The Department for Work and Pensions (DWP) has recently published its promised guidance on the conversion of guaranteed minimum pensions (GMPs).
Following the High Court judgment in Lloyds Banking Group Pensions Trustees Limited v Lloyds Bank plc and others (Lloyds) in late 2018, many trustees were waiting for DWP conversion guidance to decide whether GMP conversion would provide a suitable method to equalise GMPs. As previously explained, equalisation exercises will need to be carried out by formerly contracted-out defined benefit occupational pension schemes.
What is GMP conversion?
The Pension Schemes Act 1993 contains a statutory process for amending schemes so that they no longer contain GMP rules – in other words, converting GMPs to benefits which are not GMPs. Conversion was introduced prior to confirmation that GMPs needed to be equalised; its original purpose had the idealistic intention of simplifying pensions. The mechanism has been an option for pension schemes since 2009 but, in practice, it has rarely been used.
In order to convert GMPs under the statutory process, a number of conditions must be met:
- the post-conversion benefits must be at least actuarially equivalent to the pre-conversion benefits
- the amount of any pension a member was receiving before conversion must not be reduced as a result of conversion
- the post-conversion benefits cannot include money purchase benefits (except any money purchase benefits which were already provided under the scheme pre-conversion)
- a minimum level of survivors' benefits must be provided following conversion
- the employer must consent to the conversion in advance of conversion
- the trustees must consult affected members in advance, and must notify members and beneficiaries as soon as reasonably practicable after conversion, and
- the trustees must also notify HMRC of the conversion, on or before the conversion date.
The DWP's GMP conversion guidance
The concept of using GMP conversion as a way to equalise GMPs was considered in Lloyds and the DWP was joined as a party. The judgment made clear that GMP equalisation could be achieved by way of conversion and that the actuarial equivalence calculation which would form part of the process does not fall foul of the "principle of minimum interference" because GMP conversion is enshrined in legislation. As such, it has been mooted as an attractive option, since it avoids the administrative burden associated with the other GMP equalisation methods permitted by the judgment, all of which rely on maintaining a "ghost record" for scheme members on an ongoing basis.
Following the Lloyds judgment, the DWP committed to issue guidance on how schemes could use the statutory GMP conversion process to equalise benefits for the effects of GMP. The DWP's guidance, published on 18 April 2019, provides further detail on the GMP conversion mechanism, including an analysis of the practical implications of the legislation. The key points are as follows:
- GMP equalisation by way of conversion involves first calculating (a) the projected benefits of each member and (b) the projected benefits of the member if he/she had been of the opposite sex. The two sets of projected benefits are given an actuarial equivalent value, and the higher of the two is used as the "budget" from which new benefits are costed for the purposes of conversion from GMP to non-GMP. Actuarial input will be vital; although there is wide scope for selecting assumptions, trustees will ultimately be responsible for adopting the methodology
- Trustees will need to take advice on the proposed structure of the converted benefits. If the benefits will be materially different from pre-conversion benefits, they may wish to give members options – in which case the process may need to be treated as an incentive exercise. In our view the exercise is complex enough without introducing more risk and member options! Once again there is wide scope as to the shape of the future benefit but trustees will need to have regard to their fiduciary duties
- Although GMPs ceased to accrue in 1997, equalisation is concerned with adjusting the excess to take account of unequal GMPs. In a final salary scheme members' benefits may not be known until they leave pensionable service. If active members' benefits (including those with continued linkage to salary) are to be converted, trustees will need to decide on which of three bases to value their benefits: either the member is treated as continuing in service, or is treated as immediately leaving service at the conversion date, or a more complex calculation is applied, involving a scale of assumed probabilities of withdrawal at different ages. It may be desirable to convert different cohorts of members at different times; perhaps leaving any "active type" members to the date they leave service
- For pensioners, it may well be the case that records are not detailed enough to establish their benefits directly on leaving pensionable service. This will mean that a more complex mechanism is needed for conversion, taking the pension currently in payment as a starting point and using this to estimate the benefits on leaving pensionable service. There may be more significant data shortcomings in relation to pensioners and survivors – in these cases, legal and actuarial advice will be needed.
