Defined contribution pensions and bankruptcy – the current state of play
In 2015, individual insolvencies in the UK dropped to their lowest levels since before the 2007–08 financial crisis.
According to the latest figures from the Insolvency Service, however, they have been trending upwards since then. And with Brexit uncertainty around the corner, there is a possibility that numbers could carry on rising.
Given that a pension is typically one of a client’s single largest assets, it’s worth having an understanding of the legal and regulatory background in this area and the extent to which a pension would be protected in the event of a client’s bankruptcy.
As we will see, it’s an area that’s seen a few twists and turns in the last few years, and the current picture is slightly blurrier than one might hope.
The Trustee in Bankruptcy
Before we examine this in detail, it’s useful to have a quick look at the bankruptcy process and, in particular, the role of the Trustee in Bankruptcy (TIB).
The main purpose of the insolvency process is to realise the debtor’s assets and distribute them fairly to the debtor’s creditors, and this is what the TIB is responsible for.
The TIB will usually be an Official Receiver (who is an officer of the Insolvency Service). In some cases, however, the Official Receiver will appoint a private insolvency practitioner to act as TIB.
Either way, the TIB’s powers are wide-ranging and they have the authority to investigate the debtor’s affairs, sell their assets and distribute funds.
From a legal perspective, a key point to note is that the debtor’s property vests in the TIB. In other words, the TIB automatically takes over legal ownership of the debtor’s property, meaning the TIB can decide what to do with it.
Property can include investments, so a TIB could conceivably claim any assets held by the debtor in an ISA, a dealing account or in their own name (e.g. certificated shares).
Investments held in a pension scheme, however, are treated differently.
How are pensions dealt with?
The key piece of legislation here is the Welfare Reform and Pensions Act 1999. Among other things, this act was responsible for launching stakeholder pension schemes and for introducing pension sharing on divorce.
From a bankruptcy perspective, it also provided a statutory footing for carving out pensions and putting them beyond the reach of creditors.
This was a deliberate policy intention by Parliament and it followed up on recommendations from the Pensions Law Review Committee chaired by Professor Goode earlier in the decade.
In practice, this means that pensions do not automatically vest in the TIB. They cannot therefore be claimed outright like other assets.
It’s important to note that this only applies to pension schemes that are registered with HMRC, which the legislation refers to as ‘approved pension arrangements’. This means that schemes like EFRBSs might not have the same protection.
How can TIBs get money out of pension schemes?
A TIB is not completely without recourse, however. And the Insolvency Act 1986 provides them with two mechanisms by which they may be able to claim pension funds:
To claim excessive contributions, a TIB must persuade the court on two points. Firstly, they must argue that the contributions were paid with a view to putting them beyond the reach of creditors. Secondly, they must demonstrate that the contributions were excessive in view of the debtor’s personal and financial circumstances at the time.
To the best of our knowledge, there is no officially reported case law on excessive contributions, so it’s difficult to provide much guidance on how a court might assess such a case. Anecdotally, however, we are aware of a small number of cases having been successfully pursued.
Income payments orders, on the other hand, are a lot more common. Here, a TIB must persuade a court that the debtor is receiving income from a pension that is beyond their ‘reasonable domestic needs’. If there is such a surplus, a court may grant an order for the TIB to claim some or all of it.
If the debtor has a defined benefit scheme pension or a lifetime annuity, there is an obvious source of regular guaranteed income that the TIB can point towards, making an income payments order reasonably straightforward.
Where the debtor has a drawdown fund, however, it’s less clear to what extent a TIB is able to claim income, particularly if the debtor is drawing ad hoc irregular amounts or even no amounts at all.
Forced crystallisation – recent court cases
The legislative provisions, as described above, had been in force since 1999, so were well-established and accepted law.
That was until the 2012 High Court case of Raithatha v Williamson. This marked the start of a chain of developments leading us to the somewhat nuanced position we now have regarding pensions and bankruptcy.
