Pension scheme rules – when’s a discretion not a discretion?

Jonathan Goodwin

When drafting pension scheme rules I sometimes think a client is looking for an easy option on a difficult decision and I find myself warning that what seems like an easy option now may turn out to be far more complex and exposed to member claims.  The scope of the employer’s duty towards members when it comes to discretionary benefits is much greater than people think.  You will doubtless have heard about the duty of good faith.

Typically this comes up when framing a rule as to who should decide whether a person qualifies for a benefit – should it be a fixed right (so all that has to be decided is whether the individual meets the qualifying condition) or should there be a decision – for employer or trustees or both – as to whether the person then gets the benefit. Benefits on redundancy, death and ill-health are the common candidates.

I often get told to make the matter in question discretionary, usually for the employer. Some trustees like this approach. They feel it passes the buck to the employer. Employers like it too as they can control employee issues and costs – and they believe they don’t have the same sorts of constraints on their decision making as trustees have.

Or do they? It’s true that employers and trustees have a different level of duty to pension scheme members. To put it broadly and crudely, the employer’s duty isn’t as strong as the trustee’s – in technical speak, the employer’s duty isn’t fiduciary – the trustee’s is.

But case law from the 1990s has firmly established that employer’s powers and discretions under pension schemes do carry significant responsibilities towards employees and former employees. These stem from the fact that the scheme benefits have been earned during employment – both by contributions paid by employees but also as an employee benefit which is a part of the remuneration package. Accordingly the law says that scheme members cannot be treated in the same way as beneficiaries of a private trust – as the law puts it – employees are not ‘volunteers’.

This has two impacts on the scheme’s rules.

First – and this starts to sound technical but I think the principle is largely common sense when you think about it – the extent of  a power/discretion given to the employer under a scheme rule is decided according to the purpose for which the power/discretion was given – or assumed to have been given when the scheme was set up or the rule adopted. So, for example, take a rule which provides for an enhanced ill-health retirement pension in defined circumstances of ill-health; assume that a member meets those conditions; but the rule sys that payment of the pension is also subject to the employer’s agreement. So, even if the individual clearly meets the test set in the rules, he can – apparently – be denied the pension. 

Going back to the law I mentioned – you have to work out why the scheme gave that power to the employer. The rule is unlikely to say why – so assumptions have to be made. In this case – ill-health pensions are often expensive – it was probably a cost control measure. If so, the employer who wanted to decline to give agreement to the pension would need to justify it on the basis that it/the pension scheme could not afford the pension. The reason could not be one which was outside the scope (assumed) of the power. So, for example, the employer could not refuse the pension on grounds of the individual’s performance at work before he fell ill.

The second constraint on employer is a duty which employment law implies into all contracts of employment (it can’t be written out). This is the duty of ‘mutual trust and confidence’, sometimes known as the duty of good faith. It works both ways as between employer and employee and extends to ex-employees.  What it means for pension schemes is that, although an employer can base its decision on its own interests – for example the funding cost of an ill-health pension – the employer can’t exercise its powers in an underhand way or for an improper motive (the irrelevant work performance issue I mentioned).  So that brings you back to the proper purpose test I mentioned earlier. It’s an area of the law which is still developing and frequently appears in claims in the courts and complaints to the ombudsman. 

So the point I’m making is that you can’t assume that leaving something important to an employer’s discretion will deliver the intended result. The trustees can’t sit back and leave the decision entirely to the employer. If the employer has a power like this, it will need to make a judgment based on the correct factors and on a case by case basis. It can’t make a blanket decision.

So sometimes it might be easier to fix the issue when drafting the scheme rules at the start. Employers, trustees and members can then be clear where they stand and avoid tricky and challengeable ‘discretions’ later on.

Jonathan Goodwin is a consultant at Allen & Overy LLP

Comments published on Pensions Talk do not necessarily reflect the views of Allen & Overy or its clients.

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