UK Pensions Law Update – May 2023

Background

The RPS has 106 sections, each of which is individually ring-fenced from the others. Each section is governed by the pension trust deed as originally established by statute and by the individual section’s rules – in this case the “Atos Scheme Rules” under which Atos is the principal employer. Each section operates on the basis of ‘shared cost’ in that contributions are generally shared 60:40 between employers and active members. The judgment relates to Rule 21 of the Atos Scheme Rules, the deficit contribution rule.

Any person who was employed in the railways industry and was in the British Rail Pension Scheme before the passing of the Railways Act, has special status as a “Protected Person”. This Protected Person status essentially provides rights to continued accrual, and certain protections around funding those benefits – the latter being key to this case. These protections are contained in the Railway Pensions (Protection and Designation of Schemes) Order 1994 (the “Protection Order”), and the RPS’ Rules contain an overriding provision which requires them to be operated in such a way that they comply with the Protection Order.

Article 7 of the Protection Order requires that employer contributions in any section of an occupational pension scheme containing Protected Persons should be sufficient (in the opinion of the scheme actuary) to provide for accrued and future pension rights of Protected Persons.

The High Court was asked to determine various questions in relation to Rule 21 and the provisions of the Protection Order, where there is a funding shortfall in the Atos Section. The answers to the questions were required to enable the actuary to complete the outstanding 2016 and 2019 valuations of the Atos Section.

In broad terms, Rule 21 of the Atos Scheme Rules provides that:

• First: If an actuarial valuation shows a funding shortfall, the employer and the trustee have the opportunity to agree how to make good the shortfall.
• Second: If the employer and the trustee cannot agree, the shortfall is to be made good by increasing member and employer contributions subject to a cap of 130% of the employer’s normal long term funding rate (unless the employer agrees to a higher rate). The actuary is to “determine the rate and period over which the increased contributions” shall apply after consultation with various parties.
• Third: If there is still a shortfall after the increase in employer and member contributions, members’ future service benefits are reduced – with such reduction to be calculated on a reasonable basis as agreed between the trustee and employer. If the parties cannot reach agreement within a set period after the signing of the actuarial valuation, the actuary “shall determine the basis of reduction in Members’ benefits in respect of future service” and shall notify the trustee and employer of this “determination”.
• Fourth: Where there are no active members, employer contributions are to be increased “as determined by the Actuary”. The actuary “shall determine the rate and period over which the increased contributions shall apply”, after consulting relevant parties.

In essence, the question the Court had to determine was whether:

• the actuary’s role was simply to calculate a contribution increase (subject to the 130% cap) and future service benefit reduction under the Second and Third limbs; or if
• the actuary could conclude that the combination of member contribution increases and benefit reductions under the Second and Third limbs would lead to poor value for members – so that active members would likely opt out, the increased contributions would not be collected and the deficit would not actually be addressed. Was it therefore open to the actuary to determine to set a lower member contribution rate, leave it to the employer to fund the remaining deficit as required by the Protection Order and avoid the need to reduce future service benefits?

It was common ground that the Fourth limb did not apply whilst the Atos section still had active members.

Summary of case put forward by Atos

Atos argued that:

• The actuary did not have any discretion under the above provisions and that he was required to simply:
  • calculate increased contributions on a 60:40 split between employers and members up to the 130% cap; and
  • if required, then to calculate a reduction in benefits to make good the shortfall in full.

In other words, the role of the actuary is simply to carry out a straightforward mathematical calculation to increase contributions or reduce benefits to the fullest extent possible to remove the shortfall. The actuary does not have any true discretion.

• If the shortfall was not at this point made good in full (due to all members having opted out instead of paying increased contributions or having their benefits reduced), then the Fourth limb above comes into play. Until the Fourth limb comes into play, there was no duty on Atos to make good the entirety of the shortfall.
• Article 7 of the Protection Order, and its freestanding obligation on Atos to make good any shortfall, only applies when the Fourth limb comes into play (i.e. after there are no longer any active members).
• A Government consultation White Paper in 1993 had indicated that British Rail’s open defined benefit pension schemes are unlike “balance of cost” schemes, in which the employer effectively guarantees specified benefits whatever the cost. Instead the employer does not undertake to provide specific levels of benefits but does guarantee preserved benefits. According to Atos, this was relevant to the interpretation of Atos’ obligations under the RPS.

