Discretionary pension increases - Issues for employers and trustees in practice

Pensions legislation requires a minimum level of inflation protection to be applied to pensions in payment. This is a minimum requirement only, and a scheme's own rules may give trustees, the employer, or a combination of both, discretion to grant increases above this. This may be limited to certain categories of members, or on certain tranches of pensionable service. For historic reasons many schemes include provisions which allow discretionary increases on benefits accrued before 1997 - legislation requiring minimum inflation protection for pensions was introduced from 1997 and so members with pre-1997 service receive no statutory pension increases in respect of that period of service.   

Discretionary pension increases may be a familiar area for trustees and employers whose schemes include such provisions. The current situation of inflation outpacing the minimum level of protection offered under legislation means, however, that there may be more pressure from members to grant increases than there has been in the past. In addition, the tension between the wishes of members to grant increases and any funding strain placed on the employer as a result of awarding discretionary increases, is likely to be particularly acute during a period where many employers are themselves experiencing the effects of inflation in other areas of their business.

Some key considerations for trustees and employers in relation to these issues are:

Stick to the rules

Not all schemes will allow discretionary pension increases to be granted. If you are not already familiar with what your scheme provides, you should check the Trust Deed and Rules. Pension increase provisions are notoriously complex, reflected by the large amount of cases in the area. We can assist in reviewing your rules.

The level of additional inflation protection, and who is covered by this, can vary significantly between schemes and, within the scheme, may have changed over time. Key points to understand where a scheme does include a discretionary increase rule are:

1. what does the discretionary increase rule cover? Are discretionary increases limited to particular tranches of service (for example, pre 1997) or certain categories of pensioner members? 
2. who is entitled to exercise any discretion? The trustees? The employer? The trustees subject to employer consent?
3. how is any discretion to be exercised? Does a particular process have to be followed? 

Relevant factors for trustees to take into account when exercising a discretion

The legal principle that trustees must take into account relevant factors and ignore irrelevant factors when exercising any discretion under a scheme should be a familiar one to trustees and applies when considering whether to exercise a power to award discretionary pension increases. 

Trustees must decide what the relevant or irrelevant factors are and determine the relative weight to give each relevant factor. It is perfectly possible for two trustee boards faced with the same facts to reach different conclusions about whether to grant an increase because they have weighted relevant factors differently. Some factors that might be relevant to trustees are:

1. Funding level: whilst it is not the case that a scheme must be fully funded before pension increases can be awarded, in our experience trustees generally tend to prioritise the funding level of the scheme (i.e., securing members accrued benefits) ahead of granting increases. If a scheme is in surplus it would be relevant for trustees to consider how the surplus arose. For example, in a case where a surplus had arisen through past overfunding by the employer, trustees might consider that it would be more appropriate to give the employer a contributions holiday than use the surplus to award increases (although trustees would not be bound to come to that conclusion). 
2. Covenant: the ability of the sponsoring employer to financially support the scheme is also likely to be a relevant factor, although the weight placed on this by trustees will vary depending on the circumstances of the scheme, particularly the funding level. For example, trustees may choose to give more weight to covenant strength when deciding whether to grant increases in a case where the scheme was not fully funded, than where the scheme was fully funded or in surplus. 
3. Employer's views: where trustees are exercising a discretion which is not subject to employer consent, the employer will not have a direct role in the decision to grant increases. An employer's views will, however, still typically be a relevant factor for trustees to take into account, given the employer's role in ensuring that the scheme continues to be appropriately funded. In this context, trustees will need to bear in mind that the courts have highlighted that trustees must be careful not to impose burdens which imperil the continuity and proper development of the employer's business and that the main purpose of the scheme is not served by putting an employer out of business. Even where employers do not have a formal role in the exercise of the discretion, it would therefore be usual for there to be a dialogue between the trustees and the employer prior to any decision being made and for trustees to consider any representations made by the employer carefully. 
4. Inflation experience and members' expectations (for example, have pensions increases typically been awarded in the past?)

A question which is often asked by trustees is whether they can treat different categories of members differently (for example, increase certain member's pensions and not others). Although trustees must treat members fairly, this does not mean treating all members equally, and, provided trustees have good reasons for adopting different approaches to different membership categories trustees can do this.

Scope for employers and members to challenge trustees' decisions

Where trustees have sole discretion to award pension increases, the bar for an employer or members to challenge the decision the decision is high. Unless it can be established that the trustees have taken into account irrelevant, improper or irrational factors, or unless their decision is one that no reasonable body of trustees could have reached the court will not interfere. It is not the court's role to say "would we have made the some decision as the trustees?"

In view of the above, challenges by employers and members would need to focus on flaws in the decision making process itself. It is therefore important that trustees follow a proper process in their decision making.

Considerations for employers to take into account when exercising a discretion (or deciding whether to give or withhold consent)

Where the employer has a formal role in the exercise of a discretion, for example its consent is required any increase, the employer is entitled to take into account their own commercial interests. Employers do, however, need to act within certain constraints.  

Employers should still, like trustees, take into account relevant factors and ignore irrelevant factors. For example, an employer might want to pay a cash bonus to current employees to help with hiring costs rather than increase benefits for former employees.

Other issues for trustees to consider

Impact of inflation - practical issues in relation to early retirement and CETVs

The rapidity with which inflation forecasts have been increasing is throwing up some issues for schemes, particularly in relation to the calculation of early retirement factors and statutory transfer values, both of which require inflation assumptions in order to calculate the member’s benefit entitlement. 

We expect most schemes will have regular review dates for both early retirement factors and CETVs. Typically, changes in inflation between these review dates will be minimal, but the current rapid changes in inflation may result in a material divergence between the scheme’s inflation assumptions and the current actual (and anticipated) level of inflation. Where this is the case, there is a risk that the trustees will not be able to satisfy the legal requirements for how early retirement benefits and CETVs should be valued, and so trustees should consider discussing with their actuarial and legal advisers if there are issues with meeting either their statutory obligations or requirements under the pension scheme rules.

Member communications

Trustees will need to consider how they are going to communicate with members about inflation, in particular if the scheme has discretionary increase provisions. Even schemes without such rules will need to ensure that they are ready to explain to members the level of pension increases they are entitled to.   

Communications with members seeking CETVs and early retirement will also need to be carefully considered.