PENSION SCHEME GOVERNANCE

The governance of pension schemes is extremely (and increasingly) complex. In this section we give a brief introduction to how pension schemes are governed, the tax regime, legislation/regulation and the various parties involved.

How Pension Schemes are Established

The two main ways of establishing tax-approved pension schemes in the UK are under trust and under contract.

Trust-based Schemes

Historically, most UK occupational pension schemes have been set up via trusts. Trusts are, in some ways, quite anachronistic, and the law governing them is mostly older case law. They are also notoriously difficult to define; however, one possible definition is that 'a trust is an equitable obligation binding a person (who is called a trustee) to deal with property over which he has control (which is called the trust property) for the benefit of persons (who are called the beneficiaries) of whom he may himself be one and any of whom may enforce the obligation' (Hewitt Bacon and Woodrow Pocket Book 2004, NTC).

However, trust law has, with a few exceptions, functioned well for many years. The reasons for using a trust are:

§  to ensure tax approval by the Inland Revenue;

§  to keep the scheme assets separate from those of the employer, thereby providing security;

§  to provide legal rights to beneficiaries who are not and have not been employees, such as partners and dependants.

Trust-based schemes are governed by a scheme trust deed and rules detailing benefit entitlements and the rights and responsibilities of the members, the sponsoring employer(s) and the trustees. It will also govern what is permissible under the scheme, including any powers of amendment.

Trustees may be individuals and/or the directors of a trustee company. They may or may not be members of the plan. A proportion must be member nominated and elected, with others typically nominated by the employer. Over the years, the importance role of the trustees has been emphasized at the expense of the sponsoring employer(s). For example, the trustees are now primarily responsible for investment strategy and appointing advisers.

The trust deed and rules and the trustees are an important consideration when considering change - there have been cases of employers taking strategic decisions on pensions that could not be delivered under the scheme rules or else required consent from the trustees.

Contract-based Schemes

Approved defined benefit schemes (at least in the private sector) are invariably set up as trusts. However, defined contribution schemes may be set up as trusts ('occupational money purchase schemes') or on the basis of a contract with an external provider, such as an insurance company. These contract-based schemes include group personal pension schemes, stakeholder schemes and retirement annuity contracts (now largely superseded).

Stakeholder schemes are a new, highly regulated, form of defined contribution schemes with very low provider charges. All employers with five or more employees must offer a stakeholder scheme unless they have another scheme with wide employee access and that meets certain criteria. There is no obligation on employers to contribute to a stakeholder arrangement.

The Pensions Tax Regime

In simple terms, the tax regime for approved UK pension schemes is as follows:

§  Employee contributions attract income tax relief.

§  Employer contributions are deductible for corporation tax purposes.

§  Employer contributions are not taxable as a benefit-in-kind.

§  Employer contributions are not subject to employer or employeeNICs.

§  Income and capital gains on scheme investments are not subject to tax (although schemes can no longer reclaim advanced corporation tax on equity dividends).

§  Pensions in payment (including those paid to dependants) are taxed as earned income and do not attract NICs.

§  A proportion of the pension may be taken in the form of a tax-free lump sum at retirement.

§  A tax-free lump sum may be paid to dependants on death in service.

Because of these tax privileges, there are restrictions on what may be provided from a tax-approved scheme. These are discussed below (see 'Executive pensions').

Pension Scheme Regulation

The UK pensions field has to operate within a bewildering framework of legislation, regulation and case law. The complexity partly reflects the fact that pension schemes have to deal not just with pension law but with trust law, employment law, tax and social security laws, financial services law and EU law. It also reflects frequent government-imposed changes, which may or may not be retrospective.

It should also be noted that the interaction between regulation and the pension scheme's own governing documents can be complex.