Summary of case put forward by the trustees of the RPS

The Trustee’s case was as follows:

• Article 7 of the Protection Order was there to impose a “balance of cost liability” on the employer. Rule 21 and Article 7 had to be read together.
• The Fourth limb, which Atos claimed would only kick in once there were no longer any active members, had only been introduced in 2006. So before 2006, Atos’ interpretation would have led to a completely unaddressed and enlarged black hole in relation to a Rule 21(1) shortfall, due to active members opting out of pensionable service to avoid increased contributions and reduced benefits.
• Reading Article 7 and Rule 21 together to produce a “balance of cost liability” on the employer delivers a solution in one valuation cycle. Under Atos’ interpretation, the Fourth limb would require a second valuation which would potentially take a number of years during which time the funding shortfall would worsen.
• The Protection Order would prevent the employer/trustee from frustrating the participation of Protected Persons by engineering the opt-out of active members.
• In relation to the point made by Atos about the White Paper in 1993, this consultation paper was very early on in the rail privatisation process and was subsequently overtaken. As such it had no relevance.

Judgment

The Court decided in favour of the Trustee and held that:

• The issues turned on the correct construction of the Atos Scheme Rules and the Protection Order. The correct approach to construction was set out in the case of Barnardo’s v Buckinghamshire County Council [2018] which established that a pension scheme’s rules should, wherever possible, be construed to give reasonable and practical effect to the scheme. In this case, this meant interpreting Rule 21(1) in a way that would actually allow the deficit to be addressed without undue delay.
• Atos’ interpretation that “determine” means no more than a calculation, would lead to a thoroughly uncommercial result which would not eliminate the shortfall. If scheme contributions were increased to c. 50% of pay and future service benefits reduced at the same time (likely to near zero) active members would simply opt out.
• The Court held that an actuarial “determination” gave the actuary broad discretion when setting member contributions – and could take account of factors such as member affordability, collectability and value for money.
• Article 7 steps in to provide protection to Protected Persons over and above that provided by the Atos Scheme Rules. Rule 21 did not in any way replace Article 7 – the two provisions operate together. As Atos did not set up separate sections for Protected Persons and non-protected members, the protection in Article 7 applies to all members.
• As Article 7 of the Protection Order imposes a balance of cost obligation on Atos, the Fourth limb above is not the “White Knight” that Atos suggests, but a provision of last resort. The Fourth limb only becomes relevant if there are no active members.

Comment

Many private sector pension schemes leave matters including contribution rates, actuarial factors and indeed even whether a pension scheme should be wound-up (triggering Section 75 Pensions Act 1995 insurance buy-out debts) to be “determined by the actuary”.

So whilst much of this judgment is specific to the RPS, the Court’s finding that actuaries have wide discretion when making such “determinations”, and that rules should be read purposively rather than mechanistically, is of general importance.

Background

From the vantage point of Carillion’s pension schemes and other external parties, Carillion’s precarious financial situation only began to emerge in July 2017. At that point, Carillion announced an unexpected provision of £845 million (i.e. the setting aside of funds for future expenses or losses), of which £375 million related to projects in Carillion Construction Services (“CSS”).

The £845 million provision was unexpected by market analysts and it effectively wiped out Carillion’s profits over the previous six years. Within three days of the announcement, Carillion’s share price had dropped by 70%. This, and a resulting multi-million pound outflow, put the group under extreme financial pressure, ultimately leading to insolvency.

