Pensions risk transfer: discretionary pension increases

What are discretionary increases?

The benefits that trustees of defined benefit pension schemes may pay to members can be divided into one of two categories: those that a member has earned and is or will be legally entitled to without any exercise of discretion, and those the member will only become legally entitled to payment if a discretion is validly exercised.

Increases to pensions in payment, which is a type of pension benefit, is a good example of how the two categories of pension benefits work.

Since 6 April 1997, most defined benefit occupational pension schemes have been required to increase pensions in payment by a minimum amount each year to protect against the effects of inflation. The rate depends on when the benefit was accrued. Broadly speaking, for service between 6 April 1997 and 5 April 2005, the rate of increase is the lesser of 5% or RPI/CPI. For service on and from 6 April 2005, the rate of increase is the lesser of 2.5% or RPI/CPI. The statutory increase rates are the minimum amounts a scheme must increase a pension in payment. The rules of the scheme might provide a guaranteed right to higher increases than the minimum required under statute.

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Inflation above the level of increases that are promised or guaranteed will eat away at the real value of members’ benefits. Therefore, scheme rules often contain a discretionary power for additional increases to be paid beyond a member’s legal entitlement, normally only with sponsor agreement. Even though exercising these powers is entirely discretionary, it is very important they are properly understood and considered by trustees.

Scheme rules to look out for

A scheme’s governing documents will usually allow discretionary increases to be granted by a number of different methods.

Some schemes’ governing documents say that pensions must be reviewed annually. Some provisions provide that there is a discretion to increase pensions where inflation is above a certain amount and a cap on guaranteed increases is hit. These provisions are likely to require the trustees to actively review the position and make a request to the sponsoring employer – but it will depend on exactly what the scheme rules say.

There may also be more neutral provisions like an augmentation power, which would allow the trustees and sponsor to agree to increase pensions in payment beyond guaranteed amounts, but this would not oblige the parties to actively consider it.

The way in which these provisions are framed in the scheme’s rules is important. The rules might provide that the trustees and/or employers “must” or “shall” consider granting discretionary increases. Where this language is used, the trustees are under a duty to consider granting discretionary increases. Alternatively, the rules could say “may” – so there would not be the same obligation – although arguably in times of high inflation, it may be appropriate for the trustees to be raising the issue with the sponsoring employer.

Duties when considering discretionary increases

There is an implied term in a pension scheme’s rules that operates to constrain the exercise by the employer of any power vested in it under the deed and rules. Following an important court case, this is often referred to as the “Imperial duty” – or the employer’s duty of good faith.

Although each case must be taken separately, the Imperial duty can operate to restrain the employer’s exercise of otherwise apparently unfettered powers. The test is one of “irrationality or perversity” – in other words, an employer will only breach the Imperial duty if their conduct is so bad that it is irrational or perverse. Another way to look at it is the employer cannot act in a way that no other reasonable employer would act.

Importantly, the employer is entitled to take into account and prefer its own economic interests to those of the members of the scheme. The employer must be able to point to reasonable considerations or factors in its decision-making process.

In the case of Prudential Staff Pensions Ltd v The Prudential Assurance Company Ltd and Others, the High Court in 2011 considered the employer’s duty of good faith in relation to the exercise of a discretionary power to grant pension increases.

The Prudential Staff Pension Scheme had a long history of paying discretionary increases broadly in line with RPI. In 2005, Prudential, the employer, decided that, in future, increases to pensions in payment would be in line with the increase in RPI, subject to a 2.5% cap. The core question for the court was whether the change in policy could be regarded as a breach of Prudential’s duty of good faith. The court did not find that Prudential had breached its obligation of good faith.

Relevant considerations

Relevant factors to consider when deciding whether to exercise a discretionary power include:

• what members’ reasonable expectations are – there may be a custom and practice to guide trustees in this regard;
• whether the scheme is targeting a buy-out funding level;
• whether there is an agreed policy or protocol;
• the funding position of the scheme and whether additional funding is required;
• the long-term funding strategy;
• the sponsor’s financial position;
• consistent treatment of pension scheme members and current employees;
• the gap between scheme increases and inflation.

Buy-out and discretionary increases

On buy-out, insurers will not provide discretionary increases and will only be prepared to insure guaranteed benefits. Trustees therefore need to have regard to the loss of any future discretionary increases on buy-out. Although relevant for schemes of all benefit types, this is especially important for schemes with no guaranteed increases to any pre-1997 benefits.

If the trustees want to secure increases to pension in payment beyond that which is guaranteed to be provided, this will need to be insured as further guaranteed increases with an additional premium to be paid. Unless there is a surplus and the sponsor agrees for it to be used in this way, the sponsor would need to provide additional funding. Therefore, as part of trustees’ decision to enter into a full buy-in and buy-out, one consideration amongst others will be the impact on discretionary increases.

The trustees’ primary legal obligation is to ensure the security of accrued benefits. The specifics of the scheme and sponsor covenant need to be considered. However, it will generally be right for trustees to prioritise the security of guaranteed benefits over the possibility of future discretionary increases.