Legislation background

There was a significant improvement in the members pension rights for private sector companies with the introduction of the Social Security Act 1973 (SSA 73). Prior to this Act members had no statutory rights to any benefits accrued in an occupational pension scheme for early leavers.

When the Act was introduced on 6 April 1975 it allowed for the preservation of a members pension rights, known as preserved benefits, after 5 years of service and would include both employee and employer contributions. For less than 5 years service the scheme member was entitled to a refund of their contributions. Preserved benefits in a previous employers pension scheme can be left to accrue until the normal pension age (NPA) of the scheme member.

As a result of Social Security Act 1986 the members pension rights can be left as a deferred pension if the individual leaves with 2 or more years of pensionable service or, if less than 2 years of service, receive a refund of contributions. For a final salary pension the members deferred pension could be granted discretionary benefits by the scheme trustees and could be entitled to other benefits such as a widows pension.

An individual may wish to have a more flexible income at retirement and opt for, from their employer pensions, a pension transfer to a money purchase scheme where they could take pension withdrawals rather than a compulsory purchase annuity.


Indexing benefits

Since the Social Security Act 1990 all occupational pension schemes must incorporate indexation of accrued benefits in line with the retail price index (RPI) to retirement age. Since 6 April 1997, limited price indexation (LPI) has applied to approved schemes and exempt approved schemes for indexation of pension income after retirement age, including deferred pensions.

In a final salary pension, deferral may result in the member benefiting from any surplus realised in the scheme. For money purchase such as an additional voluntary contribution (AVC) scheme or group personal pension (GPP) indexation does not apply on deferral but the pension fund value will increase by the investment return on the underlying assets.

Members that leave a final salary pension before their normal retirement age with 2 or more year's service can have their benefits held in the scheme until the stated retirement age. The benefits will be index linked at the rate of inflation or 5.0% whichever is the lower. A refund of pension contributions is available for scheme members with less than 2 years service in a final salary scheme. Tax and a contribution to purchase membership of state pensions will be deducted from the refund before payment. Scheme members with over 2 years membership of a final salary scheme are not eligible for a refund.

Since the Pension Schemes Act 1993 (PSA 93) the guaranteed minimum pension (GMP) part of a contracted out schemes preserved benefits, has been subject to a minimum level of revaluation that applies to both public services schemes and private sector employers. GMP accrued from 6 April 1993 up to 5 April 1997 of preserved benefits must have a revaluation equal to the average earnings index (AEI) of 7.0% and from 6 April 1997 this is reduced to the RPI or a maximum of 5.0% a year.

For a scheme member nearing retirement, the definition of final remuneration for the member can take into account increases in pensionable earnings that have not kept up with the RPI and this is known as dynamisation. Any use of dynamisation will still be subject to the earnings cap.

The earnings of the member during the definition years, say the best three years except the final year preceding the retirement age, will be averaged and revalued in line with the increase in the RPI to give the final remuneration. Dynamisation will usually increase the retirement benefits in the form of a pension income and any commutation to a tax free lump sum for the scheme member.


Pension transfers

Where a scheme member wishes to change from an existing pension scheme to a new pension scheme, a pension transfer of member rights will facilitate this move. During the early 1990s pension transfers became controversial as regulation became more effective and the Financial Services Authority (FSA) revealed in the pensions review that a substantial number of individuals were advised to transfer their pension rights from final salary occupational pension schemes to money purchase pensions and a buyout policy commonly known as section 32 policies.

Poor advice was given because clients did not understand the implications of a pension transfer or the advice given was wrong and the client suffered financial loss. To give advice on pension transfers from occupational pension schemes independent financial advisers (IFA) must be authorised by the FSA and hold a recognised qualification such as G60 Pensions or equivalent, as specified by the permitted activity 13 rule.

On divorce, there must be advice given by an IFA even if the pension transfer is as a result of a pension sharing order granted by the court and where the scheme rules do not permit dual membership. This means that an internal transfer is allowed and the pension credit to the former spouse must then be applied as an external transfer to another pension arrangement.

The amount of cash accumulated in a pension that can be transferred from a previous employment to a new pension is called a transfer value. The value is calculated by an actuary in the case of an occupational defined benefit scheme or reflected in the value of the pension fund in the case of a defined contribution scheme such as a personal pension and stakeholder pensions or money purchase scheme. It will normally be transferred to a new scheme by section 32 policies or a personal pension transfer plan.

When transferring retirement benefits from an occupational pension scheme to a personal pension or similar plan, the Inland Revenue apply actuarial guidance note 11 (GN11) as a measure to prevent the scheme member transferring the fund value and in the process produce benfits at retirement age that are greater than the maximum Inland Revenue benefits allowable under the occupational pension scheme.

The transfer value analysis system (TVAS) was introduced from 1 July 1994 and is a method specified by LAUTRO on the 1 January 1995, then the Personal Investment Authority (PIA) and now the Financial Services Authority. The TVAS is applied to all transfers from a final salary occupational scheme. The critical yield calculated by the TVAS is required from a receiving personal pension or section 32 policies to match at retirement age the benefits provided by a final salary occupational pension scheme. For the purpose of valuing the TVAS and future pension payments, a rate of interest based on the annuity interest rate (AIR) is used.

The AIR reflects the yield to redemption on high coupon medium and long term gilt edge securities and is reviewed quarterly by the FSA. The AIR will have an impact on the critical yield such that a higher annuity interest rate would reduce the critical yield, discounting future pension payments at a higher rate and result in a lower capitalised fund value needed to provide a given pension income at the retirement age for the scheme member.

At retirement it is possible for individuals of occupational or personal pension schemes to exercise an open market option to find the highest pension income. This income can be paid as a level annuity or can have added features such as a guaranteed period, varying levels of survivors pension or with RPI or fixed rate escalation.

Alternatively, the member may wish to increase flexibility with pension drawdown where the pension fund is greater than £100,000 and the member is not dependent wholly on this money to provide an income in retirement.