Raithatha related to income payments orders and whether they could be applied to defined contribution pensions that weren’t yet in payment.
The TIB took the line that because the normal minimum pension age was 55, a debtor ‘became entitled’ to the pension income on their 55th birthday. The TIB then successfully argued that, regardless of whether the debtor had elected to crystallise their pension, an income payments order could be applied based on the theoretical entitlement that existed.
In practice, this meant a debtor could be compelled by the TIB to crystallise their pension, following which the TIB could apply an income payments order to it.
A lot of commentators viewed this as a somewhat controversial decision and not entirely in keeping with the spirit of the legislation.
Many therefore welcomed the decision in a later High Court case in 2014 of Horton v Henry, where a different view was taken.
In Horton, the facts of the case were virtually identical to Raithatha. Unusually, however, the judge declined to follow Raithatha on the basis simply that it was wrongly decided. Here, the judge held that the debtor only became entitled to pension income once the pension had been crystallised.
This left TIBs, debtors and their legal advisers in a somewhat awkward position given they were faced with two conflicting cases from courts of the same standing.
Thankfully, this was cleared up in 2016 when Horton was taken to the Court of Appeal. Here, the appeal was dismissed on the basis that the right to elect how to receive a pension is part of a bundle of contractual rights that remain vested in the debtor (and not the TIB). At age 55, the debtor only becomes entitled to a ‘right to elect’ not a ‘right to payment’.
Under section 333 of the Insolvency Act 1986, the debtor has a general duty to cooperate with the TIB. The judge also noted that this section could not be used to compel the debtor to crystallise.
The end result is that Raithatha has been rolled back, and an uncrystallised pension fund is beyond the reach of an income payments order. A TIB cannot force a debtor to crystallise their pension.
Life after Horton
There is another court case of note – this being Hinton v Wotherspoon, which was heard in the High Court in 2016.
Strictly speaking, Hinton was heard before the Horton appeal, but it still followed the Horton first instance decision, which was later upheld. It was interesting as it provided some insight into how an income payments order might work in practice in a defined contribution pension scheme.
In this case, the judge commented that the mere presence of a drawdown fund was not sufficient on its own to create an ‘entitlement’ to income. It was only once the debtor had actually elected to draw an income that an income payments order could be granted against it.
It’s worth noting that these comments were outside of the main judgment, so they are not technically binding, although another court would certainly take them into account if the same scenario arose again.
Insolvency Service guidelines – a sting in the tail
This was not the end of the matter, however.
While Horton was waiting to go to the Court of Appeal, there was a further twist in March 2015. This came not from a court case but from the Insolvency Service, and it centred on the publication of their updated guidance to insolvency practitioners.
In a move clearly anticipating the pension freedoms that were due to take effect in April 2015, the updated guidance said that if a debtor is aged 55 or over and has uncrystallised funds, the debtor has the accessible wherewithal to meet their debts.
What this meant in practice was that if the pension exceeded the level of debt, the debtor might not be able to become bankrupt in the first place.
This was a slightly surprising move. While it’s understandable to look out for the interests of creditors who find themselves out of pocket through no fault of their own, it appears to go against the policy aim of the Welfare Reform and Pensions Act that pensions should be protected. Perhaps more importantly, it is an approach that has had no parliamentary or judicial scrutiny.
While it’s not yet clear how the amended policy is being applied in practice, if nothing else it seems to allow a fair degree of discretion at that initial phase. And where there is discretion there is often uncertainty.
So where does this leave us
From a legal standpoint, it is clear that pensions are (broadly) protected. Pension funds cannot be claimed outright. A debtor cannot be compelled to crystallise their pension.
From a broader perspective, however, this protection may be academic if a debtor finds they have no choice but to access their pension before they can apply for bankruptcy in the first place.
Are pensions protected under bankruptcy? The short answer must therefore be yes and no.