The Financial Conduct Authority (“FCA”) concluded in 2022 that in the years leading up to the insolvency, Carillion had recklessly published misleading financial information, specifically in relation to announcements made on 7 December 2016, 1 March 2017 and 3 May 2017. Those statements gave no indication to the market that a provision of the magnitude announced in July 2017 would be necessary. According to the FCA, the announcements did not disclose the true financial position of Carillion and instead made positive statements about Carillion’s financial performance generally and in relation to the CSS business in particular. They failed to disclose significant deteriorations in the expected performance of various CSS projects and did not take account of warning signs that indicated anticipated losses and reduced profitability across a number of major projects.

In the years leading up to its insolvency, Carillion was paying out more in dividends to shareholders than it generated in cash from its operations. Its borrowings also increased substantially to c. £1 billion by the time of insolvency.

TPR’s Moral Hazard Powers

Two of the statutory objectives of TPR are to: (1) protect the benefits of members of work-based pension schemes and (2) reduce the risk of situations arising that may lead to claims for compensation by pensions scheme members from the Pension Protection Fund (“PPF”). In broad terms, the PPF pays compensation to members of an underfunded scheme, where the scheme’s employer becomes insolvent and the scheme is underfunded below a minimum level.

To achieve these twin objectives, TPR has “moral hazard” powers to ensure that entities do not avoid their pension liabilities or fail to support them in a meaningful way. These include the ability to issue a Contribution Notice (“CN”) or a Financial Support Direction (“FSD”). A CN requires the recipient target to pay a specified sum to a pension scheme where the target has been a party to a relevant act or deliberate failure to act, and TPR considers it reasonable to impose liability. An FSD is a direction from TPR reasonably requiring the recipient target to provide ‘financial support’ to a pension scheme, in a situation where (in broad terms) the target is financially strong and the pension scheme employer is financially weak.

As the events in question took place before TPR’s new powers introduced by the Pension Schemes Act 2021, TPR considered the two pre-existing powers for the issue of a CN. In broad terms, these are whether: (1) the main purpose of any act or any failure to act by Carillion or a connected/associated party was the avoidance of debts owed to the pension schemes; or (2) the act or failure to act was materially detrimental to the likelihood of accrued pension scheme benefits being received.

TPR concluded that:

• The misleading financial information from Carillion, and the resultant dividend payments, did not amount to grounds for a ‘material detriment’ CN. If Carillion had not paid dividends in 2015 and 2016, that did not mean that additional payments would have been made to the pension schemes. Instead it was more likely that additional monies would have been used to pay down debt, given the more immediate risk of the debt to the group’s future.
• The pension schemes had acceptable deficit reduction plans in place before the July 2017 profit warning, and payments were made under these up until three months before insolvency. The fact that the group continued to trade despite its financial difficulties (funded by increasing debt and delaying payments to trade creditors) essentially meant that the pension schemes received more payments under the deficit reduction plans than they might otherwise have.
• Had Carillion’s true financial position been revealed earlier, it would likely have collapsed sooner and the pension scheme would not have received the aggregate contributions that they received in those years of £76 million.
• In relation to asset and business disposals made between 2013 to 2017, the proceeds were used to provide essential liquidity to the group and this enabled the group to continue to pay deficit repair contributions to the pension schemes. As such, there was no material detriment.

TPR also concluded that none of the main purposes of any of the events was to avoid debts to the pensions schemes. Finally in relation to a potential FSD, TPR concluded that there were no targets within the insolvent Carillion group capable of providing financial support.

Comment

Whilst TPR has concluded that the group’s pension schemes may not have been negatively affected by Carillion’s conduct, that is not the end of the story. The events leading up to Carillion’s insolvency have been the subject of investigation by various agencies in addition to TPR. That includes the FCA, the Financial Reporting Council (“FRC”) and The Insolvency Service (“INSS”). For example, the FCA has already published a statement censuring Carillion for contravention of the Market Abuse Regulations and Listing Rules under the Financial Service and Markets Act 2000. The INSS has also issued directors’ disqualification proceedings. In addition, the FRC has imposed sanctions against Carillion’s auditors, and the INSS (as liquidators) also recently reached a financial settlement with the auditors in respect of a £1.6 billion legal claim.

