Current Issues June 2014

1. Current IssuesJune 2014 April 2012

2. Contents New Definition of Money Purchase Benefits (New) 3 Pension Act 2014 (New) 5 Abolition of DB Contracting-out (New) 7 Pension Protection Fund and Experian (New) 8 Draft IORP II Directive (New) 11 Budget 2014 Bulletin 12 Ceasing Accrual and the Employer’s Duty of Good Faith 19 Previous Topics 21

3. New Definition of Money Purchase Benefits (New) ● In March 2014 we reported on changes to the definition of money purchase benefits which would be introduced in Section 29 of the Pensions Act 2011. Section 29 was not yet in force but once in force would be retrospective to 1 January 1997. ● The definition of money purchase benefits as defined in the Pension Schemes Act 1993 is “benefits the rate or amount of which is calculated by reference to a payment or payments made by the member or by any other person in respect of the member and which are not average salary benefits”. ● The new definition, which the Government has now confirmed will come into force in July 2014, states that a benefit can only be a money purchase benefit if “its rate or amount is calculated solely by reference to assets which (because of the nature of the calculation) must necessarily suffice for the purpose of its provision to or in respect of the member”. ● The new definition means that certain benefits that had previously been treated as money purchase, will no longer be treated as such and will therefore be caught by the Defined Benefit scheme funding regime. These include: • Money purchase benefits with a final salary underpin, but only if the underpin bites. • Money purchase arrangements where retired members receive an internal annuity from the scheme. This would extend to AVC arrangements.

4. New Definition of Money Purchase Benefits (New) There was concern that as the change in definition is retrospective to 1 January 1997, a number of actions would need to be revisited including schemes that had wound up and paid any emerging section 75 debt. Mindful of this the Government had proposed transitional regulations that would ensure that decisions taken before 28 July 2011 would not have to be revisited . ● ● Following consultation, the Government has now finalised the transitional regulations and the good news is that schemes will not be required to revisit most of the decisions taken before the regulations come into force. ● However, there are two circumstanceswhere actionstaken between 1 January 1997 and the date Section 29 comes into force are affected. These are: • Schemes which are in wind-up and are underfunded and include benefits caught by the new money purchase definition. • Multi employer schemes where an employer has exited and an employer debt paid and the scheme included benefits caught by the new definition. ● In these circumstances a new valuation should be obtained and debt calculations revisited However, if the employer or employers in a multi-employer scheme are insolvent this requirement does not apply.

5. Pensions Act 2014 (New) ● On 14 May, the Pensions Act 2014 received Royal Assent. The Act brought in a number of key changes which are highlighted below: • Abolition of DB Scheme Contracting-out • With effect from 16 April 2016,the practice of contracting-out members of DB schemes will no longer be possible. This will result in an increase in both employer and employee NICs (3.4% and 1.4% of contracted-out earnings respectively). • The Act contains a power for employers to reduce accrual or increase employee contributions to offset their increased costs. Crucially, the exercise of this power does not require trustee consent. • State Pension Reforms • The State pension age will rise from 66 to 67 between 2026 and 2028 with further rises to be consideredunder periodic reviews, taking into account any changes to life expectancy. With effect from 6 April 2016, a new flat rate ‘single tier’ state pension will be introduced. This will be set above the basic level of ‘means tested support ‘ (currently £142.20 per week). • New Objective for the Pensions Regulator • The Pensions Regulator has a new statutory objective in relation to DB scheme funding. This is to minimise any impact on the sustainable growth of an employer.

6. Pensions Act 2014 (New) • Later this year the Regulator will publish it’s revised DB code of practice and funding policy that will incorporate the new objective into its regulatory approach. The Regulator has stated that it will encourage trustees and employers to work collaboratively to use the new flexibilities. • Enhanced Transfer Values • The Act includes an enabling provision to prohibit incentives being offered to members to transfer out. • Abolition of Short Service Refunds • Currently members of occupational DC schemes can take a refund of contributions they have paid to a scheme if they leave within two years of joining. The Act restricts the period to 30 days with this overriding provision expected to come into force in the near future. • Pot Follows Member • The Act has an enabling provision in respect of the automatic transfer of small DC pension pots to a new employers scheme. It is expected that ‘pots’ of up to £10,000 will be automatically transferred with members being given the option to opt-out. • Changes and Quality Standards in Workplace Pensions • The Government has already stated that with effect from April 2015, it intends to restrict the Annual Management Charge applying to default investment strategies used in qualifying DC schemes to 0.75%. The Act gives the Government the power to introduce this restriction and to introduce minimum governance and administration standards in workplace pensions.

