UK Pensions Law Update – February 2023

General Background to Rectification

An order of rectification by a Court will amend a written instrument with retrospective effect to reflect the intention of the relevant parties – putting them in the position they would have been in had the mistake contained in the document not been made.

A court may grant rectification if: (a) there is a mistake in a deed or agreement such that the document does not accurately express the intention of the parties; and (b) the mistake cannot easily be corrected by other means. The inability to correct by other means normally applies to pension deeds where the mistake has ostensibly created accrued rights for affected members which cannot be removed by amendment. This is due to Section 67 of the Pensions Act 1995 and likely amendment-power-fetters within pension deeds, that prevent amendments that detrimentally affect accrued rights.

The parties must show that, on the balance of probabilities, the relevant document does not reflect their intentions at the time they signed it. However, there must be convincing proof to demonstrate that the written instrument is not an accurate reflection of the true intention of the parties. There must be evidence that each party to the document had the same intention as to the meaning or effect that was to be captured in the document (but has not been so captured).

Where a conventional contract is concerned, there must be an outward expression of accord as to this common intention. That is, in broad terms there must be evidence outside of the written document showing that the parties expressed to each other their common intention. However, in the case of rectification of pension deeds, that outward expression of accord is not required, and it is sufficient if the subjective intention of the trustees and the employer coincide so that the evidence shows they both independently have the same intention.

The above principles have been established in a series of cases, among them: Mitchells & Butlers Pensions Limited v Mitchells & Butlers Plc [2021] (the “Mitchells & Butlers Judgment”)

The Viavi case

The most recent High Court Judgment dealing with pension scheme document rectification is Viavi Solutions UK Ltd v Viavi Solutions Pension Trustee UK Ltd (the “Viavi case”).

The application for rectification in the Viavi case was made pursuant to rule 24.2 of the Civil Procedure Rules 1998/3132. This is a procedural rule that allows an applicant to avoid the costly process of a full, often multi-day, hearing. Instead, the Court will deliver a summary judgment following a hearing where the Court considers the available evidence (including written and oral submissions).

The claimant in the Viavi case was the principal employer of the Wandel & Goltermann Retirement Benefits Scheme (the “Scheme”). Along with the trustee of the Scheme, the principal employer had executed a new set of rules (the “New Rules”), which was dated 15 September 1999, although it was not finally executed until February 2000.

Up to the execution of the New Rules, the Scheme had only provided for discretionary increases to pensions in payment (supplemented by any statutory requirement to increase pensions). However, the New Rules introduced minimum pension increases of 3% per annum compound for pensions accrued both from and before 6 April 1997.

Deputy Master Marsh, who delivered the summary judgment, considered and commented on the relevant evidence as follows:

• There was no record of any instructions to the lawyer who drafted the New Rules that there should be an increase to any Scheme benefits. His instructions were to update the rules including for the purpose of reflecting statutory requirements, and those statutory requirements would not have necessitated the introduction of minimum 3% increases.
• The lawyer was unable to explain why the minimum pension increases had been incorporated within the rules and surmised that he may have taken the wording from a precedent document.
• Written evidence from a director of the principal employer was that the lawyer’s instructions were merely to update the Scheme rules, not to introduce further changes.
• Events post-dating the execution of the New Rules (which were considered to be of “great importance” by Deputy Master Marsh) provided cogent and convincing evidence that there was an error in the New Rules. An email and trustee meeting minutes from March and April 2000 both indicated that the New Rules had been incorrectly drafted.
• Since the execution of the New Rules, the Scheme had been operated and funded on the basis that the 3% minimum pension increases did not apply.

Drawing on the established principles of rectification set out in the Mitchells & Butlers Judgment, Deputy Master Marsh highlighted three points which were of particular pertinence to the Viavi case as follows:

• A claim for rectification must be established on the basis of “convincing proof”.
• There will be cases in a pensions context where the parties have not communicated to each other about the changes in question. The absence of any discussion of a change may itself be evidence that the parties did not intend it.
• The Court may have regard to events after the transaction as evidence of the parties’ intention at the time of the transaction.

Having considered the evidence and the established rectification principles, Deputy Master Marsh made an order for the rectification of the Scheme to remove the pension increase mistake.

