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This article first appeared in a slightly different form in Scheme Xpert, 23 August 2011

The UK's most senior judges have looked at the grey area between money purchase benefits and defined benefits.  In the case of Houldsworth v Bridge Trustees, the Supreme Court ruled that a pension scheme is still a money purchase scheme where some of its benefits have defined benefit characteristics. 

The court's ruling means that, although this kind of pension scheme can have a deficit, it is not covered by the key legislative protections for defined benefit schemes.  These protections include the scheme funding rules in the Pensions Act 2004 and the Pension Protection Fund.  The Department for Work and Pensions (DWP), which took part in the case, has said it is planning retrospective changes to the law to reverse the effect of the Supreme Court's decision.

So what do pension schemes need to do?

1.         Consider whether your scheme provides any of the benefits which were determined to be money purchase in the Houldsworth case 

            These were:

(a)        internal annuitieswhere a member’s money purchase "pot" is converted into a pension paid from the pension scheme, rather than buying an annuity from an insurer;

(b)        guaranteed investment returns – where a scheme provides guaranteed investment returns on the member's pot;

(c)        guaranteed minimum pension underpins – where benefits are the greater of what can be bought from the member's pot and the guaranteed minimum pension for contracting-out;

(d)       other defined benefit underpins – where benefits are the greater of what can be bought from the member's pot and a defined benefit pension.

2.         Consider what categorising these benefits as money purchase means for your scheme

Categorising these benefits as money purchase means that, even though a scheme can be underfunded, it may fall outside the scope of legal protections which are designed to reduce the risks associated with underfunding.  The list of protections that do not apply to schemes which only provide money purchase benefits includes:

(a)        the scheme funding legislation in the Pensions Act 2004.  The statutory framework for preparing a statement of funding principles, performing a valuation and preparing a schedule of contributions and deficit recovery plan does not apply to money purchase schemes.  Instead, the employer's funding obligations will be governed by the scheme's rules;

(b)        the employer debt legislation in s75 of the Pensions Act 1995.  The normal requirements for employers to make good all or part of the buy-out deficit on insolvency, winding up or ceasing to employ active members do not apply to money purchase schemes.  In theory this makes it easier for employers to walk away from underfunded schemes;

(c)        the Pension Protection Fund (PPF).  Money purchase schemes are not covered by the PPF and money purchase assets and liabilities are ignored when working out the PPF levy.  So members who are receiving a pension from a money purchase scheme would not be able to turn to the PPF for help if their scheme winds up in deficit.

In addition, the statutory winding up priority order in the Pensions Act 1995, which determines the liabilities that have first call on the assets of an underfunded scheme, does not apply to most money purchase assets and liabilities.  Instead, the scheme's rules will determine the treatment of benefits on winding up. 

3.         Watch what the Government does

It seems sensible to avoid any hasty response to the Supreme Court decision.  The DWP issued a press release on 27 July confirming that it plans to introduce retrospective legislation which would reverse the effect of the decision. 

The likely result of the planned legislation will be that benefits only count as money purchase to the extent that they are based on employer and member contributions and on investment returns.  If other steps are needed to calculate benefits, like applying annuity rates to work out a pension from the scheme, then the benefits will not be money purchase.  Schemes which can go into deficit will get the protections described in section 2 above.

4.         Consider changes to scheme design and practice

            If the DWP does introduce new legislation, schemes should consider changing the basis on which future benefits are earned so that those benefits are within any amended definition of "money purchase benefits".  For example, removing defined benefit underpins, and buying annuities from insurers rather than providing a pension from the scheme, could lead to savings in the PPF levy and avoid greater liability for the sponsoring employer under the employer debt legislation in s75 of the Pensions Act 1995.

Edward Jewitt, Pensions partner at Mayer Brown International LLP.