Settlement or compromise agreements are part of an employment lawyer’s day to day business. Building in the treatment of pension benefits can be complicated and may need specialist advice to make sure all potential liabilities are covered. Early planning of the pensions aspects of the agreement – for DB and DC pensions – will allow employers to be clear about their proposals and present a full package, avoiding spiralling costs and lengthy re-negotiations.

When negotiating a settlement agreement, a number of pension related issues can arise. Often there will simply be a straightforward payment of employer contributions to a DC arrangement. There may, however, be circumstances where the employee wants to direct part of any other agreed payment to the pension scheme and there are more issues to think about with a DB scheme.

DB Schemes

On termination of employment, an active member of a DB scheme will cease to be an active member – that means they lose the potential for future years of service in the scheme. Employers may agree to augment the member’s benefits by paying for additional years of service. This will involve checking the scheme rules to make sure any formalities are complied with; you may need trustee consent and there can often be a requirement to pay an immediate sum to the scheme to buy the extra benefits. It is often easier to make a one-off payment to the scheme to provide DC benefits if the rules will allow that. If trustee involvement is needed, that needs to be allowed for as they may operate on a different timescale to the employer.

Enhanced DB rights

Some DB schemes provide enhanced pension rights on redundancy or other termination of employment. This can be the case even where the DB scheme closed in the past so the employee is not earning any new benefits in it. There may also be enhanced benefits available to the member if they are retiring because of ill-health. The member’s entitlement will be governed by the scheme rules – and not simply the settlement agreement.

Pensions legislation renders unenforceable any agreement that attempts to waive an employee’s accrued pension rights so it is important to know what rights the employee will have in the pension scheme and ensure they are factored into the settlement agreement – finding out the employee is automatically entitled to a valuable enhanced benefit from the pension scheme after you’ve paid a significant sum under a settlement agreement is a bitter pill to swallow.

Tax considerations

Where a payment is being made to a pension scheme – or additional benefits are granted in a DB scheme – this will count towards the employee’s Annual Allowance in that year. The Annual Allowance is the maximum amount of contributions (or benefit accrual in a DB scheme) by or on behalf of an employee without the employee having to pay tax on the amount. For the year 24/25, the AA is £60,000. Higher earners have a lower AA, tapering down to a minimum of £10,000. If excess contributions are paid, the employee will have to pay an Annual Allowance Charge – this charge falls on the employee but often can be paid out of the money in the pension scheme.

Typically, payments into a pension scheme as part of a settlement agreement are limited so as not to give rise to an Annual Allowance Charge, but it is actually possible to pay much higher sums into a pension arrangement. Sometimes an employee will ask to have a larger amount paid into their pension arrangement as this may be more tax efficient for them, even taking into account the tax charge they will have to pay.

The wording of the settlement agreement needs to be carefully drafted to be clear about the amount being paid and treatment of any tax charges arising as a result of contributions to or benefits being granted in a pension scheme.

Summary

To avoid pitfalls, pensions planning should be considered at the outset. If pensions compensation is dealt with as an afterthought, there can be highly stressful last-minute negotiations, or employers can find they’ve agreed to arrangements that either can’t be implemented or which have a significantly different cost (for employer or employee) from what was expected.

Key takeaway

When planning settlement agreements, pensions should be considered early in the process and on a case-by-case basis.