… Looking Back

Following on from my companion article today, which was very much ‘looking forward’, for this article I will consider another query which is very much ‘looking back’.

Looking back – why do many DB schemes impose a maximum service limit of 40 years?

In this query, our enquirer simply asked why is it that many Defined Benefit (DB) schemes impose a ‘cap’ on the maximum period of pensionable service that it to be taken into account for benefit purposes, which is usually 40 years. We were asked whether there is a legislative or taxation reason behind this.

We were able to confirm that the existence of ‘service caps’ (maximum periods of pensionable service) within DB schemes is very much for historical reasons (although those historical reasons arose from certain tax implications).

Before A-Day, most DB schemes were subject to discretionary approval by the (then) Inland Revenue (now HMRC) under Section 591 of the Income and Corporation Taxes Act 1988 (‘ICTA ‘88’). There was also a mandatory approval under Section 590 of ICTA ’88, however the conditions for this were so restrictive that most schemes opted for the discretionary approval route instead.

Under the discretionary approval route, schemes had to comply with the maximum benefit rules imposed by a document known as IR 12 (also known as the Inland Revenue Practice Notes).

Under the maximum benefit rules imposed by IR 12, the starting point was that:

The maximum aggregate benefit payable without taking account of retained benefits is a pension (of which part may be taken in lump sum form as described in Part 8) of 1/60th of final remuneration for each year of service (up to 40 years) ...

This set a standard maximum benefit of 1/60th of earnings for each year of service, up to a maximum of 40 years to count. (The result was a maximum pension of 2/3rds of earnings.)

IR 12 did also allow for higher benefits than this:

Benefits greater than 1/60th of final remuneration for each year of service may be given up to a maximum of 1/30th of final remuneration for each year of service (up to 20 years) provided that the aggregate of the benefits in respect of service with the current employer together with any retained benefits does not exceed 2/3rds of final remuneration ...

Even under this provision, however, the maximum benefit was 1/30th of earnings for each year of service, up to a maximum of 20 years to count. (The result was again a maximum pension of 2/3rds of earnings.)

To comply with these requirements, schemes either hard coded a ‘maximum of 40 years pensionable service’ provision into their Scheme Rules, or included a general provision within the Rules such that the scheme could not make payments that might prejudice Revenue approval.

Breaching the requirements of IR 12 could have resulted in the Inland Revenue withdrawing approval from the scheme, which would have meant serious tax consequences for the members and the sponsoring employer (the tax implications that we mentioned above), so schemes complied with the IR 12 requirements.

With the advent of A-Day, the old Inland Revenue limits fell away, however any ‘maximum of 40 years’ provision in the Scheme Rules still applied (until and unless the Rules are amended to remove it).

It is for this reason that it is still very common to see a service cap (usually 40 years) provided for within Scheme Rules. As we have touched on, this is not actually required under the A-Day legislation, however schemes have tended to retain the service limit, to avoid increasing the scheme’s liabilities.

As a further historical aside, you may wonder where the ‘maximum of 40 years to count’ and the ‘maximum pension of 2/3rds of earnings’ provisions came from. In broad terms, this fell out of the provisions within the Civil Service Pension Scheme and other public sector schemes, which – at least prior to A-Day – imposed a maximum period of ‘reckonable service’ of 40 years.

Because the ‘maximum of 40 years to count’ provision is still so common within occupational pension schemes, even the ‘qualifying criteria’ for DB schemes that are to be used for automatic enrolment (Section 23 of the Pensions Act 2008) includes a provision that:

In the case of a scheme that provides entitlement to a pension as mentioned in subsection (2)(a) [in effect, this is where the scheme provides a pension], the annual rate of the pension at the appropriate age must be—

(a) 1/120th of average qualifying earnings in the last three tax years preceding the end of pensionable service,

multiplied by

(b) the number of years of pensionable service, up to a maximum of 40. [Our emphasis.]

(This, of course, is the minimum benefit that must be provided by such schemes – they can provide more, but cannot provide less.)

Aries Insight ?provides comprehensive and detailed guidance on the application of the old Inland Revenue limits, as well as insight into the meaning and impact of UK pensions regulation and clear guidance on the practical implications for pension providers, trustees, administrators and consultants.? If you are not already an Aries member and would like to find out more about what Aries Insight can offer you, then please drop me a mail at [email protected] or give me a call on 01536 763352.

Please note that?we are not lawyers or financial advisers.?The information above sets out our best understanding of the legislation and how it applies, but should not be taken as constituting legal or financial advice.