Comment

Courts are reticent to replace the words on the page of a legal agreement without compelling evidence that there was a clear mistake – and that all parties to the document did not intend for the relevant term to be included. There needs to be sufficient evidence that something has clearly gone wrong in the drafting, and obtaining such evidence about parties’ intentions after what is often decades can be challenging.

There is, however, a helpful trend in recent cases for Courts to accept such evidence, where available, and grant rectification orders in (far less costly) summary judgment proceedings rather than requiring the parties to proceed to a full hearing.

The PO had rejected a claim by Mr Andrew against Exeter NHS Foundation Trust (the “Trust”) arising from the circumstances of his ill-health early retirement.

Having developed significant ill-health problems in 2017, Mr Andrew requested an estimate of his pension entitlements. The Trust provided an estimate which significantly overstated his entitlements. In the case of his pension, the estimate was an annual figure of c. £6,000 per annum where in fact his entitlement was to a pension of c. £3,800 per annum.

Mr Andrew claimed that he applied for ill health early retirement in the expectation of the c.£6,000 annual pension - which he stated was just about sufficient for his needs.

Mr Andrew was granted ill-health retirement, but the Trust discovered the calculation error and put a significantly lower pension into payment. Mr Andrew therefore complained to the PO and sought compensation for financial and non-financial loss. He alleged that had he known he would only receive c.£3,800 a year he would have either (i) continued in his previous role or (ii) sought to be redeployed to a part-time role before returning to full-time employment if possible.

Whilst the PO found that Mr Andrew did not “have a sophisticated understanding of pensions and was reassured by the Trust that the [ill-health retirement] estimate was correct”, the PO concluded that the claim for financial loss failed. The PO found that due to his ill-health Mr Andrew would have had to retire anyway regardless of the incorrect benefit entitlement estimate (i.e. reliance on the incorrect information had not caused him to retire on ill-health, but rather his actual ill-health had caused him to retire).

In relation to redeployment the PO concluded that Mr Andrew was still able to apply competitively for another part-time job within the NHS even after his retirement, so there was no loss.

Before reaching his decision, Mr Justice Zacaroli set out the statutory framework that is applicable to the PO and any appeal applications. Under that framework there is no right of appeal against the PO’s findings of fact. The only question on appeal is whether the PO made an error of law. However a self-misdirection on the facts by the PO is capable of giving rise to an error of law. Such a misdirection would include taking into account matters that are irrelevant or failing to take into account all matters that are relevant. A decision of the PO can also be overturned if it is perverse.

Mr Justice Zacaroli then went on to find as follows:

• The PO had not failed to consider any relevant matter in reaching the decision regarding the absence of reliance by Mr Andrew.

• The conclusion that Mr Andrew would have retired anyway regardless of the incorrect benefit estimate was not perverse or without evidential foundation.
• However, the PO had not given any consideration to the possibility of Mr Andrew applying, consistent with the Trust’s duty under the Equality Act 2010 to make reasonable adjustments in the case of disability, to be redeployed to another role within the NHS. Mr Andrew would not necessarily have had to go through a competitive interview process to be redeployed, so the PO’s conclusion that Mr Andrew was still able to apply via competitive interview for another post was qualitatively different. The PO had erred in law.
• The case was remitted to the PO for reconsideration of the question of whether Mr Andrew suffered any financial loss – on the basis that, believing he was entitled to a higher pension, he had not sought redeployment to another role.

The draft DB Funding Code, once finalised, will provide guidance on how trustees can comply with new scheme funding and investment requirements. Those requirements are contained in relevant provisions (yet to come into force) of the Pensions Act 2004 (“PA04”), and regulations (currently in draft and also subject to separate consultation by the Department for Work and Pensions (“DWP”)). TPR’s ambition is for the legislation and DB Funding Code to be in force from 1 October 2023.

The new legislation follows on from the Government’s 2018 white paper (the “White Paper”) on protecting DB Pension Schemes. The White Paper referred to a perception that some trustees’ application of the triennial valuation process can result in them adopting a short term focus on the three years to the next valuation. The DB Funding Code intends to address that by requiring trustees and sponsoring employers to put in place a longer-term strategy.

