Salary cap can control final salary pension costs

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– Capping final salary benefits is one of a number of de-risking measures employers can take to control their pension liabilities.
– Increases in pensionable pay may be restricted to anything from zero up to a maximum of 2% to 2.5%, regardless of an employee’s actual pay rises. This effectively decouples salaries from the related pension benefits being accrued.
– Reducing past service benefits will have a much greater impact on liabilities, but any change that adversely affects accrued benefits needs member consent.
– Given the complexity of final salary scheme rules and regulations, legal advice should be sought when a salary cap is used and members should be consulted over any changes.

A salary cap is one way to control final salary scheme costs, but legal advice will be needed, says Matthew Craig

Almost all employers running a final salary pension scheme want to find ways to limit its liabilities, given the pressures on funding.

One option is to use a salary cap to control costs. The design of final salary schemes means staff who have many years of service and retire on a high final salary can pick up a large pension, which is subsidised by early leavers and those on moderate benefits. Danny Vassiliades, a principal at Punter Southall, says: “It means the years when they paid low contributions on a low salary do not cover the costs of their actual benefits.”

Consequently, many final salary schemes will already have rules capping pensions at a maximum sum. But for hard-pressed employers, it may also be worth considering bringing in new limits in a bid to control liabilities. In this sense, capping final salary benefits is part of a toolkit of de-risking options for final salary schemes. Deborah Cooper, a partner at Mercer, says: “The strategy is usually adopted when existing staff still accrue on a defined benefit (DB) basis and new entrants have a defined contribution (DC) scheme. When some staff are accruing a DC benefit and some a DB benefit, it can create inequality in the workforce.”

There are a number of ways to deploy a salary cap, but the basic aim is to decouple an employee’s salary from the pension they are accumulating. For example, future increases in pensionable pay could be limited to a set percentage, usually between zero and 2% to 2.5%. But employers need to check what is allowed under a scheme’s trust deed and rules, and must also ensure they comply with pensions legislation, particularly section 67 of the Pensions Act 1995. Under this law, when scheme rules are amended, an actuarial certificate is required to show that the change does not have a detrimental effect on member benefits. If a section 67 certificate cannot be obtained, the trustees must obtain member consent for making the change.

Complex rules to follow

Cooper says: “Under the preservation rules, if [employees] leave a scheme, whatever they have accrued to date is preserved. If they leave a deferred pension behind, it has to be revalued at the limited price indexation [LPI] rate. The rules are complex, so the cap on indexation has changed over time, but broadly they can leave a scheme and the benefit will increase in line with LPI.”

LPI is often used as a cap for future salary growth and because of the preservation rules, employers might say what has been accrued to date will underpin a member’s benefits in the future.

Any employer contemplating introducing a cap on final salary benefits will need to take legal advice. When past benefits are affected, employers will need to consult members and get their consent, but in the current climate, members may understand such changes are necessary and preferable to more drastic cost-cutting, such as a redundancy programme. Changing past benefits will have a significant impact on liabilities, whereas a change that affects only future liabilities will have a smaller impact, particularly if salary increases are already limited.

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