Closing defined benefit schemes to future accrual

Employers that want to close their defined benefit pension schemes to future accruals have a number of hurdles to clear, says Nicola Sullivan

According to the Pensions provision in turbulent times survey of more than 160 trustee and company representatives published by Watson Wyatt in January, more than a quarter of DB schemes that have already closed to new entrants are likely to cease future accruals within three years. The 2008 version of the survey, meanwhile, showed that as many as 15% of DB schemes were expected to cease future accruals by 2010 and this figure is expected to reach 40% in 10 years’ time.

Paul McGlone, principal and actuary at Aon Consulting, says: “Many businesses now find themselves in the best position to make such a significant change to their pension scheme. They may have wanted to make this change for some time and the recession gives them the excuse they have been looking for.”

Actuarial scheme evaluations of DB plans are presenting sobering findings for many organisations, reinforcing the need for swift action to reduce rocketing liabilities. But closing schemes to future accrual is a complex and time-consuming process that can take a year or more to complete.

If the actuarial evaluation shows that a scheme is not meeting its statutory funding objectives, its trustees are required put a recovery plan in place showing how this will be met and over what period. Such a plan, which must be agreed by both the employer and trustees, will detail measures to be taken to make up funding shortfalls, including those relating to ceasing future accruals. Once the recovery plan is finalised, a copy must be sent to the Pensions Regulator.

But relationships between employers and trustees can be litigious, making it difficult to reach an agreement about future accruals. To build a strong case for halting accruals, employers first need to identify any restrictions relating to pensions provision in their contracts of employment or pension scheme rules. Robin Simmons, a partner at law firm Sacker and Partners, explains: “Some amendment powers can be trussed in a way that might prevent trustees being able to agree to stop future accruals or to even prevent them agreeing to close the scheme to active members.”

In some cases, employers might be able to make changes to employees’ terms and conditions so that no employee remains an active member of the pension scheme, says Simmons. But employers should take care not to be perceived as offering staff financial incentives to opt out of a DB pension scheme because the organisation could be accused of inducement by an employment tribunal. Employers must also be careful that any move to cease future accruals does not trigger a full wind-up of the scheme.

“Some pension scheme rules will say that if there are no active members, the whole scheme goes into wind-up,” says Simmons. “That triggers the biggest way of calculating a debt on the employer, which could get stuck with, say, a £100m liability just by stopping future accrual.”

Employers have a legal obligation to pay members’ accrued benefits up until the date future accrual is stopped. They must also find the money to plug any deficit that has accumulated up to that point.

When a scheme closes, all remaining members become deferred pensioners of the DB scheme and their entitlements are, typically, linked to increases in price inflation. But Clive Grimley, a partner at Barnett Waddingham, says employers that do not break the link between pension accruals and salary increases will have to pay the accrued pension benefits based on the member’s final salary, which might have increased significantly since accruals were stopped.

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Employee consultation

When communicating the change, they should be frank and open with their staff, says Grimley. There are ways employers can sweeten the pill for existing members of a DB pension, for example by introducing higher employer contributions for longer-serving staff. “An employer might say ‘I don’t want to lose all these valuable staff’, especially if they have been with the company longer and have certain skill sets. Commercially, employers don’t want to ignore people and sweeten the pot for current DB members with higher contributions [to a defined contribution plan.”

So employers looking to close their DB pension scheme to future accrual have a number of issues they must take into consideration before they can do so.