7. Abolition of DB Contracting-out (New) ● With effect from April 2016, DB schemes will no longer be able to contract-out. The 2014 Pensions Act contains a power for employers to reduce accrual or increase employee contributions in order to offset its increased NICs. The overriding power may be used without trustees’ consent and will not be subject to the member consultation requirements. However, it can only be used if an actuary certifies that the change: • Does not result in employees’ contributions increasing by more than the employer’s NIC increases. • Does not reduce benefits by more than the increase in employer’s NIC increases. ● The DWP is consulting on two sets of draft regulations including how specifically the actuary should calculate and certify the value of the proposed amendments. ● The draft regulations provide that the calculation date can be chosen by the employer at any date after 31 December 2011 and should be based on the statement of funding principles in place at the calculation date. ● The consultation runs until 2 July with regulations expected to be finalised in the Autumn.

8. Pension Protection Fund (PPF) and Experian (New) ● On 29 May 2014, the PPF launched a consultation on its levy rules for the three year period from 2015/16 to 2017/18. This included details of the new PPF specific model for assessing insolvency risk developed with Experian. ● The PPF contend that a specific rather than generic model is required to reflect the nature of the typical sponsor of a DB pension scheme rather than the average UK business. Experian have therefore adapted their standard Commercial Delphi service accordingly. The model has been subjected to the scrutiny of PWC and an industry steering group including representatives from the NAPF, CBI, TUC and actuarial professions. ● The model is based largely on financial information which Experian will capture from a range of sources including Companies House and the Charity Concessions. ● PPF believe that the emphasis on financial variables will make the services more predictive compared to the previous D&B generic model which placed a significant weighting on non-financial variables.

9. Pension Protection Fund (PPF) and Experian (New) ● The PPF proposes the continuation of the 10 band system for insolvency risk with the bands designed to each cover around 10% of employers except that the top band will cover around 20% and the bottom two bands 5% each. It has also proposed consideration of 40% for the top band and a reduction in the total number of bands to 8. this is in recognition of the low number of actual insolvency events amongst the lower risk companies and the limited statistical evidence upon which to distinguish these risks. ● The impact analysis shows that there will be a large redistribution of the levy across the PPF universe, primarily as a result of ranking changes. The analysis indicates: • Employers who remain in Band 1 will generally see their levy fall. • There will be a material shift in the ranking of some employers and a material change in the levy. ● In order for employers to understand the new scores generated by Experian and to check the data and challenge where appropriate, the PPF have also launched a web-based portal which will display scores and the information used to calculate a score.

10. Pension Protection Fund (PPF) and Experian (New) ● The portal is initially available to trustees who will be provided with log-on details from 29 May. Once logged on trustees will be able to see ‘Pension Protection Scores’ for the last 12 months and will be able to monitor future monthly scores. Trustees will be able to provide access to advisers through the portal. ● It should be noted that only scores from 31 October 2014 will be used in the 2015/16 levy calculations. This is to provide ample opportunity to challenge the basis on which scores have been calculated.

11. Draft IORP II Directive (New) ● In June 2013, we reported on the European Commission’s proposals to update the directive on Institutions for Occupational Retirement Provisions (IORP) with stricter solvency requirements for DB schemes. ● After intense lobbying the Commission decided not to implement these and turned its focus to improving the transparency and governance of schemes in the European Union. ● In March 2014, it proposed revisions to the IORP Directive which require schemes to have “an effective system of governance which provides for sound and prudent management of their activities”. There is also a focus on risk management and internal controls and to provide better information to members including a standard annual benefit statement. ● In some ways the proposals may be seen to mirror some of the governance requirements of the Pensions Regulator and may therefore not be too much concern to trustees. However, the proposals also introduce a ‘fit and proper’ test for trustees and a requirement that they should have professional qualifications, knowledge and experience in order to carry out their key functions. If accepted by the European Parliament it is expected that the Directive will have to be implemented by member states in 2017. ●