What should trustees and employers be thinking about?
- Employer consent is needed in order for GMPs to be converted – who is the employer? Where there has only been one employer in the scheme and all members worked for that employer, the employer will be obvious, but particular problems may arise where the member's original employer is no longer an employer of the scheme or has ceased to exist. What if the GMPs accrued during service with more than one employer in the scheme? Where there have been changes to the participating employers in the scheme, legal advice will be needed in order to identify how (and whether) the employer consent requirement applies
- It might be helpful to align the timing of any GMP reconciliation and rectification exercise with the GMP equalisation/conversion, especially if rectification is likely to generate benefit reductions (if trustees have yet to complete these exercises)
- GMP conversion is not a suitable equalisation method for benefits which have already been paid – it is not possible to convert these to non-GMP. As such, any scheme which equalises benefits which are yet to be paid by way of GMP conversion will need to undertake a separate GMP equalisation exercise so as to calculate the arrears payable in respect of benefits already paid. The interaction of arrears payments with future payments is a complex matter – legal and actuarial advice will be needed to address this issue. Trustees will also need to take legal advice in relation to the look-back period for paying arrears, and any restrictions which might apply under their scheme's forfeiture rules
- Achieving GMP conversion can be done by way of a trustee resolution (under the GMP conversion legislation) or by amending the scheme rules. We recommend that trustees take legal advice in respect of the mechanism to be used for achieving GMP conversion
- The additional considerations discussed in the DWP's guidance make clear that GMP conversion is not the easy option. The guidance makes frequent reference to trustees' fiduciary duties and the need to take legal advice; merely because it is possible to convert benefits provided the conditions are met does not relieve the trustees of their fiduciary duties in protecting members' benefits
- The trustees will need to decide the shape of the benefits after conversion; for example do increases apply and if so at what rate? Should increases depend on the period in which the original GMP accrued?
- It is not clear whether it is possible to convert benefits that are not GMP (excess) into something different as part of the exercise. This could well depend on the scheme's amendment power or how you read what is "desirable" (term used in the legislation). Legal advice will be required if trustees (and employers) are looking to use conversion for a broader purpose for example in relation to benefits accrued prior to GMP being introduced or post-1997 benefits.
What else are we waiting for?
The DWP's guidance notes that HMRC is considering a number of questions relating to pensions tax, in the context of the Lloyds judgment. It is expected that guidance will be published by HMRC over the course of the next few months – until then, there is still significant uncertainty around the pensions tax treatment of benefits which are equalised for the effects of GMP.
It is also possible that further clarification will be provided in the form of another court judgment in relation to the Lloyds schemes – specifically in respect of the two issues on which the judge in the Lloyds case was asked not to decide:
- what action, if any, should be taken by a scheme in relation to benefits which had previously been transferred out of that scheme, and
- what action should be taken in relation to members for whom the cost of equalising would exceed the amount of additional benefit the member would receive if equalisation were carried out.
Of course, if the parties agree a position on these matters without going to court, the questions will remain undecided, and will need to be added to the list of issues for trustees and employers to consider.
As with most DWP guidance, the GMP conversion guidance has helped to clarify a few issues but it has raised many more questions. The Lloyds judgment and guidance does give trustees (on the advice of their actuary) wide scope in selecting assumptions and the future shape of benefits but on the more difficult questions (such as should the trustees adopt non-increasing pensions or what increase to adopt) the guidance side-steps the issue and advises trustees to seek legal advice. In the absence of case law, lawyers will inevitably fall back on existing common law principles with a covering of caution for good measure – this being new, untested law. Perhaps conversion will not be the bold panacea trustees and employers were hoping for?
Please get in touch with your usual contact in the pensions team if you would like to discuss anything in relation to GMP conversion or equalisation.