We consider below some of the new requirements.

Funding and Investment Strategy

A key focus of the new legislation and the DB Funding Code is long-term planning. In this context, trustees will be required to determine a funding and investment strategy for ensuring that pensions and other benefits can be provided over the long term (the “Funding and Investment Strategy”). The Funding and Investment Strategy will also address the trustees’ long-term objective (“LTO”). The LTO might be to buy out benefits with an insurer or to run off the scheme (paying benefits from the scheme as they fall due).

The Funding and Investment Strategy must specify the funding level the trustees intend to have achieved, and the investments they intend to hold, by the time that the DB scheme reaches its “relevant date”. The relevant date must be no later than the scheme year in which the scheme reaches “Significant Maturity”.

If, for example, the LTO is to buy out benefits, the trustees will be intending that the scheme is funded to a higher level by the relevant date than, for example, if the intention is to run off the scheme. The funding level that the trustees intend the scheme to have reached by the point of Significant Maturity is called the “Long-Term Funding Target”.

Significant Maturity

The concept of Significant Maturity was the subject of detailed discussion under the first DB Funding Code consultation in March 2020. TPR considered four potential measures of DB scheme maturity including: (a) the duration of liabilities measured in years; and (b) the proportion of scheme assets (or liabilities) paid as benefits. The current draft DB Funding Code has settled on the ‘duration of liabilities measured in years’, as the appropriate measure. The draft DB Funding Code provides that the duration at which a DB scheme has reached significant maturity is 12 years.

As set out in TPR’s first consultation document, a duration of 14 years to 12 years is broadly equivalent to the point at which a scheme will be paying out 5% or 6% of its liabilities each year as benefits. If a scheme is underfunded at this point it may be susceptible to an “investment spiral risk”. This occurs where assets are depleting at a faster rate than liabilities, with investments and returns failing to bridge the gap. To avoid this risk, trustees must assume that the scheme will be invested in accordance with a “Low Dependency Investment Allocation” from the point of significant maturity.

Low Dependency Investment Allocation

The draft DB Funding Code indicates that a Low Dependency Investment Allocation is an investment strategy under which cash flow from investments broadly matches payments of benefits, and the value of the scheme assets relative to liabilities is highly resilient to short-term adverse changes in market conditions. However, TPR recognises that a Low Dependency Asset Allocation may potentially have a lower level of ‘matching’ assets, provided there is an alternative hedging strategy to manage interest rate and inflation risks for liabilities that are not covered by matching assets. Either way, the aim should be that by the Significant Maturity point, no further employer contributions are expected to be required to fund accrued rights under the scheme.

Trustees must also assume that the scheme assets will be invested from the point of Significant Maturity in assets that are sufficiently liquid to meet expected and unexpected cash flow requirements. The draft DB Funding Code is noteworthy for the extra guidance that is now provided on liquidity requirements in the aftermath of the LDI (liability driven investment) crisis – when the sudden rise in gilt yields following the Government’s mini-budget in September 2022 meant that many pension schemes had to meet large cash collateral calls relating to their LDI portfolios.

Long-Term Funding Target

Whilst trustees may be intending that the scheme is funded to a higher level (if, for example, they are targeting buy-out), the minimum Long Term Funding Target must be at least 100% funding on the low dependency funding basis (the “Low Dependency Funding Basis”). A Low Dependency Funding Basis must use actuarial assumptions that are set prudently such that trustees are satisfied that further employer contributions are not expected to be required. The draft DB Funding Code sets out guidance on the approaches that trustees are expected to take in setting a low dependency discount rate. These include a ‘risk-free +’ approach (e.g. gilt yields plus a margin) or a ‘dynamic discount rate’ approach (e.g. if the scheme has appropriate cash flow matching assets, a discount rate linked to the return on those assets adjusted for prudence).

Journey Plan

Trustees must have a journey plan (“Journey Plan”) in place for how they will reach the Long-Term Funding Target. The Journey Plan should address how the trustees will transition from their current investment strategy to one that meets the standards of a Low Dependency Investment Allocation. The transition will be dependent on the strength of the employer covenant (so that more risk can be taken if the covenant is strong), and will also depend on the level of maturity of the scheme.

