Outsourcing transactions - ensuring that pensions will not be the 'last straw'

Background

Unless the transferring entity retains a substantial interest in the business, which usually needs to be at least 30 per cent ownership, the transferring employees will not be able to carry on as members of their existing occupational pension scheme. The receiving employer will therefore need to decide what alternative pension benefits it wishes to provide.

The receiving employer is not currently obliged by law to provide a replacement occupational pension scheme. The regulations which cover employment transfers in the UK, known as "TUPE", contain an exception which means that rights to "old age, invalidity or survivor's benefits under supplementary company… pension schemes" do not transfer with the rest of an employee's contractual rights. It is important to remember that this exception does not cover personal or stakeholder pension schemes which the receiving employer is obliged either to continue or replace.

The exact scope of this exception was recently considered by the European Court of Justice which ruled that it only applied to rights paid when an employee reaches retirement age. The exception does not apply to rights payable to a member on redundancy or on the member's leaving employment at the employer's request, such as early retirement pensions or enhanced pension benefits. This means that even if the new employer does not offer a replacement pension scheme, it can still find itself liable to provide valuable pension rights if it makes employees redundant.

Any changes to pension arrangements, whether or not they come within the TUPE exception, are nonetheless "measures" which must be included in the consultation process which TUPE requires to take place on employment transfers. The obligation to consult rests with the transferring employer. However, if the transferring employer fails to carry out the required consultation, liability for this failure may pass to the receiving employer.

Contractual obligations

Whilst TUPE does not require the new employer to provide replacement occupational pension rights, the transferring employer may make the provision of such rights an obligation on the receiving employer (the 'Supplier') under the outsourcing agreement. The contract can also set out what type of pension benefits are to be provided by the Supplier.

The UK government requires any employers receiving a transfer of public sector employees under an outsourcing contract to provide equivalent value pension rights for existing employees and employer contributions to a stakeholder pension scheme for new employees. Trade unions tend to put pressure on private sector employers to do likewise.

If the Supplier does offer a replacement pension scheme, it is usual to offer the employees the opportunity to transfer the rights they have built up with the transferring employer (or the "customer") into their new scheme. The outsourcing contract will often state the basis on which that transfer of pension rights is to be calculated and the benefits which are to be offered in the receiving employers' scheme as a result. The aim of such an arrangement is usually to ensure that the employees receive the same benefits in the new scheme as they would have received if their employment had not transferred to the Supplier. Depending on the terms agreed for the transfer of pension rights, the Supplier will not be certain that the funds transferred to its scheme are sufficient to cover the pension benefits it is obliged to take on and may be taking a substantial liability as a result. A miscalculation could wipe out the profit element of the outsourcing contract.

If employees do not transfer the pension rights they have accrued with the transferring employer to their new employer's pension scheme, the transferring employer's pension scheme will retain responsibility for those rights. Depending on the type of benefits provided, this means that the transferring employer may not be free from liability for the funding of those accrued pension benefits.

So not only will Suppliers need to consider pensions liabilities in making any bid for the outsourcing contract but so will the prospective customer in assessing the various bids.

Managing the transfer

The changes to pension rights arising from a transfer of employment are often complex and difficult to administer. As a result, it is sometimes useful to have a transitional period whilst the changes are made. The transferring employer could allow the employees to remain in its scheme for up to 12 months from the date of transfer of employment which will allow time for new arrangements to be set up by the Supplier.

Whilst it will be obliged to consult with the employees, the transferring employer should be careful not to make promises to its employees about their pension rights; particularly promises which encourage the employees to agree to the TUPE transfer. If those promises prove to be untrue, the transferring employer could be held liable for any resulting loss of pension rights.

The trustees who run the various pension schemes involved will not be a party to the outsourcing contract. However, they may have to agree with any arrangements proposed by the two employers and so should be involved as soon as possible.

Proposed changes to TUPE

The UK government has for some time been considering changes to TUPE so as to remove the exception for occupational pension rights. A number of proposals have been made by the government, with the most recent being a requirement for existing employees to be offered either equivalent value pension arrangements after transfer or employer contributions to a stakeholder pension scheme which match the employee's contributions up to 6 per cent of salary.

If adopted, these changes will probably come into force in April 2005. However, it is not known whether the new requirements will apply to contracts signed after that date or to employment transfers which take place after that date. This means that even if pensions are excluded from TUPE at the time an outsourcing contract is signed, it is possible that pension rights will fall within an amended TUPE by the time of the initial transfer of employment to the new employer.

In addition, it is likely that an amended TUPE will apply to employment transfers which take place on termination of the contract. Any requirements inserted into the outsourcing contract covering transfers on termination need to be widely drafted in case they are invalid under the law which applies at the time of termination of the agreement.