Moral hazard arises when one person's exposure to an adverse risk is mitigated by insurance cover. Insurance may create perverse incentives for the insured person: he may become less careful about his activities, and he may even plan his affairs in ways that deliver benefits to himself but which are ultimately loss-making since he knows that another person, the insurer, will carry the cost of them.
Independent Trustee Services Ltd v. Hope [2009] EWHC 2810 (Ch), an application by trustees for directions heard by Henderson J., shows how the equitable restraints on trustees' discretionary powers can control moral hazard in defined benefit pension schemes. Mr Hope and certain others had been long-serving and relatively high-earning employees of Ilford Ltd. They took early retirement in 2001 during a company restructuring, and qualified for annual pensions of over £40,000 under the Ilford pension scheme. In 2004, the company went into administrative receivership, leaving the scheme with a deficit of at least £25 million. The scheme very likely qualified for entry to the Pensions Protection Fund (“PPF”), which is the insurance fund established under the Pensions Act 2004 to underwrite eligible UK defined benefit pension schemes. The PPF assumes responsibility for schemes that are in deficit when they are wound up owing to the insolvency of their sponsoring employer. But Mr Hope and his colleagues – like all other early retirees and active members of pension schemes – stood to lose if they remained in the scheme when it entered the PPF. Under the PPF regime, they would only have been entitled to 90% of the maximum annual compensation payable, which is currently capped at some £32,000.
The scheme trustees' question for the court was whether they must protect the position of Mr Hope and the other similarly affected members by exercising a power to “buy-out” their pension benefits. They proposed to spend a considerable portion of the scheme assets to purchase annuities from insurers which would pay the members their full promised income. The buy-outs would increase the scheme's deficit. But the cost would ultimately be borne by the PPF when, as seemed inevitable, it assumed liability for the scheme. The PPF feared that the Ilford trustees' exploitation of moral hazard in this way would become common practice among financially distressed pension schemes. If they were all allowed to “game” the PPF in this way, the viability of the fund would be threatened.
Henderson J. relied on two familiar equitable doctrines to hold that the trustees' proposed exercise of the buy-out power would be unlawful. First was the “proper purposes doctrine”. To depress the value of the scheme assets to secure benefits for certain members which they would otherwise have no prospect of receiving would be an abuse of the buy-out power (at [70]). The fundamental purpose of the scheme was to provide benefits for all members. The trustees could not use the power to deploy a disproportionately large share of the scheme assets to purchase benefits for certain members that would be better than they would get if the scheme were wound up in deficit or if it entered the PPF (at [96]). Second was the doctrine of relevant and irrelevant considerations. The availability of PPF compensation was an irrelevant consideration that the trustees could not take into account when they exercised their buy-out power. If they did, they would subvert the policy of the Pensions Act 2004 in establishing the PPF. They could not treat the availability of PPF compensation as an asset of the scheme. The PPF was intended only to provide compensation in the last resort (at [115–116]).
The decision underscores the deepening distinction between pension trusts and traditional donative trusts (see, e.g., D. Hayton [2005] Conv. 229). It has become almost a commonplace to say that pension trusts are different because the members have earned their trust entitlements by working for their employer (Imperial Group Pension Trust v. Imperial Tobacco Ltd [1991] 1 W.L.R. 589, 597 per Browne-Wilkinson V.-C.). But the more significant difference is that pension trusts do not operate in a narrow setting where the trustees' exclusive concern is to promote the members' best interests. The view of Sir Robert Megarry V.-C. in Cowan v. Scargill [1985] Ch. 270, 288–89 that pension trustees, like traditional donative trustees, must aim to promote their beneficiaries' best financial interests might have been true for their investment powers but it is not necessarily true for all powers of pension trustees. The members are one section of a larger network of relevant participants in the pension scheme. So the trustees must also have regard to the employer's interest in operating the scheme (Edge v. Pensions Ombudsman [2000] Ch. 602, 627 per Chadwick L.J., confirming [1998] Ch. 512, 537 per Scott V.-C.). This is entirely appropriate. The scheme is an adjunct to the employer's business. The employer carries the immediate risk of moral hazard arising from the trustees' decisions since it is liable to pay the balance of cost of funding the scheme if it falls into deficit. Hope confirms that the PPF is also a significant participant in the operation of a pension scheme. It ultimately bears the risk of any deficiency in the scheme investments if the employer becomes insolvent. Inevitably, pension trustees will have regard to the PPF when they exercise their powers but not, after Hope, in ways that improperly exploit its insurance functions.
Hope offers little comfort for the many scheme members who have lost their full pension benefits owing to the insolvency of their sponsoring employer. But perhaps it is a mistake to expect that it should. The legal standards of governance in UK pension schemes are higher now than ever before, and the legal regimes for spreading the investment risks on pension scheme assets are more sophisticated now than at any time in the past. But regulation by statute or case-law cannot save sponsoring employers from insolvency or ensure that pension investments stay in surplus. The law cannot defy the economic conditions that are the real reasons why pension schemes fail.
In the long term, however, the decision in Hope is good news for employers and pension scheme members since it supports the PPF's insurance role. It prevents the PPF from being undermined by pension trustees' short-term exploitation of moral hazard.
