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An explanation of the different legal structures for pension schemes, including personal and group pensions and master trusts.
Trust-based schemes are governed by a trust deed and rules.
Contract-based schemes are governed by individual contracts between the member and the pension provider.
Trustees of a trust-based group scheme need to understand trust law and legislation and are responsible for investments, preparing annual reports, audits and paying for any trustee liability insurance.
Employers do not have trustee responsibilities with contract-based group schemes (e.g. some Group Personal Pension schemes), which means the employer has more time to focus on their business.
Master trusts give the employer the reassurance that scheme governance requirements will be met without the responsibility of running a trust-based scheme.
Summary of legal structures
There are a number of legal structures for pension schemes. These are:
Occupational group pension schemes (e.g. defined benefit, executive pensions, occupational money purchase etc), which will be trust based.
Group personal pension schemes (with or without employer contributions), which can either be trust or contract based
Personal pension schemes, which can either be trust or contract based
Trust based and contract based have different meanings in different contexts and this can cause confusion.
Trust-based personal schemes
This is where a pension scheme is established by a pension provider under a trust deed. A trustee company is appointed to provide oversight and ensure compliance with the trust deed and rules. This means that the scheme is governed by the trust deed and rules.
Contract-based personal schemes
Contract-based pension schemes are individual contracts between the member and the pension provider. The pension provider is often an insurance company or an investment platform, although there are also a number of independent providers.
The provider establishes the personal pension under deed poll (or a board resolution in Scotland). The provider is the scheme administrator and there are no trustees.
However, in practice the board resolution or deed poll will refer to a trust deed and rules. This is because the distribution of death benefits must be discretionary to avoid inheritance tax.
Section 5 of Inheritance Tax Act 1984 states that if you have the power to dispose, then you are treated as being beneficially entitled to the property. However, settled property is specifically excluded. Section 58(1)(d) states that a registered pension scheme is settled property if the lump sum death benefit is paid in accordance with section 58(2)(A).
The trust deed and rules will appoint the trustees or the scheme administrator as having the discretion, so death benefits will normally be exempt from inheritance tax.
Trust-based group schemes
Traditionally, trust-based schemes were viewed by employers and employees as superior. This was because a trust-based occupational scheme would be established by an employer to provide benefits for the employees. It would be managed by the trustees, who would hold the assets of the scheme and pay any pensions and lump sum benefits. In essence there’s a three-sided relationship between the employee, employer and trustees.
Advantages of trust-based group schemes
Before 6 April 2006, trust-based schemes had two major advantages – employers could pay more money into the scheme and members could take a larger tax-free cash amount than members in contract-based schemes. The other advantage over contract-based schemes was that if a member left within 2 years, the employer could receive a refund of contributions, referred to as a ‘short service refund’.
However, after 6 April 2006 the first two advantages disappeared. So the only remaining advantage trust-based schemes have over contract-based schemes is the refund of contributions. However, the ability to refund pension contributions if the member leaves service within two years has been amended.
The Government made provision for the abolition of short service refunds in section 36 of the Pensions Act 2014. This amends section 71 of the Pension Schemes Act 1993, with effect from October 2015.
Defined contribution occupational pension schemes will still be able to offer those who joined through their contract of employment a refund of their contributions, if they opt out within the first month. Defined benefit occupational schemes will retain the facility to make short service refunds under the previous rules (refund of contributions made if under two years of scheme membership).
Personal pension schemes (including GPP's), being contract-based, aren’t affected by this change in policy as they’ve never had the facility to make short service refunds.
Disadvantages of trust-based group schemes
The major disadvantages are the amount of obligations which trustees have, the amount of legislation and trust law that they are required to understand, the fact that trustees are responsible for investments, preparing annual reports, audits and paying for any trustee liability insurance.
Contract-based group schemes
In a contract-based scheme (such as a group personal pension scheme) the employer would appoint a pension provider (normally an insurance company) to run the scheme. This creates a contract between the provider and the employer, and the provider makes all the decisions about how the scheme is run. In most situations the employer will have made a promise to the employee to contribute to the pension scheme every month, but their obligation ends there.
Advantages of contract-based group schemes
The employer doesn’t have trustee responsibilities as the provider is responsible. So the employer has more time to carry out their actual business. The employer is only obliged by the Pensions Act 2004 to pay contributions on time. The employer also has no responsibility regarding investment decisions.
Disadvantages of contract-based group schemes
Most contact will be between the provider and the employee, so there isn’t the relationship that may exist in a trust-based scheme. In addition, it may seem like there is no-one accountable for investment decisions.
A master trust is an arrangement where a product provider – either an insurance company or trustee body – manages pension fund assets for a group of unrelated employers under a single trust arrangement.
Advantages of a master trust
The advantage of a master trust is the trust-based structure is seen as more beneficial for the individual member and it gives employers the reassurance that scheme governance requirements will be met without the responsibility of running a trust-based scheme.
Disadvantages of a master trust
Trustees of a master trust are normally appointed by the provider. In addition, the master trust may establish other restrictions which a normal trust-based scheme wouldn’t have. It could be that the master trust places obligations on the employer in relation to investment choice, which wouldn’t happen under a contract-based scheme.
The regulatory issue
The Financial Conduct Authority (FCA) often talk about contract based schemes as being those where there is a contract between the member and an insurance company. However, this is really to differentiate between the responsibilities of the FCA and The Pensions Regulator (tPR). If it is a group personal pension scheme or an individual personal pension then it is not an occupational scheme. Therefore the FCA are responsible.
However, simply because there is a contract with the member and the scheme, that does not mean these types of schemes must be contract based. They may be set up under trust.
Many companies have set up their Self-Invested Personal Pensions (SIPPs) under trust, i.e. with a trust deed and rules rather than by deed poll or board resolution. There is still a contract with the member but this does not make it a contract based scheme.
Why this doesn't matter
When considering the Financial Services Compensation Scheme (FSCS) cover for non-occupational type schemes, there is no difference in relation to whether a scheme is contract based or trust based.
In summary, on a non-group basis, there is no difference between a contract based or trust based pension scheme and it is treated exactly the same for FCA and FSCS purposes.