions and moral hazard. The Regulator's "moral hazard" (or "anti-avoidance") powers enable it to force participating employers and others to pay some or all of the employer debt, or to put in place financial support for a DB scheme. Employers need to be vigilant during commercial transactions to avoid the risk of the Regulator exercising its powers if it considers that the financial position of the scheme is threatened. Clearance is available before and after a transaction: effectively, the Regulator confirms that it will not exercise these powers.
- Pensions in the UK: overview (www.practicallaw.com/2-235-7983).
- Pensions for employment lawyers (www.practicallaw.com/0-200-2530).
- Multi-employer pension schemes (www.practicallaw.com/4-206-0962).
- Scheme-specific funding (www.practicallaw.com/7-203-0742).
- Statutory debt on the employer: overview (www.practicallaw.com/3-203-4898).
- Employer debts in multi-employer pension schemes (www.practicallaw.com/7-382-6288).
- Pensions Regulator: overview (www.practicallaw.com/3-203-0447).
- Pensions Regulator: anti-avoidance powers (www.practicallaw.com/2-205-4995).
- Pensions Regulator: clearance applications (www.practicallaw.com/2-205-5042).
- Pensions: asset purchases (www.practicallaw.com/1-107-3542).
- Pensions: share purchases (www.practicallaw.com/1-107-3759).