12. Budget 2014 Bulletin ● The 2014 budget introduced a number of far reaching changes for pension schemes. Some of the changes take effect from 27 March 2014 and some are subject to consultation which ends on 11 June 2014. Changes with Immediate Effect ● The changes that take effect from 27 March 2014 are as follows: • Trivial commutation limits are increased from £18,000 to £30,000 in total. • Small pots commutation is increased from £2,000 to £10,000 per pot with the number of pots that can be commuted , increased from two to three. • Flexible drawdown is available subject to a minimum income requirement of £12,000 p.a. reduced from the previous requirement of £20,000 p.a.. • Capped drawdown maximum income ,increases from 120% to 150% of the GAD rate. Trivial Commutation and small pots ● It should be noted that trivial commutation is only possible if an individual has total pension savings of no more than £30,000 and has attained age 60. The same age restriction applies to taking small pots.

13. Budget 2014 Bulletin ● Whilst the Government’s intention is to introduce these new limits, legislation is not yet in force to permit them. In this regard the Finance Bill is expected to receive Royal Assent in July 2014. Until then scheme rules take precedence and as such schemes wishing to take advantage of the impending legislation should consult with their legal advisers regarding any possible rule amendments. Changes Subject to Consultation ● The changes that are subject to consultation include: • Greater flexibility in how members can access their DC pension pots • A guidance guarantee for members at the point of retirement • Potential restrictions in DB to DC scheme transfers • Different taxation of death benefits • A proposed change to the minimum pension age Greater flexibility in how members can access their DC pension pots ● From April 2015 it is proposed that individuals will be able to access their DC pension pots without the requirement to purchase an annuity. From age 55 an individual could choose to take their entire pot in one go with the first 25% being tax free and the remainder taxed at the their marginal rate of tax. Alternatively, the individual could leave their pension pot invested and drawdown funds on an annual basis. This effectively is a form of flexible drawdown without the minimum income requirement.

14. Budget 2014 Bulletin ● The Government’s consultation document “Freedom and Choice in Pensions” sets out a number of sample case studies explaining how the new system would affect individuals. This is replicated below: Sample case studies How the new system will affect you will depend on your individual circumstances and whether you have an income from other sources. However, the case studies below seek to demonstrate how you might be affected by this change in the tax system. These are stylised examples intended to demonstrate the tax implications. The amount of tax deducted from pension payments under PAYE will need to be reconciled by HMRC at the end of the tax year to ensure that the individual has paid the correct marginal rate of tax on all their income including any pension savings. Where the correct rate of tax has not been deducted the individual will receive a repayment of overpaid tax or will have to pay any additional tax due. Case A Ms A is 57 and has a salary of £45,000 per year from her employer. She has a defined contribution pension pot of £100,000. She chooses to cease contributing to her pension - takes her 25% tax-free lump sum (£25,000) and invests the remaining £75,000. At age 66 she retires and chooses to use her pot (which has now grown to £80,000) to purchase an annuity. She will therefore receive £5,200 per year on top of her State Pension of £7,500. This means that she would be liable for the basic rate of income tax on £2,700 (based on a personal allowance of £10,000).

15. Budget 2014 Bulletin Case B Mr C is 68 and has an income of £7,500 per year from his State Pension. He has a defined contribution pot of £40,000. He takes a tax-free lump sum of £10,000, and chooses to invest the rest through a drawdown product. He takes £2,000 from his drawdown fund each year. This keeps him below the personal allowance. He therefore pays no tax on his income. Case C Mrs C is 62 and has no other income, but does have a £20,000 defined contribution pension pot. She withdraws all £20,000 in one year and places £15,000 of this in her ISA. When withdrawing the £20,000 from her pension fund, she receives 25% (£5,000) tax free and pays no tax up to her personal allowance of £10,000. She therefore pays 20% tax on the remaining £5,000. Case D Mr D is 66 and has an income of £7,500 per year from his State Pension. He has a defined contribution pot of £100,000 and decides to take £55,000 from his pension pot, which includes his 25% tax-free lump sum (£25,000), to pay off his mortgage. Of the £30,000 above the lump sum, £2,500 will be taxed at 0% as, together with his State Pension, it falls within his £10,000 personal allowance. The remaining £27,500 would then be taxed at 20%. In year 2, Mr D takes the full £45,000 left in his pension pot. Assuming the tax thresholds remain unchanged in year 2, the first £2,500 and his State Pension will be taxed at 0%, the next £31,865 will be taxed at 20% and the final £10,635 will be taxed at the higher rate of 40%.