Abolition of the lifetime allowance (“LTA”) tax charge

The LTA was introduced in 2006 and is the maximum amount of tax-privileged pension savings that may be built up across an individual’s registered pension schemes. In broad terms, when benefits come into payment their value is tested against the LTA.

Up to 5 April 2023, any excess above the LTA was subject to an LTA tax charge. The LTA tax charge was 55% for lump sums paid in excess of the LTA and 25% for any excess paid as a pension.
Since 6 April 2023, the LTA charge no longer applies. Instead, any part of the following lump sums that would previously have been subject to a LTA charge will be subject to income tax at a person’s marginal rate:

• a lifetime allowance excess lump sum;
• a serious ill-health lump sum;
• a defined benefits lump sum death benefit; and
• an uncrystallised funds lump sum death benefit.

The changes to the LTA regime will be made when the Finance (No 2) Bill 2022/23 is enacted (i.e. after it has been debated and approved by each House of Parliament, and has received Royal Assent).

Pension Commencement Lump Sums (“PCLS”)

The maximum amount that most individuals could claim as a PCLS prior to 6 April 2023 was broadly the lower of: (a) 25% of the value of their benefits; or (b) 25% of their available LTA at the time the sum was taken. Since 6 April 2023 a PCLS upper monetary cap of £268,275 (25% of the current LTA) applies. However, those individuals who already have a protected right to take a higher PCLS will continue to be able to do so.

Members with enhanced protection or fixed protection are now able (since 6 April 2023) to accrue new pension benefits, join new arrangements or transfer without losing this protection. They will also keep their entitlement to a higher PCLS.

Increases to the Annual Allowance

Whilst the LTA charge is abolished, there still remains an annual limit on the amount of tax privileged pension savings that an individual may build up. This is the Annual Allowance. If there is an excess above the Annual Allowance, a tax charge arises. Higher earners are subject to a Tapered Annual Allowance.

The Annual Allowance has increased from £40,000 to £60,000 with effect from 6 April 2023. The minimum Tapered Annual Allowance has increased from £4,000 to £10,000. In addition, the adjusted income level required for the Tapered Annual Allowance to apply has increased from £240,000 to £260,000.

The Money Purchase Annual Allowance (“MPAA”) is a reduction to the Annual Allowance that applies to individuals who have flexibly accessed their money purchase pension savings (but still wish to build up more pension savings). The MPAA has increased from £4,000 to £10,000.

Comment

Given that the LTA framework remains in place for the moment (notwithstanding the LTA charge has been abolished), schemes will need to continue to operate lifetime allowance checks when making benefit payments and to issue benefit crystallisation event statements. Past LTA tax charges that were triggered before 6 April 2023 still need to be paid.

To the extent that employers have not already done so, cash in lieu schemes for higher earners will need adjustment to reflect the new higher tax allowances.

Looking further ahead, the Government has announced its intention to remove the LTA framework (as well as the LTA tax charge) entirely in future. It remains to be seen when and how this will be effected – particularly given the complexity of the amendments required and the Labour Opposition’s stated intent to reintroduce the LTA if it comes into government.

TPR statement: supporting defined contribution (“DC”) savers in the current economic climate

The statement sets out TPR’s expectation for trustees in respect of reviewing their governance and investment arrangements and communicating with savers. TPR notes that, even though DC schemes do not utilise leverage in their investment strategies, DC schemes are not immune to wider market events and some DC savers (particularly those close to retirement with a significant allocation to bonds) will have seen significant adverse impacts.

TPR expects trustees to review the statement and take appropriate action as part of their ongoing governance responsibilities and has provided a checklist to assist trustees with developing an action plan for ensuring that DC savers are adequately supported.