Statement of Strategy

Trustees will be obliged to prepare a written statement of strategy (“Statement of Strategy”), which records the Funding and Investment Strategy (Part 1). It will also need to record other supplementary matters relating to the Journey Plan and how well the Funding and Investment Strategy is being implemented (Part 2). The trustees must consult the scheme employer when preparing or revising Part 2 of the statement of strategy.

Timings and deadlines

Trustees must determine the first Funding and Investment Strategy within 15 months of the effective date of the first valuation that follows the coming into force of the new legislation. The Funding and Investment Strategy must be reviewed and, if applicable, revised within 15 months of the effective date of each subsequent valuation. The Funding and Investment Strategy must be recorded in the Statement of Strategy and a copy must be sent to TPR with the relevant actuarial valuation.

Comment

It remains TPR’s ambition that the new DB Funding Code, and associated DWP regulations, will be in force in October this year. Much will, however, have to be done to achieve that – as the draft DB Funding Code and DWP Regulations do not quite align in a number of areas.

It is notable that TPR has moved away from the concept of setting out a “Fast Track” route to agreeing funding valuations within the DB Funding Code itself – which will give TPR greater flexibility to amend Fast Track without having to lay amendments to the DB Funding Code before Parliament.

TPR’s consultation on the DB Funding Code closes on 24 March 2023, and the next iteration of the DWP Regulations is likely to be published after that. We shall keep you updated on developments as the consultations progress.

Among the reforms which could touch on the pensions world are:

• The DWP, in conjunction with the Financial Conduct Authority (“FCA”) and TPR will consult on a new value for money framework for defined contribution schemes. It is anticipated that the consultation will be aimed at setting the required metrics and standards for all schemes in areas such as investment performance, costs and charges, and quality of service.

• Regulations which will remove well designed performance fees from the pensions regulatory charges cap (applicable to certain defined contribution funds) will be laid this year. The Government consulted on the draft Occupational Pension Schemes (Administration, Investment, Charges and Governance) (Amendment) Regulations 2023, last year.

• The Government will consult on new guidance for the Local Government Pension Scheme (“LGPS”) on asset pooling. The Government will also consult on requiring LGPS funds to ensure they are considering investment opportunities in illiquid assets (such as venture and growth capital) as part of a diversified investment strategy.

• The Government has published a consultation document setting out its plans to codify the existing UK VAT exemption for the management of special investment funds. In essence, the Government intends to replace the existing definition with a simplified rule allowing investment managers to determine whether they fall within the VAT exemption with greater certainty.

Comment

It is not immediately apparent that these reforms will constitute a radical departure from the status quo, but we can already tell that a lot of work lies ahead for everybody. We (and, in particular our funds colleagues) will be keeping a close eye on how the reforms unfold and what the potential impact on pension schemes could be.

The LDI Statement is a sequel to TPR’s statement in October 2022, which noted the extreme movements in gilt yields and the subsequent intervention in the gilts market in September 2022 by the Bank of England (“BOE”).

The LDI Statement emphasised the need for scheme trustees, with support from advisers, to test their liquidity buffer given the recent higher level of market volatility, and the need to ensure the scheme can post collateral when required.

Trustees should work with advisers to demonstrate the buffer the scheme has in place, and document their risk assessment in response to market volatility and where required prepare a step-by-step plan to improve scheme resilience. The LDI Statement also sets out steps for trustees to ensure that they can react quickly in response to the stressed market, which include ensuring that authorised signatories are up-to-date, and robust governance is in place.

As noted above, further guidance from TPR is included in the draft DB Funding Code. Separately, the Work and Pensions Committee of the House of Commons also launched an inquiry into the regulation and governance of DB schemes with LDI. The inquiry called for evidence on, among other things, whether TPR has taken the right approach in regulating the use of LDI, and had the right monitoring arrangements in place.

Comment

More guidance and statements from TPR on LDI can be expected. TPR also indicated its plan to provide a further update on LDI in its annual funding statement in April 2023.

Trustees should continue to monitor the impact of the changing market conditions on the investment portfolio and liquidity of the schemes, and ensure that they take steps to maintain resilience in LDI funds, where appropriate.