to pay for the benefi ts of other members, potentially leaving them with nothing.

Bainbridge v QuartersThis unfair treatment is what Mr Ronald Bainbridge complained about in the 2008 High Court case of Bainbridge v Quarters. Mr Bainbridge joined a hybrid scheme as a DC member in 1998. He stopped being an active member of the scheme in 2002. In 2003 the sponsoring employer became insolvent. The scheme started to wind up.

The scheme rules said that, when the scheme wound up, priority had to be given, in particular, to pensions in payment and guaranteed minimum pensions. There were not enough assets to pay for these in full.

There was nothing in the scheme rules which said that DC assets should be used only to provide benefi ts for DC members. The High Court said that this meant that the DB and DC assets formed a “single fund” and both kinds of assets had to be used to pay for the benefi ts which had priority under the rules. The result was that all of Mr Bainbridge’s DC account would have to be used to pay for the benefi ts of other members, including DB members. Mr Bainbridge would receive no benefi ts, despite having contributed to the scheme for four years.

A question of priority Where a hybrid scheme winds up in defi cit, legislation

Robbing Peter to pay PaulAre hybrid schemes unfair to DC members? Edward Jewitt, Mayer Brown International

A 2008 case in the High Court exposed an area of unfairness, approaching a scandal, if you

are a defi ned contribution (DC) member of a “hybrid scheme”. The unfairness lies in the fact that DC members can unexpectedly have their benefi ts reduced to pay for the benefi ts of defi ned benefi t (DB) members if the scheme winds up without enough assets to pay for the defi ned benefi ts.

Best of both worlds? A hybrid scheme provides both DC and DB benefi ts. Typically, a DC section is added to a scheme which originally provided only defi ned benefi ts as the employer’s pension policy changes. This allows the existing trustee governance structure to be used to run the DC section and, in better times, can allow a surplus in the DB section to be used to fund the employer’s contributions to the DC section.

The DC members will be told that their pension depends on what can be bought from an account set up for them. They will probably be told that they will not get any guaranteed level of pension. But they may not be told that, if things go wrong, the assets in their account can be used

“hybrid schemes” provide both DC and DB benefi ts

unfairness can arise in a hybrid scheme because members think their DC benefi ts are protected, but in fact they may have to be reduced to pay for defi ned benefi ts if the scheme winds up in defi cit

trustees can stop this unfairness by changing their rules or by getting a discharge for the defi ned benefi ts under s74 Pensions Act 1995.

In a nutshell

sets out a priority order that determines which defi ned benefi ts are paid for fi rst from the available DB assets. DC assets and liabilities are ignored when you apply this priority order, so they are protected as far as the statutory priorities go. After the DB assets have been applied following this priority order, a hybrid scheme will be left with just the DC assets.

However, these assets are not automatically ringfenced for DC benefi ts. The trustees will be required to use these DC assets to pay for whatever benefi ts are at the top of a priority order written in the scheme’s rules. The priority order in the rules is often diff erent from the priority order in legislation.

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If defi ned benefi ts are at the top of the priority order in the rules and there are not enough DB assets to pay for them in full, DC assets will have to be used to make good the shortfall. The result is that DC benefi ts will be reduced to pay for defi ned benefi ts.

Changing the rules Trustees should check whether their scheme rules say that DC assets can only be used to pay for DC benefi ts on winding up. If they do, there is no problem. If not, a formal rule amendment may be needed.

However, there can be situations where a rule amendment is not possible, for example because the amendment power is subject to restrictions or amendments cannot be made because

winding up has already started. In such a case some creativity is required.

Trustees can still ensure that DC assets are used only for the benefi t of DC members by following the procedures in s74 Pensions Act 1995.

Section 74 says that the trustees will be discharged from responsibility for the scheme’s DB liabilities if they arrange for those defi ned benefi ts to be bought out with an insurer. This discharge is available even if the benefi ts are reduced because there are insuffi cient DB assets. If the trustees can get a discharge for their defi ned benefi ts, they will be left with the full amount of the DC assets to provide DC benefi ts. DC benefi ts will therefore be provided in full.

This solution requires care because it is necessary to follow a lot of detailed procedural requirements to get a discharge. These formalities include restrictions on

the kind of insurance company which provides the buyout

policy, restrictions on when benefi ts can be

exchanged for cash and a requirement to give advance notice to members.

A particular issue is that the legislation does not seem to allow a buyout policy to contain an option for members to take a “pension commencement lump sum” (the tax free cash sum that pension scheme members usually take at retirement). Although it may be possible to fi nd a way round this, it seems an unreasonable restriction. Representations have been made to the Department for Work and Pensions (DWP) asking that this be addressed. Until and unless that restriction is changed, the solution is not ideal but it may be a lesser evil than using DC assets to pay for defi ned benefi ts.

Duty discharged One peculiarity is that regulations apparently say that voluntary contributions which have been paid to provide DC benefi ts have to be treated like defi ned benefi ts where a hybrid scheme winds up in defi cit. This means that they may also have to be reduced where there are insuffi cient assets. This seems illogical and there may be a mistake in legislation. This point has been raised with the DWP.

The unfairness of reducing DC benefi ts to pay for defi ned benefi ts only arises where a scheme does not fall into the Pension Protection Fund (PPF). If a hybrid scheme enters the PPF, the PPF must arrange for any DC benefi ts to be provided for in full. The PPF has a number of options for doing this, including buying an insurance policy or making a transfer to another pension scheme. There is nothing in the legislation which allows the PPF to reduce DC benefi ts.

Substantial unfairness can arise for DC members where a hybrid scheme winds up in defi cit, but there are ways to solve this. If you are a trustee of a hybrid scheme, the best course is to ensure that your rules make it clear that, on winding up, DC assets can only be used to pay for DC benefi ts. If that is not possible, you may still be able to ensure that DC assets are used only for DC members by getting a discharge for defi ned benefi ts under s74 of the Pensions Act 1995.Edward Jewitt is a partner at Mayer

Brown; ejewitt@mayerbrown.com

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