There are a number of reasons trustees and employers may want to sectionalise their schemes, but it is not always plain sailing, according to Laura McLaughlin and Thibault Jeakings at law firm CMS.
Action points
Think about whether there is reason to create a sectionalised scheme
Make sure the scheme is fully and formally sectionalised
Watch out for the scheme becoming desectionalised
A sectionalised pension fund is a scheme that contains two or more ‘sections’ that are formally separate for funding and benefit purposes.
What are the main drivers?
Sectionalised schemes are almost always the result of a scheme merger or a business demerger.
In the context of a scheme merger, one of the biggest obstacles is often different funding levels between schemes.
Sectionalisation avoids the risk of diluting an existing funding position through a merger
Where employers are not in a position to top up the weaker scheme’s funding, a merger would weaken the funding position of the stronger scheme, making it difficult for its trustees to accept.
This is particularly true where one scheme has a surplus on a Pension Protection Fund basis and the other does not, as the reduction to members’ benefits on an employer insolvency could be quite stark.
In the context of a demerger, newly separate employers may wish to avoid exposure to each other’s pensions obligations.
As each section must be independent of other sections for contribution and funding purposes, sectionalisation avoids the risk of diluting an existing funding position through a merger, or future exposure to a separate business.
However, sectionalised schemes also have a downside. Pension schemes are often merged to reduce administrative costs and duplication; these benefits are significantly reduced in the context of a sectionalised merger as, in practice, each section will need to be treated more like a separate scheme for administrative and actuarial purposes.
Sectionalisation can also considerably increase the complexity of the scheme, creating more demands on limited trustee time.
Where a sectionalised scheme has been created, trustees and employers will also need to ensure it meets the conditions for sectionalisation and does not inadvertently become desectionalised.
What are the legislative requirements?
Many schemes have multiple benefit categories, which are sometimes the legacy of past mergers, and these are often casually referred to as ‘sections’.
However, benefit categories have no special legal status unless they meet the legislative requirements for sectionalisation.
While there is no single definition of what constitutes a sectionalised pension scheme in pensions legislation, areas of legislation that recognise the concept of sectionalisation include the statutory funding requirements in the Pensions Act 2004, PPF legislation and the regulations governing employer exits and debts under section 75 of the Pensions Act 1995.
These areas each contain their own definitions of what constitutes a sectionalised scheme; although the requirements are broadly the same.
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To be considered sectionalised the scheme must have more than one employer and satisfy two core requirements.
One of these requirements is that contributions payable by a member and by the member’s employer must be allocated to that employer’s section of the scheme.
The other is that part of the assets of the scheme must be attributable to each section and cannot be used for the purposes of any other section.
Is the scheme fully and formally sectionalised?
It is important to keep an eye on whether the scheme is still sectionalised, because sectionalisation is a continuing status and can be lost if any of the conditions are not met.
In a recent High Court case, for example, a pension fund was held not to be formally sectionalised.
The scheme’s governing documentation allowed for expenses incurred in one section to be recovered from the scheme generally, including from sections other than those in respect of which the expenses were incurred.
The judge found this cut across the requirement that assets in one section cannot be used for the purposes of any other section; whether or not cross-subsidy between sections actually occurs in practice is irrelevant.
If a scheme ceases to have at least two different participating employers for statutory purposes, it will cease to be a sectionalised scheme.
Sectionalised status will also be lost if all the sections in a scheme have the same employers.
Laura McLaughlin is a senior associate and Thibault Jeakings an associate at law firm CMS
