A new statutory power for trustees to amend their scheme’s GMP revaluation rules has been introduced, in advance of the abolition of defined benefit contracting out from 6 April 2016. The DWP acted in response to industry concerns that a mismatch between the abolishing legislation and the provisions of many schemes’ GMP rules would lead to a requirement for schemes to provide a potentially costly underpin. Employers and trustees should act now to ensure their scheme is not affected.
Background
Final salary schemes that were contracted out prior to 1997 are obliged to provide members with guaranteed minimum pensions (GMPs) in respect of pre-1997 service. Under the preservation requirements, GMPs are revalued broadly in line with earnings until the member leaves service, at which point many schemes switch to providing fixed rate revaluation. The fixed rate varies depending on when the member left service and is currently 4.75%.
Revaluation issue arising from abolition
From 6 April 2016, all schemes will cease to be contracted out as a part of the overhaul of the state pensions system. Changes were made to legislation to ensure that the switch to fixed rate GMP revaluation won’t take effect until a member actually leaves service under his or her pension scheme.
However, many schemes’ rules require the switch to take effect when the member leaves “contracted-out employment,” rather than leaving service. Because all active members will cease to be in contracted-out employment on 6 April 2016, concerns were raised that this could lead to an underpin effect for schemes, as:
- The scheme rules would require fixed rate revaluation to apply for all active members from 6 April 2016.
- The new preservation laws for GMPs would require earnings-related revaluation to continue to apply for all active members until they actually leave service.
- Schemes could therefore be required to provide the best of both for the period between 6 April 2016 and the member leaving service.
This position is undesirable for employers, who would be required to meet any additional costs, and would also make it more difficult for trustees to administer GMP revaluation correctly.
Statutory modification power
The DWP recognised these concerns, and noted that some schemes contain restrictive amendment powers that might make it difficult to counteract the underpin effect under the scheme’s rules.
It has therefore introduced a statutory modification power, which will allow trustees to resolve to amend their scheme’s rules to mirror the new preservation requirements. This has been broadly welcomed by the industry as a straightforward solution to a complex and unintended consequence of the abolition of contracting out.
The power allows changes to be made retrospectively, but must be exercised before 6 April 2017.
Action required
If employers of contracted-out, defined benefit schemes wish to avoid the cost and complexity associated with operating an underpin for GMP revaluation, they should approach their scheme’s trustees as soon as possible and ask them to consider exercising the new statutory power to modify their rules.
From a trustee perspective, the intention behind most schemes’ GMP rules is to mirror the statutory requirements, so they may look favourably on any such proposal from an employer.