Interested Parties

One of the many complications of pension provision is the sheer variety of interested parties. In a final salary scheme, these will typically include most of the following:

§  the employee;

§  the employee's dependants;

§  the sponsoring employer(s);

§  the employer's pensions manager;

§  the trustees;

§  the actuary (who gives advice on funding);

§  consultants who may give advice on design, communication, etc;

§  administrators (may be in-house or third party);

§  lawyers (responsible for drafting the scheme rules and other advice, as required);

§  the scheme auditors;

§  the investment manager(s);

§  investment consultants (giving advice on which managers to select);

§  the Inland Revenue;

§  the Occupational Pension Regulatory Authority (OPRA);

§  the Pensions Ombudsman.

Some of the above roles may be combined. For example, a firm of consulting actuaries may provide actuarial, consultancy, administration, legal and investment consultancy advice.

SIMPLIFIED EMPLOYEE PENSIONS

The simplified employee pension (SEP) is an expanded version of the employer-sponsored IRA, designed by Congress to make it easy and attractive for employers to adopt a retirement plan which, although not a qualified plan as such, has similar features. A SEP is designed much like an employer-sponsored IRA, but the deduction limits are much higher-instead of a $2,000 annual deduction limit, the limit on deductible contributions for each employee is the lesser of $30,000 or 15 percent of the employee's compensation. The price for this expanded deduction limit is that the employer loses discretion as to who must be covered; there is a coverage requirement that in some ways is more stringent than that for regular qualified plans.

Eligibility and Coverage

If the employer has a SEP plan, it must cover all employees who are at least 21 years of age and who have worked for the employer during three out of the preceding five calendar years. Part-time employment counts in determining this; there is no 1,000-hour definition of a year of service. However, contributions need not be made on behalf of employees whose compensation for the calendar year was less than $300 (as indexed for inflation; 2000: $450). The plan can exclude employees who are members of collective bargaining units if retirement benefits have been the subject of good-faith bargaining, and it can also exclude nonresident aliens. Employer contributions to a SEP can be made for employees over age 70½; these employees are not eligible for regular IRAs, as discussed earlier.

Contributions and Deductions

An employer need not contribute any particular amount to a SEP in a given year or even make any contribution at all. In this respect, a SEP is more flexible than any type of qualified plan, even a profit-sharing plan, which requires substantial and recurring employer contributions. However, any employer contribution that is made must be allocated to employees under a definite written formula. The formula may not discriminate in favor of highly compensated employees. In general, the formula must provide allocations as a uniform percentage of total compensation of each employee, taking only the first $150,000 (as indexed for inflation; 2000: $170,000) of compensation into account. The SEP allocation formula can be integrated with Social Security under the usual integration rules for qualified defined-contribution plans.

Each individual in a SEP maintains an IRA and employer contributions to the SEP are channeled to each employee's IRA. For tax purposes, the employer contributions are treated as if they are paid to the employee in cash and included in income and then contributed to the IRA. The Code provides a deduction to both the employer and to the employee for these amounts.

If the employer maintaining a SEP also has a regular qualified plan, contributions to the SEP may reduce the amount that can be deducted for contributions to the regular plan.

Other Requirements

Except for the contribution, allocation, and deduction provisions, the IRAs maintained as part of a SEP are the same as other IRAs and the rules discussed in the previous section apply to them as well. For example, the rules for taxation of distributions from SEP-IRAs are the same as those for other IRAs. As with regular IRAs, loans to participants from SEP-IRAs are not permitted.

Labor and IRS regulations contain certain reporting and disclosure provisions for SEPs. These are simplified if the employer uses the IRS prototype SEP contained on Form 5305-SEP. This form was designed to simplify the adoption of SEPs by employers; however, it uses a nonintegrated formula.

When Should an Employer Use a SEP?

The term simplified in the name of these plans is somewhat misleading; a SEP is not really much simpler than a regular qualified profit-sharing plan, especially where a qualified master or prototype plan is used. However, installation costs are minimal where the government Form 5305-SEP is used; administration costs are low because the annual report form (5500 series) need not be filed. Thus, SEPs are attractive for cases where administrative costs must be absolutely minimized, such as a one-person plan. In other specific situations, the special coverage rules for SEPs may be more attractive than the regular coverage rules. From an employee viewpoint, the complete portability of the SEP benefit is attractive.