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Are your plan's pension increases being calculated correctly? Significant cost savings may be available

The Court of Appeal this year in FDR v Dutton considered the impact of compound interest on the calculation of pension increases. Its decision resulted in huge cost savings for FDR Limited of approximately £17m. This is a universal decision that potentially applies to all plans with pension increase underpins, where retrospective changes have been made to the plan’s pension increase rules and the plan contains a restrictive power of alteration. For such plans both employers and trustees should review how their pension increases are calculated and arguably must, as this is a Court of Appeal decision, change the way those increases are calculated.

The Plan changed the pension increases it gave its pensioners in 1991 from a fixed 3% pa increase to the lesser of 5% pa and the increase in the Retail Prices Index (5% LPI). The change was meant to apply retrospectively and there was no differentiation between pension earned before and after the date of the change. However, the Plan’s constitution – its trust deed and rules – restricted changes being made that would prejudice any pension already in payment at the date of the change or any rights or interests that a prospective beneficiary has in the Plan up to the date of the change. Given this proviso, the 1991 change to the pension increase rule just did not work, so the Court of Appeal had to consider how the Plan’s pension increases should be calculated i.e. What was the right that the pensioner enjoyed under the old rule which is protected by the proviso?

The Court analysed three approaches for calculating pension increases. These are in descending order as regards the cost to the Plan.

1. The trustees’ annual approach – this is the standard approach currently used by most, if not all, pension trustees for calculating pension increases. It gives the most generous increases to members. Pension increases are calculated using as a starting point the pension given to the member in the previous year. So the pre-1991 element of a pension in any given year is increased each anniversary date by the greater of 3% pa compound and 5% LPI.

2. The trustees’ alternative approach – the annual increase is the higher of (i) the value of the pre-1991 element of the member’s pension as at the date of retirement increased each year on year by 3% pa compound up to and including the year in which the increase takes effect and (ii) the value of that element of the member’s pension paid in the year immediately before the increase takes effect increased by 5% LPI.

3. The employer’s modified cumulative approach – this approach is the same as is used for the statutory revaluation of deferred pensions, but it is not used for determining the pension increases for pensions in payment. It requires two separate calculations of the member’s pension entitlement, namely (i) calculate the value of that element of the member’s pension retrospectively as from the date of retirement increased year on year by 3% pa compound up to and including the year in which the increase is to take effect and (ii) calculate the value of that element of the member’s pension retrospectively as from the date of retirement increased year on year by 5% LPI compound up to and including the year in which the increase is to take effect, subject to a floor of 0%. (This is to avoid the effects of any negative retail prices increase. Legally pensions in payment cannot reduce to below zero.) The relevant element of the pension payable in any given year is the higher of the two calculations, with the pensioner never getting less than the pension entitlement he or she had before the 1991 alteration to the Plan and the pensioner never getting more after the 1991 alteration so no year-on-year reduction occurs.

The Court decided the employer’s modified cumulative approach was correct as it resulted in the least interference in the Plan’s trust deed and rules. This principle of least interference is a standard court-approved way of interpreting the rules of pension plans. So while the restriction in the Plan’s trust deed and rules protected the amount of the pensioner’s pension, the annual pension increases should apply only to the pension that has been increased by 3% and not at any higher rate.

In reaching this decision, the Court of Appeal decided:

  • The intention of the trustees and the employer when they made the alteration was irrelevant in deciding how the compound increases should apply
  • The restriction in the trust deed and rules about what changes could be made to the Plan did not help the Court’s interpretation as to how the pension increase should be calculated as it just did not cover the point
  • It was not relevant that the trustees and the employer might have changed the pension increase rule itself if they had been aware at the time of the difficulties in determining how the underpin was to apply
  • The administrative difficulties of implementing the Court’s decision were irrelevant.

The Court did not consider (as it did not have to consider) the following, but these factors may be relevant in relation to other pension plans:

  • what approach should be taken as regards discretionary pension increases which are common in many plans
  • whether plans can, and should, recover overpayments of pension calculated on the wrong basis

This judgment is likely to change how pension increases are calculated where there is a pension increase underpin, where retrospective changes have been made and the plan contains a restrictive power of alteration. As it is likely to reduce pensioners’ pensions, member communication is key. However, this could be as simple as saying your pension increases have been calculated in one way. The Court of Appeal now says they should be calculated in another way so your pension has reduced. It is extremely unlikely that pensioners will be able to point to some other document like a benefit statement or plan booklet to show an entitlement to a pension increase being calculated in a specific way as these documents do not include this level of detail about how pensions are increased. This makes it unlikely that these documents would restrict the ability of employers and trustees to change the basis on which pension increases are calculated where there is an underpin.

Published:21 July 2017


Pensions Law Update - July 2017




Key Contact

Penny Cogher