Discretionary increases to pensions in payment – the new black
24th May, 2022
Inflation is back: the April 2021 to April 2022 increase in RPI was 11.1%. So what? Well, it’s very likely that your investment consultant and your actuary will have been flagging the impacts from their perspectives, but what about the impact on the members, especially pensioners, now?
It’s fair to say that most scheme rules do not contain the infamous triple lock of the state pension, but what might your rules contain that you’d last worn in the ‘70s, had stuffed at the back of your wardrobe, and forgotten about during the long era of low inflation and trends for squeezing of rights? And if you do have options, what should you be considering before stepping out to your local disco?
Look out! There’s a Humphrey about
As we’ve discovered from the ever-growing body of cases on RPI/CPI, the way rules are written on pensions increases and (to a lesser extent) revaluation, can vary enormously. To me, there are two key things trustees should be looking out for:
- No cap: first, what if the rules just say benefits increase by RPI? Well, on one level there’s nothing you can do about this. But of course, the implications for the liabilities should be considered and, if material, some thought should be given to whether funding is still adequate. And it’s worth reminding yourself that there is an option to offset payments above statutory levels in one tax year against the next tax year’s statutory increase.
- A discretionary power. This is where it becomes interesting. Many schemes will contain a power for the trustees or the principal employer (or both of them by agreement) to increase pensions in payment by a higher amount than is expressly stated in the rules. Some of these powers might only apply where the inflation index used for the mandatory increase is higher than the cap. Others will be broader, but it would not be surprising if all of them had been forgotten. In a long era where inflation was low and deficits were high, it would probably not take long to rule out using the power for the average scheme.
Flares and Drainpipes
As with many pension scheme rules, these powers come in different forms. So the starting point is to analyse what the rule looks like:
- Who has the power?
- What are the requirements for using it?
- What process has to be followed?
- Do we need to take advice?
- To which members does it apply?
- What is the default position?
Mister big stuff
But which of these points are most likely to make a difference?
- The question of who has the power will be really significant, as the considerations the employer might give weight to might differ significantly from those of the trustees. The combination of the Prudential case, back in 2011, and the Court of Appeal in IBM means that it will rarely be possible to require an employer to grant a discretionary increase if it doesn’t want to. Where the trustees have the power, they will, of course, need to ensure they are not ‘adding the role of paymaster’ to their duties in administering the scheme – as the trustees in the BA case were found to have done. However, I would imagine that, provided trustees are sensible, exercising an existing power under the rules is unlikely to fall into that category – the discretion is already part of the benefit structure, and it would seem unlikely that the trustees could be accused of designing the benefit structure in exercising it. And equally, whilst it’s proper to take into account the employer’s interests, Key Med tells us they shouldn’t trump those of the members.
- The application to member groups can lead to significant disparity within the membership of a single scheme, particularly if the scheme has been patched together following corporate activity and, therefore, has different benefit structures for different groups of members. As a trustee of such a scheme, this can present challenges in terms of equity between different groups of members. However, it’s always worth remembering that there is no absolute requirement to treat different groups of members the same: particularly when the provisions that govern them are different. So, in essence, the trustees shouldn’t duck a decision on the basis that they can only benefit one group of members. That said, the impact on the remaining members who do not benefit from a decision to award greater increases is, of course, a relevant consideration.
How to decide
First of all, it’s best to address any conflicts. Whilst one could debate the point, it’s probably more comfortable for those who stand to benefit not to be involved. However, it’s equally, if not more important to ensure that nobody has a proper conflict with their fiduciary duties to the company.
It is an oft trotted out (and, whilst accurate, not terribly helpful) piece of legal advice that trustees, when making any discretionary decision, must take into account all relevant and no irrelevant factors. What is perhaps more helpful is to give some guidance as to what information the trustees need to arm themselves with to properly discharge their duties. Demonstrating a good audit trail is critical.
In these circumstances, I think some key pieces of information with which to arm yourselves might be as follows:
- Do the rules specify anything to take into account?
- How is the scheme’s funding level looking? In recent months, trustees might be pleasantly surprised at this.
- What impact might this decision have on relations with the employer on funding, and did the trustees give any assurance on the use of their discretionary powers at the last valuation?
- What covenant does the scheme enjoy? Is the employer able to bear any extra funding needed?
- What is the scheme’s journey plan to buy out? The shorter it is, the less you might want to add to liabilities at this stage.
- What impact might inflation be having on the membership and what might be the right measure of that impact? Given that discretionary powers are often fairly flexible, there are less likely to be constraints about the right measure.
- How generous has the increase provision been in the past? Is it likely that pensions will have more than kept pace with inflation?
- How would a decision to grant a discretionary increase impact on the funding level and the security of the remaining members? The class in line to benefit might be small or large – and the impact may, therefore, range from a rounding error to really material.
- How might a decision taken this year affect the members’ expectations in future years (this might, of course, be manageable)?
There may, of course, be other factors you can think of, but that’s my list.
Record for posterity
Once you’ve got all that and have had a good debate, you should be ready to decide and then, of course, the all-important recording (perhaps not on vinyl in this instance!) of the decision – both for your own benefit, for next year; and in case the members ask!