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Two liability management options we are seeing considered more and more frequently by Irish sponsoring employers of defined benefit schemes are pension increase exchange exercises (where members agree to forego an entitlement to increases on their pensions in the future in return for something now, for example, a higher starting flat pension) and transfer out exercises (where members agree to an enhanced transfer value in lieu of a future pension promise and transfer out of the scheme).

The rationale for these types of exercises is that liabilities are crystallised at the inducement date and risk of future adverse experience (for example, higher index-linked increases than estimated or adverse investment experience) are eliminated from the scheme.  An enhanced transfer value will usually be more than the statutory minimum funding standard but less than the equivalent of the cost of buying out the pension with a deferred annuity.  The funding position of the scheme and financial position and prospects of the sponsoring employer will drive this.  A key risk, of course, is that members do not fully understand what they are being asked to give up and seek to challenge the inducement exercise in the future.

Both of these exercises have been used for a number of years in the UK and, while there is no legislation which governs them, the UK National Association of Pension Funds (NAPF) has published a voluntary code of practice and the UK Pensions Regulator has published a set of guidelines.  In Ireland, as these exercises have only relatively recently begun to gain traction, there is no equivalent guidance and therefore there is an element of uncertainty around exactly what the risks might be in this area.

This note considers what, in our experience, are the five most common hazards associated with pension inducement exercises.

The First Hazard – Informed Consent

The key risk is that members do not understand what benefit they are giving up.  Employers and trustees should take care to ensure that it is clear to members that they are foregoing, for example, a pension which will increase annually for something which, though as a flat pension is more significant, is not inflation-proofed.  This should be by way of clear, realistic, worked written examples and perhaps access to a qualified pensions adviser who can explain the impact of the choice to the member.  Employers and trustees might also consider refusing to comply with an election for an inducement from a member unless that member confirms that they have taken advice from a qualified pensions adviser and fully understand the choice that they are making.

The Second Hazard – Clear Communication & Fair Process

Inducement exercises often include quite detailed guides for members explaining the inducement option they are being given and the scheme/employer’s rationale for offering the option.  This type of document could form part of an employee/former employee’s terms and conditions in respect of his pension and could be the type of document that an employee argues gives rise to an expectation or a contractual commitment as to what his pension will be.  For this reason, it is crucially important to ensure that the information in this document is clear and, where appropriate, consistent with scheme booklets and rules (in terms of describing a member’s current benefits).  In addition, it should not contain any language which suggests that, on accepting the inducement offered, a member is guaranteed a particular level or type of pension irrespective of, for example, scheme experience, Revenue rules, regulatory change or scheme amendments.

The Third Hazard – The Trustees Recognise the Choice

The inducement exercise will be of limited use unless the trustees of the scheme recognise and comply with an election made by a member.  The trustees should usually be kept on board and independently advised throughout an inducement exercise process and should be asked to make clear what they require in order to comply with an election by a member to accept an inducement.  For example, will trustees agree to pay a higher flat pension and not pay pension increases where a member elects this option?  If so, will they require additional funding to do this to be paid up-front or over a period?  Similarly, if the trustees control whether and how much transfer values should be paid, will they comply with an election for an enhanced transfer value and will they require, for example, proof of members having taken independent advice on their choice?

The Fourth Hazard – The Preservation Regime

Part III of the Pensions Act protects, broadly (and subject to satisfaction of a number of conditions), the benefits of members of occupational pension schemes who are no longer employed by a scheme employer.  The Act describes the protected benefit as a preserved benefit.  A preserved benefit would include any guaranteed pension increase entitlement a member may have earned on his accrued benefits prior to leaving the employer’s service.  Detailed consideration would need to be given to whether a particular member with a preserved benefit is limited or prohibited by the Pensions Act from giving up that benefit in the context of an inducement exercise.

The Fifth Hazard – The Scheme Documentation

The rules of the scheme should be checked out at an early stage to confirm that they permit an enhanced transfer value to be paid or a member to exchange pension increases for something else.  If an amendment needs to be made, agree it with the trustees and make it well in advance of announcing the inducement exercise to members.

This is an area which we expect will continue to gain traction in Ireland and, given the impact some of these exercises may have on scheme members and the complex nature of pensions, one where caution should be exercised.