The Chief Executive of the FCA has written a letter in response to the Chair of the Work and Pensions Committee addressing the Bank of England’s Financial Stability Report recommendations on the resilience of LDI funds

The FCA Chief Executive, Nikhil Rathi noted (amongst other things) that:

• the FCA has worked closely with regulatory partners in the UK and in Europe to ensure LDI funds retain an appropriate level of resilience;
• schemes and asset managers have taken action to improve their readiness to deal with future stress events;
• the FCA expects asset managers to take any necessary or appropriate action including to ensure they operate in a way that does not pose risks to market integrity or financial stability;
• asset managers need to consider whether they are capable of communicating critical information at an individual client level in a timely manner; and
• all market participants should factor market conditions of the sort witnessed last Autumn into their risk management considerations, acknowledging a wider horizon of scenarios that might be considered extreme but which may nonetheless prove plausible.

The Industry and Regulators Committee of the House of Lords has made several recommendations to Government in relation to the use of LDI strategies by pension funds

This House of Lords Committee has recommended that:

• the Government and the UK Endorsement Board should review the system of pensions accounting to see whether a less volatile, longer-term asset-led approach would be more appropriate for schemes that still have some time left to run;
• the Government should review whether the use of leverage and derivatives by pension schemes should be more tightly controlled in the future. If schemes are to continue to use leveraged LDI, there should be far stricter limits and reporting on the amount of leverage allowed in LDI funds and greater liquidity buffers introduced for leveraged exposures;
• the Government should ensure that investment consultants are brought within the regulatory perimeter as a matter of urgency; and
• regulators should ensure that they have more information on the leverage present within pension scheme finances and that stress tests are conducted. The more bank-like strategies and instruments are used by pension schemes, the more bank-like its supervision should be; and the Government should consider giving the Prudential Regulation Authority a role in overseeing pension schemes. Meanwhile, TPR should be given a statutory duty or ministerial direction to consider the impacts of the pensions sector on the wider financial system. The Financial Policy Committee should continue to take the lead on systemic risks to financial stability and should be given the power to direct action by the regulators in the pensions sector if they fail to take sufficient action to address risks.

TPR has published LDI guidance aimed at ensuring schemes minimise risk

The guidance, which the PLSA Deputy Director has stated “is a helpful resource for pension schemes seeking to make use of liability-driven investment strategies”, sets out specific steps trustees should be taking when investing in LDI.

It focuses specifically on:

• where LDI fits within a scheme’s investment strategy;
• setting, operating and maintaining a collateral buffer;
• testing for resilience;
• making sure schemes have the right governance and operational processes in place; and
• monitoring LDI.

TPR acknowledges that LDI (including leveraged LDI) has a place in a well-managed scheme. LDI can help manage volatility in funding positions and support schemes on a journey plan towards self-sufficiency or buy-out. It is concerned, however, to ensure that the risks (in particular the liquidity risk arising from having to meet unexpected collateral calls) that arise from leveraged LDI in particular are better understood and controlled.

Comment

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

Amendments made by the Regulations include:

• excluding specified performance-based fees from the DC charge cap;
• in relation to default arrangements, requiring schemes to include an explanation of their policy in relation to investment in illiquid assets in their statement of investment principles (“SIP”) with effect from the earlier of the first time the SIP is revised after 1 October 2023 and 1 October 2024;
• requiring trustees to report on any specified performance-based fees incurred in relation to each default arrangement in the chair’s statement with effect from the first scheme year which ends after 6 April 2023 and on asset allocation from the first scheme year which ends after 1 October 2023; and
• providing that information in relation to performance-based fees and asset allocation must be made publicly available free of charge on a website.

Comment

The Government’s drive to encourage DC pension schemes to invest in illiquid assets continues. It hopes that excluding certain performance fees (which are applied by most illiquid investment managers) and adopting a “comply or explain” regime will encourage a far greater allocation to illiquids that will in turn benefit the UK economy.

A greater exposure to illiquids may produce better net-of-fees returns for DC pension savers over longer investment horizons. That said, DC pension scheme trustees will be keen to ensure that the greater liquidity and capital risks inherent in these types of investment are well managed.