16. Budget 2014 Bulletin Guidance Guarantee ● The government recognises that in expanding the range of choices available (which will of course still include the option to buy an annuity), consumers will need help in making good decisions which suit their own needs and requirements. ● Under the new system the government proposes a guarantee that all individuals with a DC pension will be offered guidance at the point of retirement that: • is impartial and of consistently good quality • covers the individual’s range of options to help them make sound decisions and equip them to take action whether that is seeking further advice or purchasing a product. • is free to the consumer • is offered face to face ● From April 2015, pension providers and trust based schemes must offer DC members a “guidance guarantee” at the point of retirement. It is unclear how the cost of this “guidance guarantee” would be paid for but the government has set aside a development fund of £20m to get the initiative up and running.

17. Budget 2014 Bulletin Potential Restrictions in DB Scheme to DC Scheme Transfers As the legislation stands, members of DB schemes cannot take advantage of the new DC flexibilities unless they elected to transfer their benefits to a DC scheme. ● ● However,the Government intends to introduce legislation to remove the transfer option from a public service DB scheme to a DC scheme. The rationale is that as the majority of these public service schemes are unfunded, a glut of potential transferees seeking to take advantage of the new DC tax regime would expose the Exchequer to significantly higher costs than if members simply retire and receive an annual pension. ● The Government is also concerned that a large scale transfer of members from private DB schemes to DC arrangements could have a detrimental impact on the wider economy, given that DB schemes are major investors in long term UK assets. ● The Government is therefore consulting on a number of options including legislating to remove the right of all members of DB schemes to transfer to a DC scheme, except in exceptional circumstances.

18. Budget 2014 Bulletin Different Taxation of Death Benefits ● Under current drawdown rules, residual DC pension funds are taxed at 55%. The government believes that the tax rules that apply to pensioners on death need to be reviewed to ensure that they are appropriate under the new system. Proposed Change to the Minimum Pension Age The government has proposed an increase to the minimum age at which benefits can be accessed. The proposal is to change this to age 57, effective from 2028. ●

19. Ceasing Accrual and the Employer’s Duty of Good Faith Over the last few years numerous Defined Benefit (DB) schemes have closed to future accrual. Invariably trustees have been asked to consent to closure subject to the results of an employer consultation process with affected members. ● ● The High Court, in the case of IBM v Dalgleish has held that IBM breached its duty of good faith to members of its DB scheme when the scheme closed to future accrual. ● Under the closure project, members were asked to agree to future pay increases not being pensionable or alternatively not to receive a pay increase. They were also asked to agree to the removal of enhanced early retirements where previously IBM consent was required. ● Employers have a duty of good faith to pension scheme members and beneficiaries. In deciding whether an employer has breached this duty, the employer would have to be judged to be acting irrationally and perversely compared to the action a reasonable employer may have taken in a similar set of circumstances. Employers also have an implied contractual duty of trust and confidence to their employees. ●

20. Ceasing Accrual and the Employer’s Duty of Good Faith The judge concluded that IBM breached both the duty of good faith and contractual duty in giving members the choice of either agreeing that pay increases would not be pensionable or not receiving future pay increases. It has also breached its contractual duty in the manner that the consultation process was conducted as this was neither open or transparent. ● In deciding whether the duty of good faith had been breeched, the judge considered what “reasonable expectation” a member could have regarding the pension benefits provided. This required an investigation of previous communications that IBM had issued to members and the extent to which members would have made decisions about their pensions in light of these communications. The judge held that the communication had created a reasonable expectation of continued accrual and enhanced early retirement benefits. ● ● Whilst IBM are appealing the High Court’s decision, the implications are significant and employer’s considering similar exercises should examine what sort of reasonable expectations members may have, based on previous communications and ensure that the consultation process is carried out properly.

21. Previous Topics in 2014 We detail below topics covered in our previous 2014 Current Issues.

22. Previous Topics in 2014 We detail below topics covered in our previous 2014 Current Issues.